Hi, sounds like we are ready to start. Good morning, everyone. My name is Joanna Gajuk. I'm a Bank of America Healthcare Facilities and Management Analyst. Thank you so much for joining the conference, and thanks for joining this session. It's my pleasure now to host the next 30 minutes with Encompass Health, who's the largest operator of inpatient rehab facilities in the U.S.. Today with us, we have Doug, who's going to introduce Brad. Doug, excuse me, is the CFO of the company. Brad, I guess maybe you introduce yourself too.
I'll introduce Brad very quickly if I may, Joanna. First of all, good morning, everyone. Thanks for your time and consideration this morning. Brad Kennedy is our Group President at Encompass Health. Brad started with Encompass Health 15 years ago. He was a physical therapist, but by the time he joined Encompass Health, he had risen to hospital CEO. As Group President, Brad now oversees three of our eight geographical regions and is responsible for 60 of our 167 hospitals. So very pleased to have Brad up here, a voice that perhaps many of you in this room don't get to hear from too often.
Great. Thank you so much. Yes, we go right into the Q&A. The topic of the quarter was volumes in the quarter were very, very good. Maybe walk us through how we should think about this translating to the rest of the year and going forward. I guess you do have your long-term guidance for volumes, 6%-8% organically. How much, I guess, is coming from bed additions and de novos and such, and how we should think about this translating 2026 and forward.
Yeah, so for a period of time, we've had a long-range target of discharge growth of 6%-8%. That is a multi-year CAGR. We anticipate that there will be fluctuations from quarter to quarter based on things like what our comparable from the prior year is, and also when new capacity is being added and the ramp up of that new capacity. Having said that, we've been pretty steady. For the last 11 quarters, we've had total discharge growth that exceeded 6%. For those same 11 quarters, our same store growth has exceeded 4%. We were very pleased with our growth in the first quarter because we were up against a very difficult comp from last year. Last year, in the first quarter, our total discharge growth was 10%. That was aided by two factors.
First, and it does make a difference, is the first quarter of last year included an extra day because of leap year. The second is the first quarter of 2024 ended on Easter Sunday. What we have observed historically is when you have the quarter end on a holiday, which is rare, but sometimes Easter comes into play, it has the effect of pulling forward discharges that might otherwise have occurred in the first week of the second quarter into the first quarter. You know, we continue to hold to that long-term discharge growth pattern. Again, it will fluctuate based on when capacity is coming on board. If you just do a comparison of 2025 to 2024, our capacity additions for this year are heavily weighted towards the back end of the year.
We're opening up seven de novo hospitals in 2025, and five of those openings are occurring after September, whereas in 2024, we had many more of those openings occurring in the spring. Generally speaking, we would expect the breakdown between new store and same store discharge growth to be about two-thirds same store and the balance in new store.
Talking about the new store, right, you recently raised your targets in terms of the bed additions for this year and also the next two years. Maybe you can remind the audience in terms of the economics, the returns you target for bed additions versus de novos.
Yeah, so first, a real why in terms of why we increased the bed expansion activity is that our occupancy rate has been going up pretty rapidly. In the first quarter, our occupancy rate was at 78.8%. That is the highest it has ever been. That was an increase of 210 basis points over an already high occupancy rate that was observed in the first quarter of 2024. It is important to note that we have been systematically increasing the theoretical occupancy rate of the company by increasing the portion of our overall portfolio that is comprised of private versus semi-private rooms. As a point of comparison, if you go back as recently as the end of 2020, about 40% of our overall portfolio was comprised of private rooms, and the balance was in semi-private rooms.
The breakdown between those two is important because your occupancy level is always going to be higher if you've got more private rooms, and that is due to the fact that you do not have to account for issues of gender or germ compatibility. It is also the case that just given the conditions that we are treating in our hospitals, a high percentage of our patients come to us with some form of cognitive impairment, and that can require patient isolation as well. As a result of really three initiatives, one is the fact that all of our de novo activity is comprised of private rooms. Almost all of our bed expansion opportunity is comprised of private rooms.
When we are doing remodels of older hospitals, which have semi-private rooms, which was a convention as recently as 10 years ago, we try to take the opportunity to convert some of those into private rooms. We have lifted the percentage of our portfolio that is comprised of private beds at the end of the first quarter to 56%. A very substantial increase. Even with that, it is a high-class problem at a 70% occupancy rate, and that is not evenly distributed across all of our hospitals. We identified some opportunities based on sustained growth that we have been realizing over several years to pull forward some bed expansions that were otherwise likely to occur in 2027 or 2028 into 2026, and that will increase our overall capacity. The returns on bed expansions are the highest return that we get on a deployment of capital.
That is because we are building into a market where the demand is already known, just justifying the bed expansion to begin with. We are leveraging components of the fixed infrastructure and the administrative staff. We already have payer contracts and referral sources in place. It is not infrequent that we will see a return on a bed expansion with an IRR that is north of 30%. Basically, we will take all of those opportunities that we can get. We have increased the targeted number of beds that we will be adding to existing hospitals for each of 2026 and 2027 to about 120 each. Again, look forward to additional opportunities to be able to do that.
You said 30% on the beds, and could you compare it to de novos when you build completely new facility? How are the returns on those?
We look at the de NOVO returns a couple of ways. The first is that we want the ROIC by the end of year three of a de NOVO opening to exceed our weighted average cost of capital. When we're looking at the IRR on those, it's typically in the 12%-15% range. We've got a pretty good track record of being able to exceed those targets.
Right. No, these are very attractive numbers. I guess explain why you're feeling strongly about the ability or the reason why you're going to accelerate, like you said, the bed expansions and such. Maybe, Brad, you can talk about it sounds like you oversee a good chunk of the company. Maybe kind of walk us through the plans in your regions in terms of the de novos and also maybe give us some examples of the success stories or how you're kind of looking at how, I guess, the strategy is playing in real life.
Absolutely. I think what underpins this growth is the aging demographic. We are experiencing those demographic tailwinds. One out of every five Americans will be over age 65 by the year 2030. That is our cohort over age 65. In fact, our average age patient is 77. We are experiencing those demographic tailwinds. Additionally, when we identify a market that has the possibility for de NOVO, we take a very data-driven approach to our due diligence. We look at what the competitive landscape is, the demographics of the market, the divergence of the supply and the demand in that particular market, how fast the age 65-plus population is aging in that market. We look at the Medicare Advantage penetration. We look at labor costs, land costs, what potential construction costs would be. We even look at the proximity to an existing hospital.
I want to share our success stories with that strategy in my region. We have used that strategy in several of our larger markets, such as Houston, St. Louis, Atlanta, some of our markets in Florida. Even here in Las Vegas, we have three hospitals proximate to each other. We realize some economies of scale with that situation because we're able to share staff freely. We're able to share medical staff freely. Also, importantly, two of these strategies were implemented along with two major joint venture partners, BJC Healthcare in St. Louis and Piedmont in Georgia. We aligned ourselves with each other's growth strategy, and we determined that we could expand to align with our joint venture partners' footprint so there would be overlap. That has been very successful in both markets. In St. Louis, we started with one hospital in 2001.
Since 2017, we've both opened an additional hospital and two additional satellites. In Georgia, we are now up to seven operating JV hospitals with Piedmont, and one is under construction.
I guess maybe just touch a little bit more on that JV strategy, right? Is there also some numerical thought process there, kind of the returns on a JV, non-JV? Because it sounds like there's some benefits, clear benefits for any JV partner.
It's part of our due diligence. When we are looking at a market, we look at how many acute care hospitals are in the market, what are the individual market shares for those acute care hospitals. We look at whether an acute care hospital has an in-house inpatient rehabilitation unit. Is it operating well? Do they have opportunities with their length of stay in the acute care setting, readmission rate, things that we can help them with? We are a very attractive partner for acute care hospitals for different reasons. Typically, they actually come to us. One reason, maybe they want to add IRF to augment their continuity of care. They need a partner to help them do that. Another reason may be that they are operating an in-house inpatient rehabilitation unit. It's either not operating well, or they need that space for another service line.
They come to us to help them roll those beds out. We absorb the beds and roll them out into a freestanding hospital. JV partners are about 40% of our book of business, and we have a very robust pipeline. In any typical moment, about 50% of our pipeline consists of potential JV partnerships. We see that as an upside.
From pure financial return, there's not a very distinct difference between a JV and a wholly owned hospital, but there are two advantages that a JV structure brings to the table. One is, as Brad mentioned, most frequently when we're doing a JV, we're having them contribute a unit that's housed within their acute care hospital into a new freestanding IRF. That gives us an immediate boost in the out-of-the-ground ADC or average daily census. The ramp-up tends to be a bit faster in the joint venture opportunities. The second is we get a management fee.
On our portion of the capital, you're adding a spread that is typically 3%-5% revenue in the form of a management fee, which we think we earn, and we believe that our joint venture partners would agree with that, but it does help from a pure financial perspective boost the return.
I guess we started this conversation, you mentioned the occupancy, right? It was so high, but also inside your payer mix, right? The Medicare mix was very high. Maybe you can talk about this a little bit. Is there something that is sustainable? I mean, you mentioned that the aging demographic inside. Should we just expect kind of this to continue, or was there something else that happened in this quarter that was unusual that drove that 76% Medicare fee mix?
Actually, it was 67%.
67%. Oh, I flipped it.
Yeah. So what Joanna is referencing is in the first quarter of 2025, our traditional Medicare discharges grew faster than Medicare Advantage. That is not something we had observed since early in 2022. In the periods preceding this, Medicare Advantage discharges had been growing faster than Medicare fee for service, although both of them had been progressing at a very nice CAGR. As a matter of fact, if you take the period from 2020 to the end of 2024, our discharge growth CAGR for Medicare fee for service was north of 7% and was right at about 9% for Medicare Advantage. Seeing nice growth in both of those payer mixes. We did not take any kind of different strategic approach in the first quarter that led to that change in the relative discharge growth rates. One quarter does not a trend make.
We think there remain very good growth opportunities within both of those payer classes. We'll continue to observe that over time.
Maybe to that end, you can talk about your strategy with Medicare Advantage plans, right? You have done a pretty good job increasing that payer mix, right? Because historically, it was sort of underpenetrated, so to speak. It sounds like maybe there is still a little bit more room. Also to that end, can you talk about your contracting strategy? It sounds like you did a pretty good job on closing the gap in the rate. Can you kind of remind us where you are? Is there more, I guess, you can do with Medicare Advantage plans?
Sure. Maybe I'll start with a few of the numbers that underline that discussion. I'm going to hand it over to Brad, really, to talk about the strategy because he's one of the folks that's out there on the front line dealing with this on a regular basis. To Joanna's point, we've made a lot of progress with regard to our Medicare Advantage book of business. If you roll back the clock to as recently as 2018, Medicare Advantage in terms of our payer mix would have comprised just under 9% of our overall discharge base, and it's closer to 17% now.
Some of that is just a result of enrollment trends within the Medicare beneficiary population, but much of it has been a deliberate effort of us getting out and meeting with the plans and underscoring our value proposition, particularly around complex medical conditions like treating stroke and neurological disorders. It is also the case that if you went back to really the initial adoption or the tick up in the adoption rate of Medicare Advantage, which would have been on the heels of the introduction of the Affordable Care Act in, say, 2011, that we started with a very significant gap in terms of reimbursement rates between fee for service and Medicare Advantage. It was north of 25%. At the end of the first quarter of 2025, it was less than 2%. And so we have been doing two things in conjunction as part of our contracting.
We have been moving ou
r contracts from being paid on a per diem basis to being paid on an episodic basis. We now have more than 90% of our contracted Medicare Advantage revenues paid on an episodic basis. As we've been doing that, we've been tying those episodic rates to the Medicare fee for service rates. Frequently, when we're initially flipping a contract over to episodic, it will require us offering a discount. Then either based on quality measures being achieved or just the passage of time or sometimes both, that discount narrows. I'm going to ask Brad to talk specifically about some of the components of our value proposition.
Sure. One major difference between Medicare Advantage and fee for service is that Medicare Advantage requires pre-authorization for our services. There is a difference. Our conversion from referral to admission for Medicare Advantage is less than fee for service Medicare. We see that as upside because most of these pre-authorization decisions are made regionally or locally. Our hospital operators frequently meet with representatives from the Medicare Advantage plans to discuss our value proposition. Most Medicare Advantage plans, as Doug mentioned, now pay us a capitated rate. They also pay acute care hospitals a capitated rate. They are aiming to control the episodic cost of care. That is where we can help them. The major inflation factor for increasing the episodic cost of care is a readmission back to acute care.
Because of our value proposition, because of our clinical initiatives such as predictive analytics that help us identify patients who are at high risk for readmission, our evidence-based clinical protocols to take care of high acuity patients, and our therapy advanced technology to take care of those stroke, brain injury, neurological condition patients. Our message is resonating. In the last quarter, we saw our MA stroke mix increase by 20 basis points. We feel there is continued upside. We continue to educate the Medicare Advantage plans.
Would you say, right, because based on just the nationwide penetration, MA is maybe 53%, 54%?
In our markets, it's 54%.
Okay. So are you there or there's more, I guess, even on the penetration with MA to go for you guys specifically?
I think there's a lot more upside to get back to something that Brad mentioned, and that is the conversion rate. We look across payer classes at the percentage of referrals within a payer class that ultimately get converted into an admission. Even with the tremendous progress that we've made with Medicare Advantage, predominantly based on restrictive pre-authorization procedures, our conversion ratio for Medicare Advantage is about half what it is for fee for service. There's no reason when we look at the underlying patient base why that distinction should occur. It's hand-to-hand combat. We are armed with very good results for the patients that we are treating, and we're making progress along the way, but it represents significant opportunity for us.
Right. The topic of today is health plans complaining about high utilization and higher trend. Because of that, and I guess it is not really maybe today, but through this year and the last two years, really. Are you seeing more denials from MA plans because of that, as in they try to manage the cost better, or is it the reverse where maybe you are a beneficiary of it, as to your point, Doug, in terms of your solution to maybe some of the cost trend issue that they have with inpatient?
It varies from plan to plan. Overall, it's been pretty steady. As I said, it's really hand-to-hand combat. Brad mentioned the fact that many of the decisions, all of the large national plans operate on a very decentralized basis. That is fine with us. It just means that in each one of our geographies and each one of our marketplaces, we have to observe on a regular basis what's happening within those plans and take concerted efforts to address any areas where we feel there's not an understanding of the value proposition that we bring to the table or where there are unnecessary pre-authorization requirements that are really impeding upon the Medicare beneficiary's choice for where they should receive their care.
All right. So you're not seeing any increase in terms of denials?
No, I think it's getting modestly better. We'd like to see it move faster. If you go back and if you look at the Medicare Advantage update in 2024 that came out of CMS, it was some very specific language about the utilization differentials between Medicare Advantage and Medicare fee for service. They were really getting called out on that. We'd like to see some additional teeth behind that. We carry our own experience to the halls of CMS on a regular basis just to keep them informed about what we're observing in the field because we're the largest player in this space.
Right. I guess maybe shifting the gears a little bit to the fee- for- service. In D.C., a lot of discussions right now on a lot of different topics. At least you guys are not exposed to Medicaid discussions. As you know, there is talk of fraud and abuse and going after that. Is there any risk in your head that somehow IRFs are going to be there in terms of just part of some cuts to Medicare spending at some point? Obviously, MedPAC has been going out with this report every year and flagging that Medicare margins for IRFs are pretty high relative to, say, hospitals. Do you view this as a risk that at some point something might happen from CMS or Congress, I guess?
We do not know that there are any flashing red lights or even yellow lights. If you think about it, IRF is a relatively small segment of the overall Medicare program. We make up less than 2% of the overall expenditures on an annual basis. It is not as if that level has been rising at an alarming rate, which would signal some kind of attempted fraud or abuse. It is also the case that we are subject to numerous and frequent audits already that are authorized and administered by CMS. We talk about TPE, Targeted Probe and Educate, which goes on on a regular basis. We have got review choice demonstration that is underway in the state of Alabama. There are more audits with more acronyms than I could go through. We are a high percentage of our claims are audited on either a prepayment or a postpayment basis every year.
We prevail at very high rates. Our overall bad debt expense tends to hover right around 2%. On any comparative basis, that's very favorable. We put a big emphasis on compliance. The fact that so much of our documentation is automated through the clinical information system that we first began developing and investing in in 2011 is a big advantage in that regard.
Right. The one item that CMS, I guess, must have been already a couple of years ago, been considering around the transfer policy for home health transfer policy. They have not really come back to this idea. Do you think this is kind of like off the shelf or it might come back at some point?
You never say never, right? It's like one of those recurring characters in a Halloween horror movie and so forth. You think it's been killed several times, and it tends to raise its head. There has been absolutely no discussion of this topic at all in the last two years. Even its initial level of discussion, I think, was substantially overplayed. I think it was back in 2023 in the proposed rule, there was simply a request for comments from the industry, not a suggestion that it was going to be incorporated into the rule in coming years. Those comments were provided by participants in the industry, including us. When the final rule came out later that fall, there was absolutely no mention of the home health transfer policy. We have gone now two rulemaking cycles without any further mention of it.
We hear nothing about it in the halls of Congress or in our frequent discussions with CMS. Obviously, we're cognizant of the fact that it is one of the issues that are on the table, as are so many that have been brought up as a potential threat to the industry and never materialized. I mean, go back and think about, "Oh my goodness, you're going to go from a 60% required CMS 13 compliance to a 75%. There's going to be a site-neutral payment." All of these things come up. The fact is, and Brad alluded to this earlier, the underlying demand for the patients that are treated in the IRF setting is only growing. Those patients cannot be treated in many different settings. Somebody has got to be there to treat those patients.
To tag on to that, only 14% of presumptively eligible IRF patients actually make it to IRF in the United States. That means that there is a large portion of IRF-appropriate patients that are going to other settings, but they could be better served in IRF. We know that there is a total addressable market that is not currently reflected in the current penetrated market.
I guess we have a few minutes. There are two topics I want to hit on. Another one in D.C. around tariffs, because I'm thinking what else could be, I guess, impactful to you, because again, reconciliation bill does not seem like there is anything in there. Maybe walk us through your thought process around the supply expenses. If we get there, right, and there is some increase in costs, how are you thinking about this? Is there any mitigation strategy you might have been considering if that was to happen?
Yeah. With regard to the threat of tariffs and the story literally changes from hour to hour for all of us, right? There are two areas that we've really focused on. One is because we're adding so much capacity in the form of de novo construction and bed expansions as well, do we see anything immediately that is pressuring the cost of that construction? Again, to provide a basis, we have been running for the last several years at a cost of roughly $1.2 million per bed for de novo construction. We do a little bit better than that on bed expansions because, again, you're leveraging components of the fixed infrastructure. Those tend to run about $800,000-$850,000 per bed. In terms of the activity that is underway right now, which really covers 2025 and 2026, we're not seeing any upward pressures.
I had a discussion just last Friday with our head of design and construction. We had four projects that were put out for final bids. We had had a preliminary bid. They moved forward in our approval process internally, and we put them out for final bid. Two were de novos, and these are for projects beyond 2026, and two were bed expansions. All four of those bids came back at or below the preliminary bids. We are not seeing upward pressure on building materials right now. We are actually seeing the benefits of some slacking demand amongst general contractors and subcontractors, which is increasing capacity and influencing price. The answer there is for the foreseeable future, we are not seeing any pressure on building supply costs or construction costs from the tariffs. The second area that we look at are our variable supplies.
When a patient is in our facility, we're responsible for feeding them every day and also for all of our medical supplies, including we are responsible for administering and covering the pharmaceuticals that our patients are on. That is not insignificant because on average, a patient in one of our facilities is on nine different medications. Thus far, we have not identified any upward pressures. We worked with Vizion for many of our supply chain strategies. Much of that was reordered out of necessity during COVID. We will continue to keep an eye on that. As of right now, we're not anticipating any upward pressures that would influence our guidance.
Great. No, thank you. One more left. Another topic or my interest around if free cash flow is pretty good, right, and leverage is already low. How we should think about deployment. Obviously, you've increased your plans in terms of spending money on beds and de novos and such, but what else, I guess, you can do? In terms of can you also talk about the leverage targets?
think it is we are an and story, not an or story, Joanna. 2.0 in terms of the leverage rate that we are currently at right now feels like the old 3.0. I think that there is an appreciation within our investor class that we hear about frequently for maintaining a lower degree of financial leverage. We are in a fortunate position to be able to do that and not be constrained in terms of the capital that we can deploy towards our best use, which is expanding capacity of our systems with the de novos and the bed expansions. We talked earlier about the fact that we have raised that target. We are now complementing that with share repurchases. In the first quarter, we repurchased $32 million of our stock. Interestingly enough, that was more than we had purchased in all of 2024.
We expect to continue pulling that lever.
Great. This is right on time. Thank you so much.
Great. Thank you, everyone.
Thank you.
This is Mike Riskin on the Bank of America Life Science Tools and Diagnostics teams. I'm excited to host Revelie for our next session. I'm joined by Max Karkovic, Senior VP and CFO. Max, thank you for being here.
Yeah, thanks for having us, Mike.
Kick things off, our opening question, sort of you reported one Q recently, gave an update on the guidance. Could you talk us through how the quarter played out? Sort of what are the big changes? Obviously, there's a lot to unpack there, but give us a high-level overview, and then we'll attack each of the points separately.
Yeah, sure. I would say overall, first, the first quarter was, I would say, solid performance. Obviously, a little bit different macro environment than what we had assumed at the time of our initial 2025 guidance. I think the sort of three main takeaways, I would say, from our first quarter earnings call is, one, the beauty of our portfolio. I think it has been a big part of the transformation. You can see the strength in our diagnostics business as well as our software business that continue to perform extremely well. I would say the second piece is we had appropriately prudent guidance to start off 2025. I think we had baked in for some uncertainty. Did not know the level of or extent of change, but I think that was a very appropriate prudency.
It is part of the reason why we are able to maintain our full-year guidance despite a weaker macro backdrop. The third thing I would say is really our ability to execute. I am sure we will talk about tariffs today, but our ability to sort of hold our full-year EPS and operationally mitigate the majority of the tariff headwinds sort of exiting the second quarter here, I think, is a testament, again, to our ability to execute.
Okay. Let's pick it up right there on the tariffs and the mitigation front. Can you expand a little bit on your mitigation strategy, how that's being implemented, the timing of that, phasing out over the course of the year?
Yeah. Maybe to just to reframe for everyone to how we sort of talked about tariffs on the earnings call. For us, we framed it at about $135 million of gross tariff headwinds. We said the net impact was roughly $0.12 of EPS after the operational mitigation. When you think about that, it's majority in the second quarter. We were really able to operationally mitigate the headwinds here in the second half with a lot of supply chain actions, but then also some additional belt tightening.
Why are you able to, or how are you able to implement the mitigation steps so quickly? Because I think a lot of other peers have talked about taking most of 2025, in some cases, into 2026. By the end of Q2, is this sort of from an end market perspective, from a geo perspective, just sort of walk us through that?
Yeah, I'd say there's really probably two main drivers.