Robert Ortenzio - Executive Chairman and Co-founder Martin Jackson - Executive Vice President and Chief Financial Officer

Frank Morgan - RBC Capital Markets Peter Costa - Wells Fargo Securities, LLC Joanna Gajuk - Bank of America Merrill Lynch William Sutherland - The Benchmark Company LLC

Good morning and thank you for joining us today for Select Medical Holdings Corporation Earnings Conference Call to discuss the Second Quarter 2018 Results and the Company’s Business Outlook. Speaking today are the Company’s Executive Chairman and Co-founder, Robert Ortenzio; and the Company’s Executive Vice President and Chief Financial Officer, Martin Jackson. Management will give you an overview of the quarter and then open the call for questions. Before we get started, we would like to remind you that this conference call may contain forward-looking statements regarding future events or the future financial performance of the Company, including, without limitation, statements regarding operating results, growth opportunities and other statements that refer to Select Medical’s plans, expectations, strategies and intentions and beliefs. These forward-looking statements are based on the information available to management of Select Medical today, and the Company assumes no obligation to update these statements as circumstances change. At this time, all participants are in a listen-only mode. [Operator Instructions] As a reminder, this conference call is being recorded. I will now turn the conference call over to Mr. Robert Ortenzio.

Thank you, operator. Good morning, everyone. Thanks for joining us for Select Medical’s second quarter earnings conference call for 2018. Before I outline our operational metrics, I wanted to provide you with some summary comments and updates since we spoke last quarter. We were generally pleased with the quarter with nice growth in volume in all four of our business segments. The cash flow from operations was very strong this quarter with proceeds of over $166 million. We paid down over $96 million of our debt this quarter and we've seen a nice reduction in our leverage and we are on track to hit our year-end leverage targets. The U.S. HealthWorks integration is progressing very well and our core Concentra business continues to exhibit strong growth in terms of both rate and volume. Our Rehab Hospital business continues to achieve double-digit growth for both revenue and EBITDA for the quarter. We're able to expand our EBITDA margins despite $2.1 million in startup losses with the opening of our new Ochsner hospital. We realized nice topline growth in our core Outpatient Rehabilitation business and continue to see improvement in the Physio markets. In our LTAC division, we had nice growth in terms of patient days and admissions, but saw a reduction in our overall rate per patient day. This rate reduction had a negative impact on EBITDA for the quarter. The primary reason for the rate reduction is a shift in our Medicare patient day mix, and Marty will provide more details on this on his comments in a minute. Overall, we are pleased with the continued progression we are making on our criteria. We should also note that we have rebranded our LTAC and they are now referred to as critical illness recovery hospitals, which more accurately reflects the acuity of our patient profile. This name has been vetted with many of our referral sources and has been received quite favorably. On the development front, we are currently on track to open a new joint venture Rehab Hospital with the University of Florida Shands early next year. Also, a joint venture Rehab Hospital with Dignity Health in Las Vegas is expected in the second quarter next year and a new joint venture Rehab Hospital with Riverside Health in Virginia sometime in mid-2019. Our development pipeline remains robust. We now take you through our operational metrics. Overall, net revenue for the second quarter increased by $104 million to $1.29 billion, which was a 17.6% year-over-year growth rate and included topline growth in each of our four business segments. Net revenue in our Critical Illness Recovery Hospitals segment in the second quarter increased slightly to $442 million compared to $439 million in the same quarter last year. Patient days increased 1.9% to 256,000 days compared to 251,000 patient days in the same quarter last year. Occupancy in our critical illness recovery hospitals was 68% in the quarter which compares to 66% in the same quarter last year. Net revenue per patient day was $1,710 per patient day in the second quarter compared to $1,733 in the same quarter last year. The decrease in net revenue per patient days was due to a decrease in our Medicare and Medicare HMO revenue per patient day. The main reason for the shortfall in our net revenue per patient day rate is due to a change in our Medicare patient mix for the quarter. If the Medicare patient day mix would have remained consistent with our Q2 2017 mix, we would experience revenue per patient day in the second quarter this year in excess of our rate in the same quarter last year. Net revenue in our Rehabilitation Hospital segment for the second quarter increased 14.8% to $174 million compared to $151 million in the same quarter last year. Patient days increased 18% to 77,000 patient days compared to 65,000 days in the same quarter last year. Net revenue per patient day increased to $1,608 in the second quarter compared to $1,569 per day in the same quarter last year. It was primarily driven by improvement in our non-Medicare revenue per patient day. Net revenue in our Outpatient Rehab segment in the second quarter increased 4.8% to $267 million compared to $255 million in the same quarter last year. Patient visits increased 1.8% to 2.14 million visits in the second quarter compared to 2.1 million visits in the same quarter last year. Our net revenue per visit was $103 in the second quarter compared to $101 per visit in the same quarter last year. Net revenue in our Concentra segment for the second quarter increased 60.7% to $413 million compared to $257 million in the same quarter last year driven by both the contribution of U.S. HealthWorks and over 6% growth at the legacy Concentra business. For the second quarter, revenue from our centers was $378 million, and the balance of approximately $35 million was generated from onsite clinics, community-based outpatient clinics and other services. For the centers, we had patient visits over $3 million and net revenue per visit was $125 in the second quarter. This compares to $1.9 million visits and $114 per visit in the same quarter last year. Increases in our net revenue per visit related to both higher reimbursement rates of U.S. HealthWorks centers and improved workers compensation rates at the existing Concentra centers. Total adjusted EBITDA for the second quarter increased 12.3% to $178.2 million compared to $158.7 million in the same quarter last year with consolidated adjusted EBITDA margin at 13.7% for the second quarter, compared to 14.4% for the same quarter last year. Our Critical Illness Recovery Hospitals segment adjusted EBITDA was $60.7 million in the second quarter, compared to $75 million in the same quarter last year. Adjusted EBITDA margin for the segment was 13.7% in the second quarter compared to 17.1% in the same quarter last year. The shortfall in EBITDA is primarily due to a reduction in our patient day rate as I mentioned. Our rehabilitation hospital adjusted EBITDA increased 21.9% in the second quarter to $28.2 million compared to $23.1 million in the same quarter last year. Adjusted EBITDA margin for the Rehab Hospital segment was 16.2% in the second quarter, compared to 15.3% in the same quarter last year. The increase in adjusted EBITDA and margin were primarily the result of improved performance in the new hospitals that we opened in 2016 and 2017. Adjusted EBITDA results for the Inpatient Rehab segment include start up losses of approximately $2.1 million for the second quarter compared to approximately $1.2 million of start up losses in the same quarter last year. Outpatient rehab adjusted EBITDA was $41.9 million for both the second quarter this year and last year. Adjusted EBITDA margin for the Outpatient segment was 15.7% in the second quarter compared 16.4% in the same quarter last year. During the second quarter, adjusted EBITDA and adjusted EBITDA margin were impacted by certain markets where we experienced higher relative labor costs as compared to the same quarter last year. Concentra adjusted EBITDA was $72.6 million for the second quarter compared to $43.1 million in the same quarter last year. Adjusted EBITDA margin was 17.6% in the second quarter, compared to 16.8% in the same quarter last year. The increase in adjusted EBITDA margin is primarily attributable to achieving lower relative operating costs across our combined business with U.S. HealthWorks. Earnings per fully diluted share was $0.35 for the second quarter compared to $0.32 for the same quarter last year. Adjusted earnings per fully diluted share was $0.31 per diluted share for the second quarter compared to $0.32 per diluted share for the same quarter last year. Adjusted earnings per fully diluted share excludes the non-operating gains in the related tax effects in the second quarter of this year. Earlier this week, the final Inpatient Rehab rule for fiscal 2019 was released and generally in line with expectations. Final rule includes a 1.2% increase in the standard payment rate as well as an 8.3% increase in the high cost outlier threshold. Late yesterday afternoon, the final LTAC rule for fiscal 2019 was released. We are still evaluating the rule in its entirety. At this point, I’ll turn the call over to Marty Jackson for some additional financial details before we open the call up for questions.

Thanks Bob. Good morning, everyone. For the second quarter, our operating expenses, which include our cost of services, and G&A expense were $1.1 billion. This compares to $948 million in the same quarter last year. As a percent of our net revenue, our operating expense for the second quarter were 86.7% compared to 86% in the same quarter last year, cost of services were $1.09 billion for the second quarter. This compares to $920 million in the same quarter last year. As a percent of net revenue, cost of services were 84.5% for the second quarter. This compares to 83.5% in the same quarter last year. G&A expense was $29.2 million in the second quarter. This compares to $28.3 million in the same quarter last year. G&A as a percent of net revenue was 2.3% in the second quarter, compared to 2.6% of net revenue for the same quarter last year. As Bob mentioned, total adjusted EBITDA was $178.2 million and the adjusted EBITDA margin was 13.7% for the second quarter. This compares to adjusted EBITDA of $158.7 million and adjusted EBITDA margin of 14.4% in the same quarter last year. Depreciation and amortization was $51.7 million in the second quarter. This compares to $38.3 million in the same quarter last year. This increase is primarily the result of the U.S. HealthWorks acquisition. We generated $4.8 million in equity and earnings of unconsolidated subsidiaries during the second quarter. This compares to $5.7 million in the same quarter last year. In addition, we recognized a non-operating gain of $6.5 million during the second quarter, which was primarily related to the sale of our outpatient rehab clinics to a non-consolidating subsidiary and a payment associated with the 2016 sale of our contract therapy division. Interest expense was $50.2 million in the second quarter. This compares to $37.7 million in the second quarter last year. The increase in interest expense is primarily related to the financing of the U.S. HealthWorks acquisition at Concentra. The Company recorded an income tax expense of $21.1 million for the second quarter. This compares to income tax expense of $32.4 million in the same quarter last year. This represented an effective tax rate of 25.8% and 38.7% respectively. The lower effective tax rate this year is the result of the Federal Tax Reform legislation that was enacted in December of this past year. Net income attributable to Select Medical Holdings was $46.5 million for the second quarter with fully diluted earnings per share of $0.35. Adjusted EPS, excluding the non-operating gain and related tax effects were $0.31 for the quarter. At the end of the quarter, we had $3.4 billion of debt outstanding and $141 million of cash on the balance sheet. Our debt balance at the end of the quarter included, $1.14 billion in Select term loans, a $150 million in Select revolving loans, $710 million in Select 6.38% senior notes, $1.17 billion in Concentra first-lien term loans, $240 million in Concentra second-lien term loans, $53 million in unamortized discounts, premiums and debt issuance costs that reduced the overall balance sheet debt liability. And we had $54 million of other miscellaneous debt. We had a very strong quarter of cash flow in the second quarter with operating activities providing $166.2 million of cash flow. This compares to $96.2 million in the same quarter last year. Our days sales outstanding, or DSO was 54 days at June 30, 2018, this compares to 56 days at March 31, 2018 and 58 days at December 31, 2017. Investing activities used $39.9 million of cash in the second quarter. The use of cash was primarily related to $42 million in PP&E, which was offset slightly by the sale and investment activity during the quarter. Financing activities used $104.9 million of cash in the second quarter. We had net repayments of $95 million on the revolving loans, $14.6 million in distributions to non-controlling interests, $2.9 million in term loan payments offset in part by $2.9 million of proceeds from the issuance of non-controlling interest, net borrowing of other debt of $2.7 million, and $1.7 million in proceeds from overdraft in the quarter. Additionally, in our earnings press release, we reaffirmed our business outlook for calendar year 2018, provided the end of the last quarter for net operating revenue, adjusted EBITDA, and adjusted earnings per share. We continue to expect net revenue to be in the range of $5 billion to $5.2 billion, adjusted EBITDA to be in the range of $630 million to $660 million. We now expect fully diluted earnings per share to be in the range of $0.97 to $1.12. We continue to expect adjusted earnings per share to be in the range of $0.97 to $1.12, which excludes the loss on early retirement of debt, U.S. HealthWorks acquisition costs, and non-operating gains and the related tax effect. Finally, I would like to address the reduction in our per patient day rate in the second quarter for our critical illness recovery hospitals. As Bob mentioned, there was a change in our mix of patient days that had a negative impact on our revenue and EBITDA. Our patient day mix represents days and how those days are reimbursed. We break-out our patient day mix into four different categories, which are DRGs, short stay outliers, high cost outliers and threshold days. Threshold days are those days that exceed the length of stay of the patients discharged DRG, but have not yet reached high cost outlier status. These are days that are not reimbursed by the Medicare program. In Q2, we experienced a higher than average amount of threshold days that had the effect of reducing our overall Medicare per patient day rate. Historically, we do see both negative and positive fluctuations in our patient day mix and this is something one would expect to see on a reimbursement system that's built on averages. We do not see any systemic issues with changes in our patient day mix. This concludes our prepared remarks. And at this time, we’d like to turn it back over to the operator to open up the call for questions.

Thank you. [Operator Instructions] And our first question comes from the line of Frank Morgan with RBC Capital Markets. Your line is now open.

Good morning. Beyond just things starting returning to the normal averages, are there any mitigation strategies that you can use to address this whole adverse threshold mix issue?

Hey, Frank. It’s Bob. Thanks for the question. I would say probably not. As you know the new criteria and particularly the way with Select’s program of accepting just the LTAC compliant patients. This is a higher acuity patient mix and I think we've ever seen in this industry. And with patients that have that kind of acuity, it is – they are going to have the length of stay that they're going to have. And our physicians and our clinical operators are making those decisions on the appropriate discharges clinically. And so this is something that I don't think that we’re surprised as we’ve really drilled into the numbers. I think it was mapped a little bit before we did segment reporting and the effect of the increasing rate on the rehab, probably muted some of the variation that you got on the threshold days in our critical illness recovery hospitals. So again, I think as Marty pointed out, as we've looked at this even closer, it's a system it’s built on averages. And if you see the first quarter it was the threshold days may have been less, second quarter they maybe more, and that will vary some more in the third and fourth quarter both positively and negatively. And I think in this segment, I think it’s the other reason why we feel much more comfortable giving guidance on an annual basis rather than on quarterly splits because you can have these kind of the variations. Now as the company grows and we see greater revenue from the Concentra segment and outpatient and the rehab hospitals continue to grow. This probably evens out a little bit more. I mean the impact was a little greater than we would have liked to seen it in the second quarter. But I think generally speaking, we feel it will even out over the course of the year. But the direct answer to your question is that no, there's not a lot of that we can do to mitigate that. These are clinical operational decisions.

Gotcha. And is it fair to say that when you look at the margin decline, can you say it's – essentially, all of that is attributable to this increase in the amount of threshold volume that you had? So in a more normalized quarter, even if you look to year-ago, some like a 300 basis point decline, I think it went from 17.1 to 13.7. Is it fair to say that essentially all of that is related to this specific issue?

Yes, Frank. The majority of it is, we've gone back and we basically took a look and said okay, what if the patient day mix was the same as what it was in Q2 of 2017? And when we took a look at that, it was about $10 million of incremental revenue, which when you factor that in would get you to an EBITDA margin of about 15.6%. They would move the rate up to about $1,749.

Okay that actually was going to be – my next question which is do and then I’ll look at the comparison in the rates year-over-year, if not for the threshold issue, so that’s number $1,749. What is that compared to last year?

Last year it was $1,733 versus the $1,710 – this year.

Okay. And then finally it looks like a really good cash flow quarter and obviously some of that's used for – was used for debt paydown. Just maybe refresh us your thoughts on your CapEx spend and when you think about how much of discretionary versus continued debt reduction and what's your comfort level or what is your targeted level for both in – by the end of this year and maybe longer-term and in terms of leverage? Thanks.

Sure, a couple different questions there. One was on the CapEx for the year. We anticipate CapEx for the year will probably be in that $160 million to $180 million range, based on what we see. And with regards to the leverage target, we anticipate by the end of the year on a bank calculated leverage number. We will be in the 4.6% range.

Okay, I’ll hop back in the queue.

Thanks, Frank.

Thank you. And our next question comes from the line of Peter Costa with Wells Fargo Securities. Your line is now open.

Thanks. So let’s probably do the threshold days a little bit further. Can you tell us if – did any of this happening in the specific region or specific facilities of yours and then from a timing perspective, was any of that more weighted towards the beginning part of the quarter versus the end of the quarter? And then does anything have to do with patients that you had first quarter versus second quarter? So was some of this really first quarter problem and maybe that was actually a worse quarter than it looked and this is actually a better quarter than it looks?

No, it was – first of all, again there are a couple different questions there. Number one is, it was really spread across a number of hospitals. It really just wasn't focused on a couple of hospitals. With regards to your question on, was it the beginning of the quarter, the end of the quarter, did we see any differences? The latter – actually June was probably – we saw some additional threshold days in June relative to April and May. So hope your question is – so your question with regards to was that have made the first quarter? Was that have changed the first quarter? The answer to that is no.

Okay. So what gives you the confidence that this is a shorter-term issue and this is just the function of – this is where the patients are going to be and the new world of criteria patients that they are going to be sitting here in this less compensated area, which is not bumping over to the outlier problem?

Yes, I mean – it’s a great question and there is two reasons why we believe that's the case. First of all, if you go back and take a look at the changes in these patient days over the past 10 years, we've seen this fluctuation all the time. I mean we talked about it in our scripts there are both positive and negative variances and it's something that's just inherent in the system because, it is based on averages. The second reason is because it is based on averages and it's based on collection of information and adjustments are made every year, it's made based on your experience. So you would see an adjustment in future years based on the experience that you’ve had historically.

Got it. Okay, just one final question. With yesterday’s final rule, getting rid of the 25% threshold level, have you been approached more aggressively by larger facilities about perhaps doing more LTAC volume with them now?

Yes. Again good question, the 25% rule has been an overhang on this industry since 2004 and now that we have a complete elimination of the rule. I think it will open up more opportunities for Select. As you know we have a lot of strong partnerships with a lot of big systems and as – all the healthcare systems are looking more to expand and complete the Continuum of Care in their markets. We think there will be greater opportunities. And it is a solid policy and a good policy doesn’t make 25% rule because as you have bigger and bigger systems that are more tertiary that have a majority of the ICU beds. You would expect a greater number of the LTAC compliant population to be coming from fewer larger more sophisticated medical centers. So those happen to be the partners that we're working with. To the exclusion quite honestly of smaller community-based acute care hospitals, so we do think that that's going to bring more opportunities to us and I would say, in fact we have seen an increase in opportunities on the LTAC development side.

Great. Good job on the Concentra business development. Thanks.

Thank you. We couldn't be more pleased with the job that that management team at Concentra doing both on the legacy business and the integration of the U.S. HealthWorks acquisition. It’s really been a great success story.

Thank you. And our next question comes from the line of Kevin Fischbeck with Bank of America. Your line is now open.

Good morning. This is actually Joanna Gajuk filling in for Kevin today. My question was actually on the Concentra. Definitely margins improved very nicely there, so can you flesh out a little bit more in terms of the performance of HealthWorks sounds like maybe that's ramping up better still. Any color you can give in terms of what's going on the Concentra segment?

Yes. Joanna, I think what we're seeing is we're seeing in, synergy start to play a role. So we're seeing some reduced costs on the administrative types of services. So we think that has a benefit, but – and again, as Bob mentioned, Concentra is doing a great job in the integration. But the other story is the 6% growth on a same-store basis at Concentra is really very significant in both from a volume perspective as well as rate. Again, the guys have just done a great job, making sure that they're on all of the provider panels, and from a marketing perspective, we're starting to take market share.

That's great. And another point I want to rise here, so in your 10-Q, when you talk about segment performance, you mentioned labor cost pressure in two segments, but critical illness recovery to LTAC and Outpatient Rehab. So have you seen any acceleration in labor cost pressure? Or you just kind of trying to explain the movement in margins? I believe previously you talk about labor cost growth of 3% to 3.5% for the year, so is it still sort of the same outlook or any change there?

Yes. Good question. We continue to see somewhere in the 3% range on the LTAC. And on the outpatient side, what we're seeing is as we’ve done a lot of work on the Physio clinics, as you know we've had to bring in additional PTs and I think that's what you're seeing where we've brought on some very good new PTs and the volume need to follow up. So that's really where the pressure is on the outpatient PT side.

And then on the LTAC, or when you talk about the 3%, is it kind of more broad-based or is it certain markets?

It is certain markets. But on average across our entire system, we're seeing about a 3% increase.

So 3% for the entire system. So anything to mention there on that front in the Concentra or the rehab hospitals, any kind of pressures there? Or those areas are kind of better manageable, I guess little more manageable on that front?

Perhaps a little more manageable, but when you look at the economy and the unemployment rate, if it continues on this trajectory I think all providers can expect to see more pressure on recruitment in rate. I mean so we're more sensitive to that. We're watching it. It’s always an issue. Toughest issue for us is in our critical illness recovery hospitals, but we see it up and down in our all of our divisions, so a greater or lesser extent. And that's going to continue to play out over the next couple quarters as we watch closely to see where it goes.

Okay. And if I may, just last question on the reimbursement side, so the Inpatient Rehab reg included also the case mix changes for 2020 and based on the how CMS of this estimated impact, it seems like will be negative even though it's supposed to be budget neutral for the entire industry, but they come up with estimates that imply negative impact for the profit or Inpatient Rehab hospitals, so any thoughts on the impact for your operations specifically for the 2020 changes? Thank you.

Well, we're watching it and we're doing some analytics around it, but I think on its face, it does look like it could be negative for the very high margins for profit rehab hospital providers. So our hope generally is that with our model and our partnership model for vast majority of our rehab hospitals that will be able to mitigate through patient mix and another element with our partners. But we're taking a hard look at that and want to face at those, look like it’s going to be negative for the core profits.

Great. Thank you.

Thank you. And our next question comes from the line of Bill Sutherland with Benchmark Company. Your line is now open.

Thanks. Good morning, everybody. Just one last one on this threshold issue, Marty, you did say it gotten more significant in June, as opposed to earlier in the quarter and wondering about if you could say anything about how it's looking as you – at this point in the third quarter?

Bill, the third quarter – we’re certainly not at liberty to kind of talk to you as to what’s going on in – at least the first month.

Yes, I mean I think the important thing that you've heard from our comments is that we're not changing guidance, and we've said that the system is built on averages and even as we've looked over the history, we do see a fluctuation different quarters to quarters, year-over-year differences that that tends to even out. And so if we saw something that was systemic as a - systemic change in the reimbursement of our hospitals, we would feel an obligation to forecast that. And so I think you can take from our comments that at this time, we don't see any systemic changes in the way our hospitals or recovery hospitals are going to be reimbursed.

Okay. Most of my others have been asked. And I was interested in the Concentra experience with higher worker comp rates. Can you provide color there as far as the fact – what’s going on and maybe the sustainability?

Sure, I mean with regard to the worker's comp rates, they are based on the majority of states utilize a fees schedule Bill and those are updated on an annual basis. I think what you've seen is the increase – a decent portion of the increase you see really has to do with the addition of U.S. HealthWorks and the fact that a significant portion of their centers are actually located in California, which actually has the highest worker's comp rates in the country.

It’s really a mix issue more than anything else?

It’s the addition of those rates, so it’s really that.

I mean mix in terms of…

I think the average is up.

Got it. All right. That clarifies that. Thanks guys. Appreciated.

Thanks Bill. End of Q&A

Thank you. And I am not showing any further questions at this time. I would now like to turn the call back over to Robert Ortenzio for any closing remarks.

Thank you, operator. Thanks everybody for joining us and we look forward to updating you again after the third quarter.

Ladies and gentlemen, thank you for participating in today’s conference. This does conclude today’s program and you may all disconnect. Everyone have a wonderful day.