Good morning, everyone, and welcome to Encompass Health's Third Quarter 2019 Earnings Conference Call. [Operator Instructions]. 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 Crissy Carlisle, Encompass Health's Chief Investor Relations Officer..

Thank you, Operator, and good morning, everyone. Thank you for joining Encompass Health's Third Quarter 2019 Earnings Call.

With me on the call in Birmingham today are Mark Tarr, President and Chief Executive Officer; Doug Coltharp, Chief Financial Officer; Barb Jacobsmeyer, President Inpatient Rehabilitation Hospitals; Patrick Darby, General Counsel and Corporate Secretary; Andy Price, Chief Accounting Officer; Ed Fay, Treasurer; and Julie Duck, Senior Vice President of Financial Operations; April Anthony, Chief Executive Officer of our Home Health and Hospice segment, also is participating in today's call via phone.

Before we begin, if you do not already have a copy, the third 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, such the expected impact of new CMS rules, which are subject to risk and uncertainties, many of which are beyond our control.

Certain risks and uncertainties 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, the Form 10-K for the year ended December 31, 2018, and the Form 10-Q for the quarter ended March 31, 2019, June 30, 2019, and September 30, 2019, 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, reconciliations to the most directly comparable GAAP measure is available at the end of the supplemental information, at the end of the related press release and is part of the Form 8-K filed yesterday with the SEC, all of which are available on our website. [Operator Instructions]. With that, I'll turn the call over to Mark..

Thank you, Crissy, and good morning, everyone. We're very pleased with the strong volume growth achieved in both of our segments in the quarter. On the inpatient side, total discharges increased 5.5% with 3.1% coming from same-store hospitals. Home health total admissions grew 22.7%.

Within that total, same-store admissions grew 9.7%, while the recently acquired Alacare locations contributed 11.6%. Hospice admissions grew 40.4% with Alacare contributing 32.3%, and same store is growing 5.8%. On a consolidated basis, revenues grew 8.8% and adjusted EBITDA increased 3.3%.

On a year-to-date basis, revenues were up 7.5% and adjusted EBITDA was up 7%. Doug will provide the specifics for each of our operating segments in his comments. During the quarter, we made excellent progress on our development opportunities.

We continue to expand our portfolio of inpatient rehabilitation hospitals by opening a new 40-bed joint venture hospital in Boise, Idaho, our first hospital in that state. We also opened a new 20-bed hospital in Katy, Texas, and added 31 beds to our existing hospitals, bringing our year-to-date bed additions to 112.

In addition, as a result of discussions with our partner to amend the joint venture agreement, governing our Yuma rehabilitation hospital in Arizona, this 51-bed hospital changed from the equity method of accounting to a consolidated hospital effective July 1.

Our development pipeline for IRFs remains robust with our new 50-bed hospital in Murrieta, California, nearing completion. 3 new hospitals already scheduled to open in 2020, and 2 more scheduled to open in 2021.

On July 1, we closed the acquisition of Alacare Home Health and Hospice, which added 23 home health and 23 hospice locations across Alabama to our portfolio, including 3 new overlap markets.

The IRF openings in Boise and Katy also created new overlap markets for us, bringing our total overlap markets to 88, and enabling us to expand the benefits of clinical collaboration to more patients.

Our 2 segments are doing an outstanding job working together to integrate CARE delivery and achieved a 35.6% clinical collaboration rate in the third quarter of 2019. A 130 basis point increase over the third quarter of 2018. We also continued our focus on meeting the needs of patients recovering from strokes.

Earlier this year, along with American Heart and Stroke Association, we released the co-branded Life After Stroke guide as part of our efforts to continue to educate physicians, payers and patients on the efficacy of stroke rehabilitation in an IRF setting.

In the first half of 2019, approximately 37,000 Life After Stroke guides were downloaded from the AHA/ASA website or distributed in hard copy form via hospitals. In addition, we have expanded our social media reach to include AHA/ASA channels, resulting in expansion of our digital audience by over 8 million people.

Progress also continues in our development of post-acute solutions that focus on improving patient outcomes, and lowering the cost of care by reducing hospital readmissions across the entire episode of CARE. We currently have 9 pilot sites for our 90-day post-acute readmission prediction model.

All these sites are in overlap markets and clinically collaborates with our home health agencies. As we continue to refine this model, we are also preparing a readmissions prevention playbook that will be part of the broader rollout of this model to all of our hospitals in 2020.

On a regulatory front, our focus remains on the reimbursement changes impacting each of our segments. Effective October 1, our hospitals transitioned to the CARE tool payment system for inpatient rehabilitation hospitals. We believe our teams were fully prepared, and I thank them for their tireless efforts in regards to this transition.

During the third quarter of 2019, we conducted training on the new functional outcome measures for all 20,000 plus of our clinicians across our entire portfolio of hospitals, including documentation requirements and system changes.

Our focus on this education continues to improve inter-rater reliability and our clinical documentation, which in turn is allowing us to revise our expectations for Medicare reimbursement rates.

We now estimate the new payment system will result in Medicare reimbursement rates for our company that will be flat to up 50 basis points in the fourth quarter of 2019 and for the first 3 quarters of 2020. In Home Health, we continue to prepare for the implementation of the Patient-Driven Groupings Model, or PDGM.

Based on our continued analysis of available data and information, we now believe the implementation of PDGM on January 1, 2020, will decrease our Medicare reimbursement rate by 1%, net of the 1.3% net market basket update. This estimate excludes the 8% proposed base rate reduction and any potential impact from the assumed behavioral adjustments.

Recall that CMS assumed provider behavioral changes will offset the proposed 8% reduction in the base rates. It is difficult with any level of certainty to estimate how much of the assumed behavioral changes we can realize. As the largest assumed behavioral change is related to coding, and coding is a patient-by-patient matter.

As we await CMS issuance of the final rule, we remain hopeful that CMS will be responsive to our many requests to eliminate or at least moderate the impact of behavior-related base rate reduction in 2020, possibly spreading the impact over a multiyear period rather than risking destabilization of the industry with a large single year-adjustment assumption.

In the meantime, we have continued to pursue legislative relief.

We are both encouraged by the significant bipartisan support we are receiving in both the House and the Senate, and are pleased that legislators understand our concerns regarding the potential negative implications to beneficiaries and provide alike, resulting from CMS' assumptions about what behavioral changes providers may undertake any future.

In the meantime, we remain focused on utilizing technology to drive incremental efficiencies as we prepare to implement PDGM. As we've stated previously, neither of the new payment systems for our operating segments changes the long-term outlook for our company.

An outlook predicated on the demographic trend driving increasing demand for the services we provide. We believe we are well positioned as a company to work through these changes and have a proven track record of being able to do so.

Based on our results for the first 9 months of 2019 and our current expectations for the remainder of 2019, we are affirming our full year 2019 guidance for net operating revenues, adjusted EBITDA and adjusted EPS. The reaffirmed ranges can be found on Page 15 of the supplemental slides that accompanied our earnings release.

With that, I'll turn it over to Doug..

Thank you, Mark, and good morning, everyone. Mark summarized the consolidated revenue and EBITDA results, so I'll begin with cash flow and the balance sheet. I'll then discuss the revenue and EBITDA drivers for Q3 when I move into the operating segment results.

Adjusted free cash flow for the first 9 months of the year was $379.6 million as compared to $424.8 million for the same period last year. The year-over-year decline primarily related to increases in net working capital and more specifically to the increased accounts receivable related to TPE activity in both segments.

Our updated assumptions for 2019 adjusted free cash flow can be found on Page 17 of the supplemental information.

These assumptions result in an expected adjusted free cash flow range for 2019 of $435 million to $510 million, up modestly from our previous range of $425 million to $505 million, primarily due to a downward revision in our expected cash payments for income taxes.

During September, we took advantage of highly favorable conditions in the debt capital markets and issued a $1 billion in new senior notes divided evenly between $500 million of 4.5% notes due in 2028, and $500 million of 4.75% notes due in 2030.

A portion of the proceeds from these notes was used to repay the principal balance of our revolving credit facility, which had been used to fund a $100 million call of our 2024 senior notes, the $217.5 million acquisition of Alacare and the $48 million DOJ settlement all in the second quarter.

Additional proceeds from these notes were used to fund the purchase of Home Health rollover shares and the exercise of stock appreciation rights in Q3. Proceeds from these notes will also be used to fund a further $400 million call of our 2024 senior notes, which will settle on November 1.

Our pro forma leverage ratio at the end of Q3 after giving effect to the aforementioned use of proceeds was 3.2x, with the capacity under our revolver replenished and our debt capital structure further enhanced by increased duration and the relatively low coupon rates on the new notes.

Following completion of the pending $400 million call, we will also have reduced our largest debt maturity of 5.75% 2024 senior notes from approximately $1.2 billion at the beginning of the year to approximately $700 million. We continue to augment the returns of our operating investments with shareholder distributions.

Through the first 3 quarters of 2019, we have paid $81.3 million in cash dividends on our common stock and repurchased $45.9 million of our common shares. Moving now on to the business segments, IRF segment revenue for Q3 increased 5.7%, driven by discharge growth of 5.5% and a 1% increase in revenue per discharge.

Revenue growth for the quarter was unfavorably impacted by a 20 basis point increase in reserves related to bad debt and a reduction in outpatient and other revenue, primarily attributable to the inclusion of $4.5 million in business interruption insurance recoveries in Q3 '18.

Same-store discharge growth for Q3 was 3.1%, it was negatively impacted by approximately 20 basis points due to the ongoing effects of Hurricane Michael on the Panama City market. Our trend of positive traction with Medicare Advantage plans continued in Q3. MA discharges grew 21.6% in Q3 and are up 18.1% year-to-date.

Revenue reserves related to bad debt increased to 1.5% as compared to 1.3% in the prior year period, primarily due to increased TPE denials. During Q3, we experienced our highest level of new denials, $11.3 million since Q2, 2017. Approximately 85% of the TPE activity was generated by Palmetto.

As we have stated previously, we have anticipated since our transition to Palmetto in February 2018 that at some point, they would initiate reviews. TPE notices were received by 30 of our hospitals, and none of those have progressed to round 3. We also had our highest level of collections of previously denied claims Q1 2018.

And although, we did see a higher number of claims resolved through the ALJ adjudication process, no progress has been made on resolving the large backlog. SWB as a percent of revenue increased 130 basis points over Q3 '18 to 52.6%.

The increase in SWB occurred in spite of consistent year-over-year labor productivity as evidenced by employees per occupied bed, or EPOB, of 3.48 as compared to 3.49 in Q3 '18. There were 4 primary factors driving the increase in SWB.

The aforementioned $4.5 million in business interruption insurance recoveries in Q3 '18, and the year-over-year increase in reserves related to bad debt accounted for 20 basis points and 10 basis points, respectively. Preopening expenses and the ramping up of new stores accounted for an additional 40 basis points.

Since May of this year, we have opened 3 new hospitals. Each of these hospitals is larger than the 3 hospitals we opened in the similar time frame last year, and each began operations in a higher occupancy level than those opened in the prior year. While this is good news in the long run, it increases cost in the near term.

Finally, training and orientation on the CARE tool in preparation for the October 1 transition accounted for 30 basis points. The past 12 months, we have been focused on working with our hospitals to improve the documentation that captures a patient's functional abilities under the new measures.

A majority of this training had been focused on a limited number of individuals at each hospital so as not to distract the majority of our employees from accurately FIM, which until October 1 remained the basis for our reimbursement.

As Mark described in his comments, we expanded our CARE tool preparation activities in Q3 by conducting systemwide training involving all of our 20,000 plus clinicians. This resulted in approximately $2 million of increased training cost as compared to Q3 '18.

The new payment system is complicated and is very different from the FIM assessment we have used for years, and we will be investing in incremental training costs throughout Q4. As a result of these factors, IRF segment adjusted EBITDA for Q3 declined by 1.1%, but remains up 2.2% on a year-to-date basis.

Moving now to our home health and hospice segment, revenue increased 19.5% in Q3 with Home Health revenue up 14.2% and Hospice revenue up 53.7%. Home Health revenue growth was driven by volume with admissions increasing 22.7%, inclusive of 9.7% same-store admissions.

Home Health revenue per episode for Q3 declined by 50 basis points, primarily due to the patient mix of the former Alacare locations. Excluding the impact of the former Alacare locations, Medicare revenue per episode was up 1.8% in Q3.

The Q3 increase in hospice revenue was largely attributable to the Alacare acquisition, but also included same-store admissions growth of 5.8%. Hospice ADC for Q3 climbed to 3,843, a 58% increase over the prior year period. During Q3, we continued to see positive trend in caregiver optimization.

With visits per episode of 17.3% down from 17.6% in Q3 '18, and cost per visit held relatively flat at $78 as compared to $77 in Q3 last year. Support and overhead cost increased as a percent of revenue in Q3, primarily due to the integration of Alacare.

As a result of these factors, home health and hospice segment adjusted EBITDA for Q3 increased 17.6% over the prior year period to $50.8 million. And now, operator, we'll open the line for questions..

[Operator Instructions]. Your first question comes from the line of Matt Larew with William Blair..

I wanted to ask about the two updates to reimbursement dynamics in 2020. On the first side, it sounds like this is sort of a distribution of the training from a select number of employees more broadly, and that kind of gives you better confidence on the range for 2020.

On PDGM, could you just give us a sense for what's driving that? It looks like a 200 basis point -- over 20 basis points increase in your expectation for next year? And whether there's any potential additional upside from additional learnings on the PDGM side?.

Matt, this is April. So regarding the PDGM question. As we dug a little bit deeper into the CMS agency level impact file, which was the basis of the 4.1% we had originally reported, what we discovered was that CMS had included in that file the individual agency impact of some of the 8% behavior adjustment.

So they had sort of mixed the buckets together a little bit. And as a result, when we began to cull through that file and realized that, what we found is that at about 1.8% was -- of our 4.1% impact was the result of the behavior adjustments that we would not be able to realize based on our mix of patients.

And so it was really kind of a classification component between the base rate implications and the assumed behavior change. We call that out because the reality is if the assumed behavior changes are to alter as a result of the final rule or potential legislation, we wanted to be clear what the starting point was for the impact there.

And so I would say, it's not as much of an improvement as it is a reclassification..

Matt, we've been focused on trying to separate the two.

The impact on our pricing from PDGM specifically, and then because there's so much unknown about the status of the base rate reductions that are proposed because of the assumed behavioral changes in about each individual provider's ability to make those behavioral changes as we did in Q2, we tried to separate the buckets.

What we discovered is that the CMS file that we had used that appeared to us and all other providers to be solely focused on the PDG impact also included, for each provider, a full amount of the proposed base rate reduction and then the CMS's assumption about the maximum level of the behavioral adjustment each provider would be able to make.

We were able to reverse engineer and take that out. And the impact that we're giving you now, 1%, is our true estimate of the PDGM impact..

Okay. Understood. And then there's also a number of things you've done preparing internally, whether it's using MetaLogics and other tools to try to optimize visits, you referred to clinical utilization as well and then focusing on institution-wide referrals.

Just wondering, April, if you have any update on some of those efforts that would be sort of separate and removed from PDGM component?.

Yes. We continue to see nice progress in our improvements in productivity and optimization, as Doug mentioned earlier.

We are also seeing nice growth from an overall perspective, seeing an improvement in our sort of scale and density on a market-by-market basis, which helps leverage our overhead, but we're also seeing a nice move toward hospital-based discharges.

So not only are we growing but we're growing in the right cohort of patients that play well with the PDGM.

We think all of that combined with these enhanced technology components, which not only includes the MetaLogics CARE tool, which will help us with really redeveloping that just right CARE plan for each patient, but also enhancements that we're working with Homecare Homebase on in the scheduling module, which will further give us a new set of tools to manage productivity and optimization.

All of that combined, we think is going to help us mitigate some of the impact of PDGM, and particularly, be prepared if the same behavior changes stick as they are today..

But to be clear, Matt, the movement, the 180 basis point from 2.8% to 1% was not reflective of any changes in our patient mix from Q2 or of any mitigating strategies. It was simply understanding now that CMS had embedded some things in the estimating file that was not understood by the provider community..

Your next question comes from the line of Whit Mayo with UBS..

Maybe just my first question for April now that CMS is delaying the review choice prepayment demo. I presume this is a good thing for you, but I believe it's still coming back this spring.

So can you maybe just spend a minute talking about this, like what this delay means for you? How you're thinking about preparing for the phase and this spring alongside PDGM?.

Sure. So we knew that RCD could come back with 30-day notice at any time. We will admit to being disappointed when it came back for December 2, really 1 month before a total payment reform.

And so the industry at large really worked hard with CMS to say, hey, the timing of this relative to being 1 month before a payment change is particularly challenging, because it's going to cause agencies to have to basically create 1 set of processes for 60-day payments, and another set of processes just less than 30 days later for the two 30-day payment period.

And so we were successful at advocating with CMS that, that was really unfortunate timing. And as a result, that was part of the reason that they suspended that until March.

The reality is, I think, we are going to continue to invest at the same pace of preparation as if it had been a December 2 day recognizing that there is still some work to be done.

Primarily, working with CMS and the intermediaries to ensure that we can build an interface between Homecare Homebase to take some of the administrative burden of the process away by automating an interface between the Palmetto system and Homecare Homebase system that'll let us transmit that data more efficiently.

But we're continuing to prepare for that, fully recognizing that it'll come back in March for Texas and May for our large Florida segment. And so we're preparing for that actively now. And think that we will be prepared for it, but are certainly grateful that it got delayed so that it's all in the new PDGM era, and not half and half..

No, that's helpful. And Doug, can you maybe just spend a minute back on the MA growth in the IRF business for the quarter? Just maybe talk a little bit more strategically what you're doing to target MA.

Just remind us contracts, how they're structured and maybe how the payers are responding for FIM? And I think that the anticipated reimbursement might be expected to be lower based off the supplemental slides that you put out. Maybe I'm misreading that. So just any color around MA would be super helpful..

Yes. So we continue to see the positive trends with -- both with regard to discharge growth and then also with the movement amid increasing number of contracts, and therefore the revenues under MA being paid on a case rate basis versus on a per diem basis.

And so as I mentioned in my comments with regard to discharge growth, we were up 21% for the quarter and on a year-to-date basis, 18%. That continues to be predominantly focused around stroke and neurological.

So clearly, the MA plans are seeing the value of the IRF setting, and particularly, of Encompass Health's IRF setting around the higher acuity, more medically complex patients. So we think we've still got room to run there. We are transitioning an increasing number of those contracts to a case rate basis.

We now have about 82% of our MA revenue payed on a case rate basis versus a per diem. And the discount between Medicare Advantage and fee-for-service continues to shrink. There's some of the law of diminishing returns settling in, but we're down to about 9% in terms of the delta right there, so that is very favorable.

I think in terms of the rate assumption, the price rate increase for next year, as you move an increasing number of your contracts to the case rate basis, they're tied directly to the Medicare fee-for-service schedule, so we should see those move relatively in tandem.

I will say, if you look on a year-to-date basis for us, revenue per discharge within the Medicare Advantage plans is actually up 4.5% versus the 1.5% on Medicare fee-for-service. That predominantly reflects the fact that we're seeing more of the growth in the higher acuity patients..

But as you know we've spent a considerable amount of time selling our value proposition and focused on our outcomes, and the reduction in the readmission back to acute care hospitals.

And more and more of the MA plan are starting to recognize that and the impact on overall cost of care, and then that just ties hand-in-hand with our clinical collaboration between our facility base and home-based setting in terms of working with patients and having those great outcomes. So I think the momentum just continues to build with MA plan..

And Whit, just to elaborate a little bit because April and her team have continued to do a wonderful job also trying to lay out the value proposition for Home Health with Medicare Advantage plans. And you would think that, that would be readily apparent to many of those plans.

So they are lagging in their awareness of the value proposition that is delivered to the table by quality home health providers such as us. And so when you look at the rate differential in Home Health between MA and fee-for-service, it remains north of 20%.

And as a result, when we see the rapid growth in Medicare Advantage on the IRF side, it actually is a bit of a weight, a counterweight against the progress that we're making on the clinical collaboration rate. So specifically, we measure the clinical collaboration rate the overlap market's based on all payers.

Well, for Q3, our clinical collaboration rate for just Medicare fee-for-service, where you see the value recognition by that payer for both segments is in the low to mid-40s. The Medicare Advantage in those same markets is 12%. And so we're glad to have the growth on the IRF side and Medicare Advantage.

We think ultimately based on the efforts that April and her team have underway, and the results that they're posting that they will raise their rates appropriately for Home Health and it will be able to bring clinical collaboration up across all pairs.

But in the near term if we continue to see this kind of despaired growth in the IRF segment for MA, it's just going to be a little bit of a counterweight on the progress that we're making in the quarterly clinical collaboration rate..

Your next question comes from the line of Matthew Gillmor with Baird..

I wanted to follow-up on the reimbursement outlook for 2020 on the Home Health side.

I think I understood the changes to the estimate that Doug and April outlined, does that updated estimate also impact the figures Doug provided on the last call regarding how that will influence EBITDA next year? And if it does, could you maybe update those for us?.

Yes. It does in both segments, Matt. So if you recall, and I won't put everybody through the pain on this call of walking you through all of the assumptions, but the assumptions that we had for SWB growth, where the deleveraging was occurring, in both business segments have not changed.

And so all that has changed is the pricing impact in both businesses. And if you roll those through the same kind of analysis that I had outlined in the Q2 call, whereas we were getting to an aggregate estimated EBITDA headwind carrying the 2019 consolidated legacy business into 2020 of $79 million, which we rounded to $80 million.

You now get a range of $49 million to $59 million. So it's gotten -- depending on where we fall within the price range of the IRF side, it has gotten $20 million to $30 million better in terms of the headwind..

Okay. That's good to know. And then I wanted to also ask about the new capacity openings on the IRF side, it seems like you're running a little bit higher in 2019, especially with respect to the bed additions to existing facilities.

And I know your go-forward outlook doesn't assume a higher rate of bed expansion in the future, but I was hoping if you could just sort of update us on your feelings about the IRF development pipeline, are the demographic trends now supporting faster and faster growth? Or if 2019 just happened to be a normally good year with respect to your ability to get new beds opened?.

So Matt, this is Mark. We are very excited about what we consider to be a very robust pipeline for both new hospitals as well as opportunities for bed expansions, we don't think 2019 is just a 1-year positive blip. We see the continuing need for our services moving forward, as you noted with the demographic tailwind.

We think we are well positioned to continue to grow the company and in both of our operating segments, taking advantage of this tailwind we have..

Matt, there is always going to be a bit of a timing issue that comes into play, depending on whether or not we are able to get the doors open on Murrieta this year, which involves some approvals from California authorities, which can be a little bit difficult to predict, we'll be right at about 320 beds in total capacity this year.

And that's a good year. And we may not be able to deliver that every year but as Mark suggested, the demographics that are out there and we've referenced before, if you look back over the last decade, the aggregate supply of licensed IRF beds in the U.S. has been relatively flat.

So we see opportunities, and again, there may be some fluctuations from year to year to consider both expanding the number of de novos we're targeting on an annual basis, and also to -- as we do that, that adds more candidates for bed expansions to the portfolio. And so hopefully, we'll have the opportunity to consider raising that target as well..

Matt, we're also excited about some of the new space that we're developing hospitals in such as the Boise, Idaho project this year. We have 1 scheduled coming up for state of Iowa. So we're starting to explore some states where we think there are some great opportunities..

And you're continuing as well to see the benefits of our expertise with regard to being able to procure CONs in states that have CON requirements. We have more CONs than any of the other providers of IRF services have units.

So we have ascended a pretty steep learning curve and are able to leverage that expertise, and then throw into the mix and we're still evaluating the opportunity, the revocation of the CON requirements in Florida. And there could be some exciting things happening with regard to the development pipeline in the years ahead..

Your next question comes from the line of Kevin Fischbeck with Bank of America..

I guess question about this change in the PDGM. I guess, if I understand the way you're describing it correctly, you were saying that CMS, originally, in their impact file included the assumption for the amount of behavior just so that you would not be able to offset.

Is that 1.8% number, I guess, how do you think about that 1.8% number? Is that in total what CMS was assuming from a behavioral adjustment that you could not offset? Is that a good way to think about that 8%? And how much you might be able to do? Or is there -- is there nothing that we can really glean from that 1.8% from the outside?.

No, actually that is exactly what you should glean from the 1.8%. What Medicare is saying in that impact file is that the agency does everything that we've assumed you'll do in the proportions that we've assumed, our agencies can't realize the full 8% realization. They're going to be 1.8% light of that opportunity.

And so that's exactly what that's telling us. So in other words, in the 4.1%, they had already categorized what we could not realize of the 8% into the impact for us..

But I guess I was asking more do you agree with that CMS analysis?.

Well, it is based on older data. And so based on that data set, we do agree that, that is what they have done and that's the impact of it because they really took an episode-by-episode view and looked at all of the coding opportunities, the LUPA opportunities and the comorbidity identification opportunities.

And kind of gave it the application in the proportions that they'd expected. So we agree with the data.

The question going forward for us is, one, as the universe of patients changes and the opportunities and mix of patients from where their discharge changes, will that be an accurate predictor of the future and I think that's always in question because 2017 patients won't be the 2020 patients.

And so utilizing an older data set can be a proxy, but it'll never be an exact match with patients that we'll be seeing then.

As a result, we also can't really predict, as Mark mentioned, the coding implications of what is realizable, simply because a proportion was realizable in prior data sets doesn't necessarily mean that those coding opportunities will exist in a new set of patients that we'll identify in 2020.

What we know is that we are training our staff to understand the coding rules to apply them consistently and along with the coding guidelines that exist. And if that produces incremental revenue opportunities, great. If it doesn't, we still have to follow those coding guidelines regardless of what Medicare's assumptions are.

So we're certainly training to those rules as we always have, but we can't necessarily predict the impact that they'll have on our 2020 patient mix..

Kevin, as I said, we continue to separate, and we think it's useful to do this, the PDGM impact from both the reduction in the base rate and the assumed behavioral change.

On the PDGM impact, which is now a negative 1%, we believe that among other things, the continued evolution in our patient mix, which includes more hospital-based referrals, which has occurred since -- in the time frame from which this data was based will be available to offset or will mitigate a lot of that 1% cut.

So put it back into a flattish range. When we then look at what kind of mitigation strategies we might have that would be available to impact any portion of the proposed base rate cut.

If we don't offset by making the assumed behavioral adjustments, it's the productivity things that April has talked about, or -- but we want to remind you that we had been on that productivity train for a period of time.

And we believe that we and our margins reflect this, if we are further along that path than any of our primary competitors and as a result the same level of opportunity to use those types of mechanisms for an offset to unmitigated reductions in the base rate is not as prevalent as it is with some of the other providers..

Okay. Doug, just to clarify something that you said earlier, you said that the wage assumption for next year hasn't changed at all. I just -- you guys talked a bit more about training cost this quarter.

Did your labor assumption for next year, does that include all training costs on the new system and everything else kind of fully loaded? Or is there potentially something to come up like we saw this quarter whether there's maybe an extra cost in there above and beyond, and you're just giving us the wage inflation versus the training cost side?.

Well, so you'll have those training costs for 2019 built into the base, so if we use the same growth rates with the 3% SW, and then it doesn't really change the beneficiaries, it should cover us for most of the training.

And if we get to through the first quarter of utilization on PDGM and find that we're not generating the kind of consistency and results that we had anticipated as we now broaden the user group from numbered in the hundreds to numbered in the tens of thousands, then we may need to add to that.

It's too early in the game to say whether or not that's the case. But right now, our base assumption is that those assumptions that we used with regard to SWB inflation are sufficient to cover next year's training cost..

Your next question comes from the line of Pito Chickering with Deutsche Bank..

Can you walk us through the MetaLogics rollout at this point, what percentage of your home health agencies have adopted MetaLogics? What's the roll out timing for 2020? And we look at the agencies that have been using MetaLogics for the longest, what reductions have you realized in the business per episode?.

Yes. So we are still in the early stages of deployment. We rolled out 20 locations in the state of Texas at this moment.

We have a 4-wave rollout plan that will get us to about a 70% deployment by early March of 2020 and then the remaining chunk will come from a few of our smaller branches plus the recent addition of Alacare, that final wave we haven't put a specific time line on, but likely another 30 to 60 days after that early March time frame.

But we think we'll get the majority of the MetaLogics deployment done before the end of the first quarter.

We are seeing some nice progress, albeit on a still a relatively small scale where we're seeing visits decline as a result of the implementation of MetaLogics without any decline in quality outcomes, which obviously is the important part of that.

Don't simply want to move visits, we only want to do so to the extent we can achieve that without any dilution in quality. And our data so far with the branches that are implemented suggest that we are achieving that perfect balance of improved efficiency with no decline in outcome.

So we're encouraged by the early results there and believe that, that will continue to be the same kind of results we'll see in our further deployments of the MetaLogics CARE tool..

Okay. Great. And then just to follow up on that.

Any sort of guidelines, I've been hearing 15-plus percent reduction of visits sort of is possible using MetaLogics without any changes to quality? Is that in the ballpark of what you guys have seen?.

Yes. We would say it's probably more in the 10% range than the 15% range. It's probably a more conservative and realizable approach. As we get a little bit more further into it, we may find added opportunities. But I think we would handicap it more in the 10% range of improvement..

Your next question comes from the line of Brian Tanquilut with Jefferies..

Doug, just with all these moving parts, I know there's been a lot of discussion already on PDGM, but just going back to the slide where you showed the change in your expectation for the CARE tool impact, that improves versus the last quarter's expectation and then same thing for home health, obviously, just moving buckets.

Has your view on 2020 EBITDA changed yet in terms of how you're feeling about where that would land versus this year's EBITDA?.

Yes. I think as I mentioned previously, the primary thing that has changed is the amount of headwind that we will carry into 2020 from the 2019 base across both business segments due to deleveraging these price increases against SWB has approved by $20 million to $30 million.

And so when we think of what we need to achieve in 2020 solely on the back of volume growth, that burden has come down.

Now to do the math and again use the same math that we did in Q2, this is again before we get into any of the unmitigated portion of the proposed base rate cut in home health not otherwise mitigated, but if you kind of do the math on that $49 million to $59 million headwind, it suggests that you need aggregate volume growth depending on your margin assumptions somewhere in the 4.5% to 5% range.

And that appears to be a much more reasonable range in order to achieve consolidated EBITDA growth next year..

Makes sense.

And then as I think about SWB, with PBPM impacting this nest, are you changing the dynamic in this just on the rehab side, does that open an opportunity for you guys to see lower wage inflation, especially on the therapist side?.

You're right. It doesn't hurt and I'll ask Barb to weigh in on this. We've -- it's still early to tell what we would see across a broader portion of our portfolio, but there has been markets where we've seen some of the nursing homes have trend back on the number of therapists they have.

So just from a supply/demand and pressure on salaries, that could be an indication at least within certain types of therapists that the markets would have a little less pressure on. I'm going to ask Barb to weigh in on that..

Yes. I don't know if it'll have an impact on the salary component because we're still competing against the acute care hospitals and other different areas where therapists work in our market. I do think we're already starting to see that it is improving the availability of the therapist.

So filling our positions will hopefully be a little bit more smooth, but I don't see it impacting what we're paying them..

Your next question comes from the line of A.J. Rice with Crédit Suisse..

Just looking at some of the metrics in the quarter. Same-store admits in the Home Health business were up 9.7%, but same-store episodes were up only 3.8%.

That's one of the biggest divergences in those metrics we've seen, anything to talk about there?.

Yes, it's a little bit timing related. Obviously, as you grow the admissions, the end of episodes or 60-days delayed. So there is always a little bit of a timing lag when you see a strong growth in admission number. So we're seeing a little bit of that.

We're also seeing that we had a little bit of a decline in our proportion of recerts, part of that is certainly driven by the Alacare mix of patients differing from our historic mix. But on balance, I think as much as anything, timing is a big part of that just because of the 60-day duration of episodes..

A.J., we also have -- I'm not going to name names but we have one relatively large MA plan that elected to begin using a patient navigator. That packed patient navigator in the markets that impact us for not only us but for all other Home Health providers that use is declining recertification 100%.

But we believe that, that is going to be a short-term phenomena because they are going to see higher hospital readmissions, and then the payer will no doubt come around to a more rational approach regarding the recertification. But that was a factor that weighed on the quarter and again, we don't know that it'll go away in Q4.

But ultimately, that's going to prove to be a short-lived strategy..

Okay. And then a follow-up, just to ask about on the acquisition side.

Obviously, you had Alacare, you mentioned a couple of times, how is that trending relative to your expectation? And any other comment about pipeline generally?.

Certainly, we're pleased with the Alacare integration and how that's going so far. We think we were confident going in that, that was going to be a good fit. And now 90 days into the partnership, we're confident of that and seeing good results from our integration efforts. There are still integration efforts to be completed though.

So although we're pleased with the progress, we also recognize that integrating an organization the size of Alacare's with the vast scale they have across Alabama that that's going to be something that's going to take longer than 90 days, so we'll continue down that integration process but we're pleased with the performance.

We're pleased with the culture match and definitely pleased with the team that we've been able to bring onto our organization. On the Home Health site from a development perspective, I think we're being cautious here, certainly in the fourth quarter with PDGM upcoming, it's not the ideal time to be jumping into another's substantive size acquisition.

We're do have some smaller things in our pipeline that we think are particularly key markets that can help drive future growth. But I think you'll see us take a little bit more of a measured approach in the next 6 months as we kind of get into the first -- the planning of PDGM and then the first quarter of actual PDGM results.

And then my guess is that starting in the second quarter you will find us being very active because I think there's going to be disruption in the market that's going to create some really appealing opportunities for us to create some cost-effective acquisition opportunities in the back three quarters of next year..

Your next question comes from the line of Frank Morgan with RBC Capital Markets..

Just back to Alacare. I know you called it out specifically having some impact on some of the metrics, things like the recert rate and maybe even your overall rates. But I'm just curious what is the opportunity that you really see there.

Is there much of an opportunity to kind of change that patient mix, so that you do get better pricing for -- on an overall yield basis? And then when you think about Alacare as it relates to PDGM, are there any levers that they may have that legacy Encompass maybe didn't have because you -- because of where your labor makes was already or your business mix was already? So I guess going back to the earlier question, just the opportunity that you see there?.

Yes, we feel very encouraged by the opportunity. We think we're going to be able to slowly but surely improve the mix of Alacare. We think particularly with our hospital relationships with our IRF partners there we'll be able to further expand our clinical collaboration in those markets.

We think we'll be able to really bring some of our specialty programs that have proven to be successful for us in building organic growth, and in driving hospital relationships, our CTCs, our specialty heart programs, our specialty orthopedic programs. We think all those things are going to be available to the Alacare locations.

We generally don't start really pushing those new specialty programs into an acquisition until about the 6-month mark because we're really working on a lot of the kind of administrative changes that come with being part of the Encompass family for the first 6 months.

And then in the next 6 months, we'll really begin to focus on new program implementation there. So I do feel like we'll be able to improve their pricing as a result of that. I'm also very confident that over time, we will see improvements in their margins. That's very consistent with our experience with other large-scale acquisitions.

But again, that takes a little bit of time. We got to first get them on our processes and then we'll start to enhance the results that they can achieve once they are kind of following the right formula..

And in terms of PDGM?.

PDGM, I think, is going to be a bigger positive for the Alacare branches than it has been -- it will be for the base of the legacy business, partly because of that mix that was a bit more heavily nursing oriented than therapy oriented. And so they will get actually a little bit of a better good guy in the case of PDGM than will the base business.

And so that'll help normalize some of that rate differential in the 2020 time frame..

And Frank, just to be clear though, the 2.8% estimate that we provided in Q2, and 1% updated estimate in terms of the impact of PDGM both include our patient mix inclusive of Alacare.

Remember, part of the reason that we had the improvement in our estimate in Q2 getting to the 2.8% was because that was the first time the estimate was inclusive of the Alacare business as well as [indiscernible].

Your next question comes from the line of Sarah James with Piper Jaffray..

I wanted to get back to the fundamentals a little bit here. You've talked before about the big-picture opportunity of taking share from SNF with Encompass caring for 32,000 of 800,000 national stroke cases.

And I'm wondering if you break this down to a local initiative level, if you have an example of the traction that you've been able to achieve in a single market where you've made a push on the acute hospital and consumer education level, you've leveraged partnerships and you can kind of spike out an average case or a best case of how you've been able to move the needle on gaining share in strokes..

Sure. So from a referral perspective, we've taken a look at a lot of the Medicare claims data. And have been able to bring that to just a stroke level to show that we are more successful at admitting a stroke patient from the acute care hospital in a lower length of stay at the acute care side.

So being able to pull them sometimes a day or two sooner than a skilled nursing facility can. We are actually helping the acute care hospital manage their length of stay on those patients. But with grade, it's also the Medicare claims data, has -- have the ability to not only say we can move them quicker, but that our readmission rate is lower.

And in some instances, our readmission rate is half of what it is if those stroke patients go to a skilled facility. And so that type of information at a local market is shared with those key referral sources so that they can see the value that we bring to them and their patients.

And then from a consumer side, you're obviously using these American Heart Stroke Association strategic sponsorship to really work on educating the communities on when a patient can tolerate inpatient rehabilitation that stroke patients should be receiving in their care.

And that sort of thing in a consumer level is allowing those patients and families to be more advocates to ask for inpatient rehabilitations versus skilled care when they haven't had a stroke in their family..

Sarah, we're very pleased with our partnership with American Stroke Association.

I think it's these activities that we do collaboratively with our hospitals and the various chapters of the Stroke Association and Heart Association in the local market that does help to gain additional exposure in the differences between what goes on in an Encompass Health rehabilitation hospital versus skilled nursing facilities in the market.

So we're very pleased with that and would anticipate having continued momentum going into 2020 with that relationship..

Sarah, I think a great way to look at how we're gaining market share, both generally and then specifically around stroke is getting back to some of the numbers that I elaborated on previously with regard to Medicare Advantage. So on a year-to-date basis, our total MA discharges on the IRF side are up 80.1% and were up 17.4% in same-store.

And yet, we've modestly also increased within our Medicare Advantage book of business the percentage that is within stroke. And we know the market isn't growing that quickly, so those patients are coming from somewhere else.

Some of them are probably coming from other IRFs, but I would venture to say that the vast majority of those are coming from a SNF because of the better treatment and the efficacy of the treatment plans we have in our facilities..

Okay. That's very helpful. And then just the other side of that, being able to accommodate this increasing demand, I know you guys build out excess capacity into the footprint.

Can you remind us what leverage there is for being able to add excess beds within the existing walls or properties that you have?.

So every one of the de novos that we've built is the typical floor plan for us, is we'll build either 40 private rooms or 50 private rooms.

All instances when we're building a de novo or acquiring excess land to accommodate bed expansions, depending on the particular market opportunity, we'll buy enough land and we'll build the initial central points of the infrastructure like the therapy gym and the nursing stations and so forth to accommodate an expansion typically in 10-bed increments, up to 80 to 100.

We see very high returns on bed expansions. It is not unusual, and may even be typical that we'll typically see an IRR on the bed expansion that will be in the mid-30% range..

Your next question comes from the line of John Ransom with Raymond James..

We have heard from some of your peers that one of the challenges of PDGM is that patients that had a code in the old system did not have a code in the new system.

So I just wanted to see if you had also found that, and if so, is this bigger than a breadbox?.

Yes, John, that is absolutely the case. Back in the old kind of prior iteration of PDGM that called these questionable encounters, it sort of left them nameless in the new PDGM rule, but they are effectively codes that are less specific. Take generalized muscle weakness unspecified.

And so if you don't know the basis for why a patient has muscle weakness, you can't utilize that diagnosis any longer. And so there's certainly a cohort of patients across the Home Health spectrum within all provider groups that were using these less specific codes.

Going forward in 2020, we're going to have to work more collaboratively with the physicians to get more specificity about the basis of why a patient is experiencing a certain combination of symptoms and really make sure that we can code that more specifically.

We're also utilizing tools within the Homecare Homebase system to alert the clinicians, so that if they choose one of those codes that's no longer going to receive payment that the system is going to literally stop them and say you can't admit this patient with that code, that's no longer an acceptable code for which reimbursement will be provided, and so go back to the physician and find that.

It is something to be concerned about. Is it bigger than a breadbox? Maybe. It has the potential to be significant, if not dealt with. I don't think we'll find it being that terribly significant.

I just think it's going to take a lot more collaboration with physicians and possibly even some incremental testing that the physicians will have to do with the patients to identify the basis for the diagnoses, where in the past it was, sort of, hey, what are they experiencing?.

And so the corollary to that is, it wasn't so much can Encompass to deal with this -- it's a -- isn't this just yet another brick in the backpack of these small mom and pops, I mean, between the partial episode financing that went away and now this and then the cut.

Do you -- has your view changed about market share shifts and agency closures, just give -- the more you learn about PDGM? And if so, are we going to be a buyer or we're just going to be a let's see how bad this and maybe we can scoop up some share for not much capital outlay?.

Yes, I think you're right. I think this change is like this, just further complicate the environment for the small providers and for those who lack a sophisticated technology solution to help their clinicians manage through it. So we do think that there is going to be disruption.

To my earlier point, I think that we will probably see that disruption really begin to take hold in the second quarter, if you kind of look at the timing of the decrease in the RAP payment amount, if you look at what I think will probably be some challenges on the part of the intermediaries to even process PDGM claims in the first few weeks out of the gate.

We think by early April time frame, there are going to be some agencies that are really feeling the pain of all of this and that there will likely be buying opportunities that will either be cost-effective and that similarly there will be opportunities just to take market share where folks are either just going out of business or they've got enough issues around their business that we wouldn't be interested in buying it, but we may be able to step in and support the patients in that community, the referral sources in that community as well as hire some of those caregivers.

So I think it's going to be a little bit of both, but I do think the disruption to small-scale providers is going to be pretty significant. We'll see it hit pretty hard beginning in the second quarter..

Your next question comes from the line of Scott Fidel with Stephens..

First question just on the payer mix in Home Health and Hospice. Noticed that it was down year-over-year in MA, which obviously was quite different than we saw on the IRF side.

You may have actually answered that before, did that relate to the one large payor using the navigator and that affected it? Or just want to clarify whether there were any other factors as well?.

That was a factor and the Alacare mix was a factor too..

Okay. Got it. And then just my second question is just, do you have a total estimate of what the costs are that you're incurring in 2019 for the preparation for PDGM..

We don't have a specific estimate that we're sharing yet. The reality is it's going to be an -- kind of an ongoing training. We began those training processes really in September of this year with a large-scale leadership meeting that focused on that.

We've had a training going on this week for our preceptors around the country that are here in Dallas going through a couple day training session on the impacts of PDGM, so that they can go back and be trainers to their field locations.

And it's great to do this advanced sort of preparatory training, but I think there'll also be things that we'll learn in the first 3 to 4 months of PDGM that will cause us to have to go back and sort of reinvest and do some more ongoing training.

And so as we think about 2020, we think it's probably going to be a year of transition, it's not all going to be prepared for in advance because this is a transformative payment change, and it's going to take some time to really learn the implications of what it means to the way we care for patients and the impact of coding rules and all kinds of things.

So I think we'll see it ongoing in the Home Health division throughout the year and kind of bake that into our planning..

That concludes our question-and-answer period. I will now turn the call back over to Chrissy for closing remarks..

Thank you. If anyone has additional questions, please call me at 205-970-5860. Thank you again for joining today's call..

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