ENCOMPASS HEALTH CORPORATION
The following Management's Discussion and Analysis of Financial Condition and
Results of Operations ("MD&A") should be read in conjunction with the
accompanying consolidated financial statements and related notes. This MD&A is
designed to provide the reader with information that will assist in
understanding our consolidated financial statements, the changes in certain key
items in those financial statements from year to year, and the primary factors
that accounted for those changes, as well as how certain accounting principles
affect our consolidated financial statements. See "Cautionary Statement
Regarding Forward-Looking Statements" on page ii of this report for a
description of important factors that could cause actual results to differ from
expected results. See also Item 1A, Risk Factors.
In addition, management's discussion and analysis of our results of operations
and cash flows for the year ended December 31, 2018 compared to the year ended
December 31, 2017 may be found in, Part II, Item 7, Management's Discussion and
Analysis of Financial Condition and Results of Operations of our Annual Report
on Form 10-K for the year ended December 31, 2018 , filed with the SEC on
February 27, 2019 .
Executive Overview
Our Business
We are a national leader in integrated healthcare services, offering both
facility-based and home-based patient care through our network of inpatient
rehabilitation hospitals, home health agencies, and hospice agencies. As of
December 31, 2019 , our national footprint spans 37 states and Puerto Rico . As
discussed in this Item, "Segment Results of Operations," we manage our
operations in two operating segments which are also our reportable segments:
(1) inpatient rehabilitation and (2) home health and hospice. For additional
information about our business and reportable segments, see Item 1, Business and
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Item 1A, Risk Factors, of this report, Note 19, Segment Reporting, to the accompanying consolidated financial statements, and the "Results of Operations" section of this Item. Inpatient Rehabilitation We are the nation's largest owner and operator of inpatient rehabilitation hospitals in terms of patients treated and discharged, revenues, and number of hospitals. We provide specialized rehabilitative treatment on both an inpatient and outpatient basis. We operate hospitals in 33 states andPuerto Rico , with concentrations in the eastern half ofthe United States andTexas . As ofDecember 31, 2019 , we operate 133 inpatient rehabilitation hospitals and manage four inpatient rehabilitation units through management contracts. Our inpatient rehabilitation segment represented approximately 76% of our Net operating revenues for the year endedDecember 31, 2019 .Home Health and Hospice Our home health business is the nation's fourth largest provider of Medicare-certified skilled home health services in terms of revenues. Our home health services include a comprehensive range of Medicare-certified home nursing services to adult patients in need of care. These services include, among others, skilled nursing, physical, occupational, and speech therapy, medical social work, and home health aide services. Our hospice business is the nation's eleventh largest provider of Medicare-certified hospice services in terms of revenues. We provide hospice services to terminally ill patients and their families that address patients' physical needs, including pain control and symptom management, and to provide emotional and spiritual support. As ofDecember 31, 2019 , we provide home health services in 245 locations and hospice services in 83 locations across 31 states, with concentrations in the Southeast andTexas . In addition, two of these home health agencies operate as joint ventures that we account for using the equity method of accounting. Our home health and hospice segment represented approximately 24% of our Net operating revenues for the year endedDecember 31, 2019 . 2019 Overview In 2019, we focused on the following strategic priorities: • providing high-quality, cost-effective care to patients in our existing
markets;
• achieving organic growth at our existing inpatient rehabilitation
hospitals and home health and hospice locations;
• expanding our services to more patients who require post-acute
healthcare services by constructing and acquiring hospitals in newmarkets and acquiring and opening home health and hospice locations in
new markets;
• making shareholder distributions via common stock dividends and
repurchases of our common stock; and
• positioning the Company for success in the evolving healthcare delivery
system through key operational initiatives that include increasing
clinical collaboration between our inpatient rehabilitation hospitals
and home health locations, building stroke market share, developing and
implementing post-acute solutions, transitioning to the new inpatient
rehabilitation patient assessment measures, commonly referred to as
"Section GG" measures, and preparing for implementation of the home
health Patient-Driven Groupings Model ("PDGM").
During 2019, Net operating revenues increased 7.7% over 2018 due primarily to
pricing and volume growth in our inpatient rehabilitation segment and volume
growth in our home health and hospice segment. Within our inpatient
rehabilitation segment, discharge growth of 3.9% coupled with a 1.5% increase in
inpatient revenue per discharge in 2019 generated 5.0% growth in net patient
revenue compared to 2018. Discharge growth included a 1.8% increase in
same-store discharges. Within our home health and hospice segment, home health
admission growth of 16.3% and hospice admission growth of 39.8% contributed to
17.3% growth in home health and hospice revenue compared to 2018. Home health
admission growth and hospice admission growth included a 7.7% and 12.2%
increase, respectively, in same-store admissions. Many of our quality and
outcome measures remained above both inpatient rehabilitation and home health
industry averages. Not only did we treat more patients and enhance outcomes, we
did so in a cost-effective manner. See the "Results of Operations" and "Segment
Results of Operations" sections of this Item.
Our growth efforts continued to yield positive results in 2019. In our inpatient
rehabilitation segment, we:
• began operating a 40-bed inpatient rehabilitation hospital in Lubbock,
Texas with our joint venture partner, University Medical Center Health
System , in May 2019 ;
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• began operating a 40-bed inpatient rehabilitation hospital inBoise, Idaho with our joint venture partner,Saint Alphonsus Regional Medical Center , inJuly 2019 ; • amended the joint venture agreement related to our 51-bed YumaRehabilitation Hospital which resulted in a change in accounting for
this hospital from the equity method of accounting to a consolidated
entity;
• began operating our new 40-bed inpatient rehabilitation hospital in
• continued our capacity expansions by adding 152 new beds to existing
hospitals; and
• continued development of the following hospitals:
Location # of Beds Expected Operational Date
De novos:
Q1 2020
Sioux Falls, South Dakota 40 Q2 2020
Toledo, Ohio 40 Q4 2020
Cumming, Georgia 50 Q1 2021
North Tampa, Florida 50 Q2 2021
Stockbridge, Georgia 50 Q3 2021
Greenville, South Carolina 40 Q3 2021
Joint ventures:
Coralville, Iowa 40 Q2 2020
San Angelo, Texas 40 Q2 2021
* We began operating this hospital in February 2020 .
We also continued our growth efforts in our home health and hospice segment. On
July 1, 2019 , we completed the acquisition of privately owned Alacare Home
Health and Hospice ("Alacare") for a cash purchase price of $217.8 million . The
Alacare portfolio consisted of 23 home health and 23 hospice locations in
Alabama . We funded the transaction with cash on hand and borrowings under our
revolving credit facility. In connection with this transaction, we expect to
realize an income tax benefit with an estimated present value of approximately
$30 million . For additional information regarding this transaction, see Note 2,
Business Combinations, to the accompanying consolidated financial statements.
In addition to completing the Alacare transaction, we acquired two home health
locations in East Providence, Rhode Island and Westport, Massachusetts and began
accepting patients at our two new home health locations in Columbia, South
Carolina and Vero Beach, Florida . We also began accepting patients at our two
new hospice locations in Burleson, Texas and Greensburg, Pennsylvania .
To support our growth efforts, we continued taking steps to further increase the
strength and flexibility of our balance
sheet. Specifically, we redeemed $100 million of the outstanding principal
balance of the 5.75% Senior Notes due 2024 (the "2024 Notes") in June 2019 . In
September 2019 , we issued $500 million of 4.50% Senior Notes due 2028 at par and
$500 million of 4.75% Senior Notes due 2030 (the "New Notes") at par, which
resulted in approximately $983 million in net proceeds from the public offering.
We used the proceeds to fund the purchase of equity and vested stock
appreciation rights from management investors of our home health and hospice
segment, redeem $400 million of our 2024 Notes, and repay borrowings under our
revolving credit facility. In November 2019 , we amended our existing credit
agreement to, among other things, increase the size of our revolving credit
facility from $700 million to $1 billion and extend the agreement's maturity by
two years to 2024. For additional information regarding these transactions, see
Note 10, Long-term Debt, Note 12, Redeemable Noncontrolling Interests, and
Note 14, Share-Based Payments, to the accompanying consolidated financial
statements and the "Liquidity and Capital Resources" section of this Item.
We also continued our shareholder distributions by paying a quarterly cash
dividend of $0.27 per share on our common stock in January, April, and July of
this year. On July 23, 2019 , our board of directors approved an increase in our
quarterly dividend and declared a cash dividend of $0.28 per share that was paid
in October 2019 . On October 25, 2019 , our board of directors declared a cash
dividend of $0.28 per share, that was paid on January 15, 2020 to stockholders
of record on
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January 2, 2020 . In addition, we repurchased 0.8 million shares of our common stock in the open market for approximately$46 million during 2019. For additional information see the "Liquidity and Capital Resources" section of this Item. During 2019, we continued to increase the clinical collaboration rate between our inpatient rehabilitation hospitals and home health locations. We increased stroke market share by continuing to meet the needs of patients recovering from a stroke, as discussed in Item 1, Business, "Competitive Strengths." We developed and implemented 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. Additionally, we transitioned to the new inpatient rehabilitation Section GG measures onOctober 1, 2019 and prepared for the implementation of the home health PDGM onJanuary 1, 2020 , which are both discussed further below and in Item 1, Business, and Item 1A, Risk Factors. Business Outlook We believe our business outlook remains positive. Demographic trends, such as population aging, should continue to increase long-term demand for the services we provide. While we treat patients of all ages, most of our patients are 65 and older, and the number of Medicare enrollees is expected to grow approximately 3% per year for the foreseeable future. Even more specifically, the average age of our patients is approximately 76, and the population group ranging in ages from 75 to 79 is expected to grow at approximately 5% per year through 2026. We believe the demand for the services we provide will continue to increase as theU.S. population ages. We believe these factors align with our strengths in, and focus on, post-acute services. In addition, we believe we can address the demand for facility-based and home-based post-acute care services in markets where we currently do not have a presence by constructing or acquiring new hospitals and by acquiring or opening home health and hospice agencies in those extremely fragmented industries. We are a leading provider of integrated healthcare services, offering both facility-based and home-based patient care through our network of inpatient rehabilitation hospitals, home health agencies, and hospice agencies. We are committed to delivering high-quality, cost-effective, integrated patient care across the healthcare continuum with a primary focus on the post-acute sector. As the nation's largest owner and operator of inpatient rehabilitation hospitals in terms of patients treated and discharged, revenues, and number of hospitals, we believe we differentiate ourselves from our competitors based on the quality of our clinical outcomes, our cost-effectiveness, our financial strength, and our extensive application of technology. As the fourth largest provider of Medicare-certified skilled home health services in terms of revenues, we believe we differentiate ourselves from our competitors by the application of a highly integrated technology platform, our ability to manage a variety of care pathways, and a proven track record of consummating and integrating acquisitions. The nature and timing of the transformation of the current healthcare system to coordinated care delivery and payment models is uncertain, as the development and implementation of new care delivery and payment systems will require significant time and resources. Furthermore, many of the alternative approaches being explored may not work as intended. However, our goal is to position the Company in a prudent manner to be responsive to industry shifts. We have invested in our core business and created an infrastructure that enables us to provide high-quality care on a cost-effective basis. We have been disciplined in creating a capital structure that is flexible with no significant debt maturities prior to 2023. We continue to have a strong, well-capitalized balance sheet, including a substantial portfolio of owned real estate. We have significant availability under our revolving credit facility, and we continue to generate strong cash flows from operations. Strong and consistent free cash flow generated by our Company, together with the unfunded commitment of our revolving credit facility, provides substantial capacity to pursue growth opportunities in both of our business segments while continuing to invest in our operational initiatives and capital structure strategy. For these and other reasons, we believe we will be able to adapt to changes in reimbursement, sustain our business model, and grow through acquisition and consolidation opportunities as they arise. See also Item 1, Business, "Competitive Strengths" and "Strategy and 2020 Strategic Priorities." Key Challenges Healthcare is a highly-regulated industry facing many well-publicized regulatory and reimbursement challenges. The industry also is facing uncertainty associated with the efforts to identify and implement workable coordinated care and integrated delivery payment models as well as post-acute site neutrality in Medicare reimbursement. The Medicare reimbursement systems for both inpatient rehabilitation and home health are undergoing significant changes. The future of many aspects of healthcare regulation remains uncertain. Successful healthcare providers are those able to adapt to changes in the regulatory and operating environments, build strategic relationships across the healthcare continuum, and consistently provide high-quality, cost-effective care. We believe we have the necessary capabilities - change agility, strategic relationships, quality of patient outcomes, cost effectiveness, and ability to capitalize on growth opportunities - to adapt to and succeed in a dynamic, highly regulated industry, and we have a proven track record of doing so. 49
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As we continue to execute our business plan, the following are some of the challenges we face. • Operating in a Highly Regulated Industry. We are required to comply
with extensive and complex laws and regulations at the federal, state,
and local government levels. These rules and regulations have affected,
or could in the future affect, our business activities by having an
impact on the reimbursement we receive for services provided or thecosts of compliance, mandating new documentation standards, requiring
additional licensure or certification, regulating our relationships
with physicians and other referral sources, regulating the use of our
properties, and limiting our ability to enter new markets or add new
capacity to existing hospitals and agencies. Ensuring continuous
compliance with extensive laws and regulations is an operating
requirement for all healthcare providers.
We have invested, and will continue to invest, substantial time, effort, and
expense in implementing and maintaining training programs as well as internal
controls and procedures designed to ensure regulatory compliance, and we are
committed to continued adherence to these guidelines. More specifically, because
Medicare comprises a significant portion of our Net operating revenues, failure
to comply with the laws and regulations governing the Medicare program and
related matters, including anti-kickback and anti-fraud requirements, could
materially and adversely affect us. The federal government's reliance on
sub-regulatory guidance, such as handbooks, FAQs, internal memoranda, and press
releases, presents a unique challenge to compliance efforts. For additional
details on sub-regulatory guidance, See Item 1A, Risk Factors.
Reimbursement claims made by healthcare providers, including inpatient
rehabilitation hospitals as well as home health and hospice agencies, are
subject to audit from time to time by governmental payors and their agents, such
as the Medicare Administrative Contractors ("MACs"), fiscal intermediaries and
carriers, as well as the Office of Inspector General , CMS, and state Medicaid
programs. These audits as well as the ordinary course claim reviews of our
billings result in payment denials, including recoupment of previously paid
claims from current accounts receivable. Healthcare providers can challenge any
denials through an administrative appeals process that can be extremely lengthy,
taking several years. For additional details of these claim reviews, See Item 1,
Business, "Sources of Revenues," Item 1A, Risk Factors, and Note 1, Summary of
Significant Accounting Policies, "Net Operating Revenues" and "Accounts
Receivable," to the accompanying consolidated financial statements.
In June 2019 , CMS commenced the Home Health Review Choice Demonstration ("RCD")
in Illinois . RCD is intended to test whether pre-claim review improves methods
for the identification, investigation, and prosecution of Medicare fraud and
whether the pre-claim review helps reduce expenditures while maintaining or
improving quality of care. The demonstration expanded to Ohio in September 2019
and will be expanded to Texas in March 2020 and in North Carolina and Florida in
May 2020 . We operate agencies (representing approximately 44% of our home health
Medicare claims) in these five states. For additional details of the RCD
program, see Item 1A, Risk Factors.
See also Item 1, Business, "Regulation," and Item 1A, Risk Factors, to this
report and Note 18, Contingencies and Other Commitments, "Governmental Inquiries
and Investigations," to the accompanying consolidated financial statements.
• Changes to Our Operating Environment Resulting from Healthcare Reform.
Concerns held by federal policymakers about the federal deficit andnational debt levels, as well as other healthcare policy priorities,
could result in enactment of legislation affecting portions of the
Medicare program, including post-acute care services we provide. It is
not clear what, if any, Medicare-related changes may ultimately be
enacted and signed into law or otherwise implemented, but it is
possible that any reductions in Medicare spending will have a material
impact on reimbursements for healthcare providers generally and
post-acute providers specifically. We cannot predict what, if any,
changes in Medicare spending or modifications to the healthcare lawsand regulations will result from future budget or other legislative or
regulatory initiatives.
Many provisions within the 2010 Healthcare Reform Laws have impacted, or could
in the future impact, our business. Most notable for us are Medicare
reimbursement reductions, such as reductions to annual market basket updates to
providers and reimbursement rate rebasing adjustments, and promotion of
alternative payment models, such as accountable care organizations ("ACOs") and
bundled payment initiatives including the Bundled Payments for Care Improvement
Initiative Advanced ("BPCI Advanced") and the Comprehensive Care for Joint
Replacement ("CJR") program. The Center for Medicare and Medicaid Innovation
("CMMI") plays a key role in the development of many of these new payment and
service delivery models. Our challenges related to healthcare reform are
discussed in Item 1, Business, "Sources of Revenues," and Item 1A, Risk Factors.
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The healthcare industry in general has been facing uncertainty associated with the efforts to identify and implement workable coordinated care and integrated delivery payment models. In these models, hospitals, physicians, and other care providers work together to provide coordinated healthcare on a more efficient, patient-centered basis. These providers are then paid based on the efficiency and overall value and quality of the services they provide to a patient. While this is consistent with our goal and proven track record of being a high-quality, cost-effective provider, broad-based implementation of a new care delivery and payment model would represent a significant transformation for the healthcare industry. As the industry and its regulators explore this transformation, we are attempting to position the Company in preparation for whatever changes are ultimately made to the delivery system. As discussed in Item 1, Business, the future of the 2010 Healthcare Reform Laws as well as the nature and substance of any other healthcare legislation remain uncertain, nor can we predict whether other legislation affecting Medicare and post-acute care providers will be enacted, or what actions theTrump Administration may take through the regulatory process that may result in modifications to the 2010 Healthcare Laws or the Medicare program. Therefore, the ultimate nature and timing of any transformation of the healthcare delivery system is uncertain, and will likely remain so for some time. We will continue to evaluate these laws and regulations and position the Company for this industry shift. Based on our track record, we believe we can adapt to these regulatory and industry changes. Further, we have engaged, and will continue to engage, actively in discussions with key legislators and regulators to attempt to ensure any healthcare laws or regulations adopted or amended promote our goal of high-quality, cost-effective care. Each year, CMS adopts rules that update pricing and otherwise amend the respective payment systems. OnJuly 31, 2019 , CMS released its notice of final rulemaking for fiscal year 2020 under the inpatient rehabilitation facility prospective payment system (the "2020 IRF Rule"). Based on the market basket update, our analysis of the Section GG changes and the other adjustments included in the 2020 IRF Rule and other factors, we currently estimate Medicare payment rates for our inpatient rehabilitation segment will be flat to up 0.75% in fiscal year 2020 (effectiveOctober 1, 2019 ). OnOctober 31, 2019 , CMS released its notice of final rulemaking for calendar year 2020 for home health agencies under the home health prospective payment system (the "2020 HH Rule"). Based on the market basket update, our analysis of PDGM's significant changes to the reimbursement model and the other adjustments included in the 2020 HH Rule as well as other factors, we currently estimate Medicare payment rates for our home health business will decrease between 2.0% and 3.0% in 2020. For additional details of the 2020 IRF Rule, 2020 HH Rule, and other proposed and adopted legislative and regulatory actions that may be material to our business, see Item 1, Business, and Item 1A, Risk Factors. • Maintaining Strong Volume Growth. Various factors, including
competition and increasing regulatory and administrative burdens, may
impact our ability to maintain and grow our hospital, home health, and
hospice volumes. In any particular market, we may encounter competition
from local or national entities with longer operating histories or
other competitive advantages, such as acute care hospitals who provide
post-acute services similar to ours or other post-acute providers with
relationships with referring acute care hospitals or physicians.Aggressive payment review practices by Medicare contractors, aggressive
enforcement of regulatory policies by government agencies, and
restrictive or burdensome rules, regulations or statutes governing
admissions practices may lead us to not accept patients who would be
appropriate for and would benefit from the services we provide. In
addition, from time to time, we must get regulatory approval to expand
our services and locations in states with certificate of need laws.This approval may be withheld or take longer than expected. In the case
of new-store volume growth, the addition of hospitals, home health
agencies, and hospice agencies to our portfolio also may be difficult
and take longer than expected.
• Recruiting and Retaining High-Quality Personnel. See Item 1A, Risk
Factors, for a discussion of competition for staffing, shortages of
qualified personnel, and other factors that may increase our labor
costs. Recruiting and retaining qualified personnel, including
management, for our inpatient hospitals and home health and hospice
agencies remain a high priority for us. We attempt to maintain a
comprehensive compensation and benefits package that allows us to
remain competitive in this challenging staffing environment while
remaining consistent with our goal of being a high-quality,
cost-effective provider of post-acute services.
These key challenges notwithstanding, we believe we have a strong business
model, a strong balance sheet, and a proven track record of achieving strong
financial and operational results. We are attempting to position the Company to
respond to changes in the healthcare delivery system and believe we will be in a
position to take advantage of any opportunities that arise as the industry moves
to this new stage. We believe we are positioned to continue to adapt to external
events and create value for our shareholders in 2020 and beyond.
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Results of Operations PayorMix During 2019, 2018, and 2017, we derived consolidated Net operating revenues from the following payor sources: For the Year Ended December 31, 2019 2018 2017 Medicare 75.1 % 75.9 % 76.0 % Medicare Advantage 10.6 % 9.2 % 8.6 % Managed care 8.3 % 8.8 % 9.3 % Medicaid 2.8 % 2.6 % 2.5 % Other third-party payors 0.9 % 1.1 % 1.3 % Workers' compensation 0.7 % 0.7 % 0.7 % Patients 0.5 % 0.5 % 0.5 % Other income 1.1 % 1.2 % 1.1 % Total 100.0 % 100.0 % 100.0 % Our payor mix is weighted heavily towards Medicare. We receive Medicare reimbursements under the IRF-PPS, the HH-PPS, and the hospice payment system (the "Hospice-PS"). For additional information regarding Medicare reimbursement, see the "Sources of Revenues" section of Item 1, Business. As part of the Balanced Budget Act of 1997,Congress created a program of private, managed healthcare coverage for Medicare beneficiaries. This program has been referred to as Medicare Part C, or "Medicare Advantage." The program offers beneficiaries a range of Medicare coverage options by providing a choice between the traditional fee-for-service program (under Medicare Parts A and B) or enrollment in a health maintenance organization, preferred provider organization, point-of-service plan, provider sponsor organization, or an insurance plan operated in conjunction with a medical savings account. Our consolidated Net operating revenues consist primarily of revenues derived from patient care services. Net operating revenues also include other revenues generated from management and administrative fees and other non-patient care services. These other revenues are included in "other income" in the above table. 52
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Our Results From 2017 through 2019, our consolidated results of operations were as follows:
For the Year Ended December 31, Percentage Change
2019 2018 2017 2019 vs. 2018 2018 vs. 2017
(In Millions)
Net operating revenues $ 4,605.0 $ 4,277.3 $ 3,913.9 7.7 % 9.3 %
Operating expenses:
Salaries and benefits 2,573.0 2,354.0 2,154.6 9.3 % 9.3 %
Other operating expenses 623.6 585.1 531.6 6.6 % 10.1 %
Occupancy costs 82.3 78.0 73.5 5.5 % 6.1 %
Supplies 167.9 158.7 149.3 5.8 % 6.3 %General and administrative expenses 247.0 220.2 171.7
12.2 % 28.2 %
Depreciation and amortization 218.7 199.7 183.8 9.5 % 8.7 %
Government, class action, and
related settlements - 52.0 - (100.0 )% N/A
Total operating expenses 3,912.5 3,647.7 3,264.5 7.3 % 11.7 %
Loss on early extinguishment of
debt 7.7 - 10.7 N/A (100.0 )%
Interest expense and amortization
of debt discounts and fees 159.7 147.3 154.4 8.4 % (4.6 )%
Other income (30.5 ) (2.2 ) (4.1 ) 1,286.4 % (46.3 )%
Equity in net income of
nonconsolidated affiliates (6.7 ) (8.7 ) (8.0 ) (23.0 )% 8.8 %
Income from continuing operations
before income tax expense 562.3 493.2 496.4 14.0 % (0.6 )%
Provision for income tax expense 115.9 118.9 145.8
(2.5 )% (18.4 )%
Income from continuing operations 446.4 374.3 350.6
19.3 % 6.8 %
(Loss) income from discontinued
operations, net of tax (0.6 ) 1.1 (0.4 ) (154.5 )% (375.0 )%
Net income 445.8 375.4 350.2 18.8 % 7.2 %
Less: Net income attributable to
noncontrolling interests (87.1 ) (83.1 ) (79.1 ) 4.8 % 5.1 %
Net income attributable to
Encompass Health $ 358.7 $ 292.3 $ 271.1 22.7 % 7.8 %
Operating Expenses as a % of Net Operating Revenues
For the Year Ended December 31,
2019 2018 2017
Operating expenses:
Salaries and benefits 55.9 % 55.0 % 55.0 %
Other operating expenses 13.5 % 13.7 % 13.6 %
Occupancy costs 1.8 % 1.8 % 1.9 %
Supplies 3.6 % 3.7 % 3.8 %
General and administrative expenses 5.4 % 5.1 % 4.4 %
Depreciation and amortization 4.7 % 4.7 % 4.7 %
Government, class action, and related settlements - % 1.2 % - %
Total operating expenses 85.0 % 85.3 % 83.4 %
In the discussion that follows, we use "same-store" comparisons to explain the
changes in certain performance metrics and line items within our financial
statements. We calculate same-store comparisons based on hospitals and home
health and hospice locations open throughout both the full current period and
prior periods presented. These comparisons include the
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financial results of market consolidation transactions in existing markets, as it is difficult to determine, with precision, the incremental impact of these transactions on our results of operations. 2019 Compared to 2018 Net Operating Revenues Our consolidated Net operating revenues increased in 2019 compared to 2018 primarily from pricing and volume growth in our inpatient rehabilitation segment and volume growth in our home health and hospice segment. See additional discussion in the "Segment Results of Operations" section of this Item. Salaries and Benefits Salaries and benefits are the most significant cost to us and represent an investment in our most important asset: our employees. Salaries and benefits include all amounts paid to full- and part-time employees who directly participate in or support the operations of our hospitals and home health and hospice agencies, including all related costs of benefits provided to employees. It also includes amounts paid for contract labor. Salaries and benefits increased in 2019 compared to 2018 primarily due to salary increases for our employees, increased benefits costs, and increased patient volumes, including an increase in the number of full-time equivalents as a result of our development activities. As a percent of Net operating revenues, Salaries and benefits increased during 2019 compared to 2018 primarily as a result of higher salaries and benefits cost increases compared to revenue pricing increases. See additional discussion in the "Segment Results of Operations" section of this Item. Other Operating Expenses Other operating expenses include costs associated with managing and maintaining our hospitals and home health and hospice agencies. These expenses include such items as contract services, non-income related taxes, professional fees, utilities, insurance, and repairs and maintenance. Other operating expenses increased during 2019 compared to 2018 primarily due to increased patient volumes. As a percent of Net operating revenues, Other operating expenses decreased during 2019 compared to 2018 primarily due to operating leverage resulting from revenue growth. See additional discussion in the "Segment Results of Operations" section of this Item. General and Administrative Expenses General and administrative expenses primarily include administrative expenses such as information technology services, human resources, corporate accounting, legal services, and internal audit and controls that are managed from our home office inBirmingham, Alabama . These expenses also include stock-based compensation expenses. General and administrative expenses increased in 2019 compared to 2018 in terms of dollars and as a percent of Net operating revenues due primarily to increased corporate salaries and benefits costs, including expenses associated with stock appreciation rights ("SARs"), offset by lower costs associated with our rebranding. The 2019 SARs expense was approximately$82 million compared to approximately$56 million in 2018. The 2019 rebranding expenses were approximately$1 million compared to approximately$11 million in 2018. For additional information on SARs, see Note 14, Share-Based Payments, to the accompanying consolidated financial statements, and on the rebranding, see Item 1, Business. Depreciation and Amortization Depreciation and amortization increased during 2019 compared to 2018 due to our capital expenditures and development activities throughout 2018 and 2019. We expect Depreciation and amortization to increase going forward as a result of our recent and ongoing capital investments. Government, Class Action, and Related Settlements The amount in Government, class action, and related settlements in 2018 related primarily to a$48 million loss contingency accrual we established in the fourth quarter of 2018 for the potential settlement of the investigation being conducted by theUnited States Department of Justice (the "DOJ"). We settled the DOJ investigation in 2019. See Note 18, Contingencies and Other Commitments, to the accompanying consolidated financial statements for additional information on this matter. 54
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Loss on Early Extinguishment of Debt The Loss on early extinguishment of debt during 2019 resulted from the June and November redemptions of our 2024 Notes. See Note 10, Long-term Debt, to the accompanying consolidated financial statements. Interest Expense and Amortization of Debt Discounts and Fees The increase in Interest expense and amortization of debt discounts and fees in 2019 compared to 2018 primarily resulted from theSeptember 2019 issuances of our 2028 Notes and 2030 Notes offset by the June andNovember 2019 redemptions of our 2024 Notes. Cash paid for interest approximated$156 million and$150 million in 2019 and 2018, respectively. See Note 10, Long-term Debt, to the accompanying consolidated financial statements. Other Income Other income for 2019 included a$19.2 million gain as a result of our consolidation ofYuma Rehabilitation Hospital and the remeasurement of our previously held equity interest at fair value. See Note 9, Investments in and Advances to Nonconsolidated Affiliates, to the consolidated financial statements. Income from Continuing Operations Before Income Tax Expense Our pre-tax income from continuing operations in 2019 increased compared to 2018 primarily due to increased Net operating revenues and the gain resulting from the consolidation ofYuma Rehabilitation Hospital , as discussed above, offset by the contingency accrual we established in the fourth quarter of 2018, as discussed above. Provision for Income Tax Expense Our Provision for income tax expense declined in 2019 compared to 2018 due primarily to the Government, class action, and related settlements discussed in Note 18, Contingencies and Other Commitments, to the accompanying consolidated financial statements. See also Note 16, Income Taxes, to the accompanying consolidated financial statements. OnDecember 22, 2017 , the US enacted the 2017 Tax Cuts and Jobs Act (the "Tax Act"). The Tax Act, which is commonly referred to as "US tax reform," significantly changed US corporate income tax laws by, among other things, reducing the US corporate income tax rate from 35% to 21% starting in 2018. See Note 16, Income Taxes, to the accompanying consolidated financial statements for further discussion. Our cash payments for income taxes approximated$104 million , net of refunds, in 2019. These payments were based on estimates of taxable income for 2019. We estimate we will pay approximately$60 million to$80 million of cash income taxes, net of refunds, in 2020. In 2019 and 2018, current income tax expense was$75.9 million and$128.0 million , respectively. In certain jurisdictions, we do not expect to generate sufficient income to use all of the available state NOLs and other credits prior to their expiration. This determination is based on our evaluation of all available evidence in these jurisdictions including results of operations during the preceding three years, our forecast of future earnings, and prudent tax planning strategies. It is possible we may be required to increase or decrease our valuation allowance at some future time if our forecast of future earnings varies from actual results on a consolidated basis or in the applicable tax jurisdiction, if the timing of future tax deductions differs from our expectations, or pursuant to changes in state tax laws and rates. See Note 16, Income Taxes, to the accompanying consolidated financial statements and the "Critical Accounting Estimates" section of this Item. Net Income Attributable to Noncontrolling Interests The increase in Net income attributable to noncontrolling interests during 2019 compared to the same period of 2018 primarily resulted from increased profitability of our joint ventures and theJuly 1, 2019 consolidation of ourYuma Rehabilitation Hospital , as discussed above, which created a new noncontrolling interest. Impact of Inflation The impact of inflation on the Company will be primarily in the area of labor costs. The healthcare industry is labor intensive. Wages and other expenses increase during periods of inflation and when labor shortages occur in the marketplace. 55
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There can be no guarantee we will not experience increases in the cost of labor, as the need for clinical healthcare professionals is expected to grow. In addition, increases in healthcare costs are typically higher than inflation and impact our costs under our employee benefit plans. Managing these costs remains a significant challenge and priority for us. Suppliers pass along rising costs to us in the form of higher prices. Our supply chain efforts and our continual focus on monitoring and actively managing medical supplies and pharmaceutical costs has enabled us to accommodate increased pricing related to supplies and other operating expenses over the past few years. However, we cannot predict our ability to cover future cost increases. It should be noted that we have little or no ability to pass on these increased costs associated with providing services to Medicare and Medicaid patients due to federal and state laws that establish fixed reimbursement rates. Relationships and Transactions with Related Parties Related party transactions were not material to our operations in 2019, 2018, or 2017, and therefore, are not presented as a separate discussion within this Item. Segment Results of Operations Our internal financial reporting and management structure is focused on the major types of services provided byEncompass Health . We manage our operations using two operating segments which are also our reportable segments: (1) inpatient rehabilitation and (2) home health and hospice. For additional information regarding our business segments, including a detailed description of the services we provide, financial data for each segment, and a reconciliation of total segment Adjusted EBITDA to income from continuing operations before income tax expense, see Note 19, Segment Reporting, to the accompanying consolidated financial statements. Inpatient Rehabilitation During the years endedDecember 31, 2019 , 2018 and 2017, our inpatient rehabilitation segment derived its Net operating revenues from the following payor sources: For the Year Ended December 31, 2019 2018 2017 Medicare 72.2 % 73.2 % 73.6 % Medicare Advantage 10.7 % 9.2 % 8.3 % Managed care 9.8 % 10.3 % 10.7 % Medicaid 3.1 % 3.0 % 3.0 % Other third-party payors 1.2 % 1.5 % 1.6 % Workers' compensation 0.8 % 0.8 % 0.9 % Patients 0.7 % 0.6 % 0.6 % Other income 1.5 % 1.4 % 1.3 % Total 100.0 % 100.0 % 100.0 % 56
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Additional information regarding our inpatient rehabilitation segment's operating results for the years endedDecember 31, 2019 , 2018 and 2017, is as follows: For the Year Ended December 31, Percentage Change 2019 2018 2017
2019 vs. 2018 2018 vs. 2017
(In Millions, Except Percentage Change)
Net operating revenues:
Inpatient $ 3,423.5 $ 3,247.9 $ 3,039.3 5.4 % 6.9 %
Outpatient and other 89.5 98.3 102.0 (9.0 )% (3.6 )%
Inpatient rehabilitation
segment revenues 3,513.0 3,346.2 3,141.3 5.0 % 6.5 %
Operating expenses:
Salaries and benefits 1,813.1 1,701.5 1,603.8 6.6 % 6.1 %
Other operating expenses 521.9 502.3 462.5 3.9 % 8.6 %
Supplies 147.0 140.6 135.7 4.6 % 3.6 %
Occupancy costs 64.8 63.8 61.9 1.6 % 3.1 %
Other income (10.5 ) (3.6 ) (4.1 ) 191.7 % (12.2 )%
Equity in net income of
nonconsolidated
affiliates (5.5 ) (7.5 ) (7.3 ) (26.7 )% 2.7 %
Noncontrolling interests 82.6 77.2 67.6 7.0 % 14.2 %
Segment Adjusted EBITDA $ 899.6 $ 871.9 $ 821.2 3.2 % 6.2 %
(Actual Amounts)
Discharges 186,842 179,846 171,922 3.9 % 4.6 %
Net patient revenue per
discharge $ 18,323 $ 18,059 $ 17,678 1.5 % 2.2 %
Outpatient visits 375,525 488,754 576,345 (23.2 )% (15.2 )%
Average length of stay
(days) 12.6 12.6 12.7 - % (0.8 )%
Occupancy % 69.5 % 69.3 % 67.8 % 0.3 % 2.2 %
# of licensed beds 9,249 8,966 8,851 3.2 % 1.3 %
Full-time equivalents* 21,967 21,335 20,802 3.0 % 2.6 %
Employees per occupied
bed 3.42 3.43 3.47 (0.3 )% (1.2 )%
* Full-time equivalents included in the above table represent our employees
who participate in or support the operations of our hospitals and include
an estimate of full-time equivalents related to contract labor.
We actively manage the productive portion of our Salaries and benefits utilizing
certain metrics, including employees per occupied bed, or "EPOB." This metric is
determined by dividing the number of full-time equivalents, including an
estimate of full-time equivalents from the utilization of contract labor, by the
number of occupied beds during each period. The number of occupied beds is
determined by multiplying the number of licensed beds by our occupancy
percentage.
Operating Expenses as a % of Net Operating Revenues
For the Year Ended December 31,
2019 2018 2017
Operating expenses:
Salaries and benefits 51.6 % 50.8 % 51.1 %
Other operating expenses 14.9 % 15.0 % 14.7 %
Supplies 4.2 % 4.2 % 4.3 %
Occupancy costs 1.8 % 1.9 % 2.0 %
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2019 Compared to 2018 Net Operating Revenues Revenue growth during 2019 compared to 2018 resulted from volume growth and an increase in net patient revenue per discharge. Discharge growth from new stores resulted from our joint ventures inMurrells Inlet, South Carolina (September 2018 ),Winston-Salem, North Carolina (October 2018 ),Lubbock, Texas (May 2019 ), andBoise, Idaho (July 2019 ), as well as wholly owned hospitals inShelby County, Alabama (April 2018 ),Bluffton, South Carolina (June 2018 ), andKaty, Texas (September 2019 ). New-store growth also resulted from the consolidation of ourYuma Rehabilitation Hospital effectiveJuly 1, 2019 . Discharge growth included a 1.8% increase in same-store discharges. Growth in net patient revenue per discharge primarily resulted from an increase in reimbursement rates and improvements in discharge destinations. The decrease in outpatient and other revenues in 2019 compared to 2018 was primarily due to the continued closures of hospital-based outpatient programs. See Note 2, Business Combinations, to the accompanying consolidated financial statements for information regarding our joint ventures discussed above. See Note 9, Investments in and Advances to Nonconsolidated Affiliates, to the consolidated financial statements for information regarding the consolidation of ourYuma Rehabilitation Hospital . Adjusted EBITDA The increase in Adjusted EBITDA for the inpatient rehabilitation segment in 2019 compared to 2018 primarily resulted from revenue growth, as discussed above. Salaries and benefits as a percent of Net operating revenues increased primarily due to higher salaries and wages per full-time equivalent, inclusive of approximately$3.5 million of training and education costs associated with the transition to CMS Section GG, as discussed in Item 1, Business, and Item 1A, Risk Factors.Home Health and Hospice During the years endedDecember 31, 2019 , 2018 and 2017, our home health and hospice segment derived its Net operating revenues from the following payor sources: For the Year Ended December 31, 2019 2018 2017 Medicare 84.2 % 85.3 % 85.7 % Medicare Advantage 10.2 % 9.5 % 9.7 % Managed care 3.6 % 3.6 % 3.8 % Medicaid 1.7 % 1.2 % 0.6 % Workers' compensation 0.1 % 0.2 % - % Patients 0.1 % 0.1 % 0.1 % Other income 0.1 % 0.1 % 0.1 % Total 100.0 % 100.0 % 100.0 % 58
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Additional information regarding our home health and hospice segment's operating
results for the years ended
For the Year Ended December 31, Percentage Change
2019 2018 2017 2019 vs. 2018 2018 vs. 2017
(In Millions, Except Percentage Change)
Net operating revenues:
Home health $ 918.0 $ 814.6 $ 702.4 12.7 % 16.0 %
Hospice 174.0 116.5 70.2 49.4 % 66.0 %
Home health and hospice segment
revenues 1,092.0 931.1 772.6 17.3 % 20.5 %
Operating expenses:
Cost of services sold (excluding
depreciation and amortization) 506.2 438.4 363.3 15.5 % 20.7 %
Support and overhead costs 381.7 323.5 277.2 18.0 % 16.7 %
Other income - (0.5 ) - 100.0 % N/A
Equity in net income of
nonconsolidated affiliates (1.2 ) (1.2 ) (0.7 ) - % 71.4 %
Noncontrolling interests 9.5 8.5 6.9 11.8 % 23.2 %
Segment Adjusted EBITDA $ 195.8 $ 162.4 $ 125.9 20.6 % 29.0 %
(Actual Amounts)
Home health:
Admissions 159,727 137,396 124,870 16.3 % 10.0 %
Recertifications 116,084 111,581 92,989 4.0 % 20.0 %
Episodes 275,578 243,698 211,743 13.1 % 15.1 %
Revenue per episode $ 2,972 $ 2,968 $ 2,984 0.1 % (0.5 )%
Episodic visits per episode 17.1 17.6 17.9 (2.8 )% (1.7 )%
Total visits 5,431,621 4,959,645 4,390,958 9.5 % 13.0 %
Cost per visit $ 77 $ 76 $ 75 1.3 % 1.3 %
Hospice:
Admissions 10,452 7,474 4,870 39.8 % 53.5 %
Patient days 1,197,927 790,984 479,350 51.4 % 65.0 %
Average daily census 3,282 2,167 1,313 51.5 % 65.0 %
Revenue per day $ 145 $ 147 $ 146 (1.4 )% 0.7 %
Operating Expenses as a % of Net Operating Revenues
For the Year Ended December 31,
2019 2018 2017
Operating expenses:
Cost of services sold (excluding depreciation and
amortization) 46.4 % 47.1 % 47.0 %
Support and overhead costs 35.0 % 34.7 % 35.9 %
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2019 Compared to 2018 Net Operating Revenues Revenue growth during 2019 compared to 2018 was primarily driven from volume growth. Volume growth included a 7.7% increase in home health same-store admissions and the impact of the acquisition of Alacare onJuly 1, 2019 andCamellia Healthcare onMay 1, 2018 . Revenue per episode decreased primarily due to the patient mix of the former Alacare locations and the timing of episodes. Hospice revenue increased primarily due to the acquisition of Alacare and same-store admissions growth of 12.2%. See Note 2, Business Combinations, to the accompanying consolidated financial statements of this report for information regarding our acquisitions discussed above. Adjusted EBITDA The increase in Adjusted EBITDA during 2019 compared to 2018 primarily resulted from revenue growth, as discussed above. Cost of services as a percent of Net operating revenues for 2019 compared to 2018 decreased primarily due to improvements in caregiver optimization and productivity in home health partially offset by higher costs at the former Alacare locations. Support and overhead costs as a percent of Net operating revenues for 2019 compared to 2018 increased primarily due to expenses associated with the integration of Alacare. Liquidity and Capital Resources Our primary sources of liquidity are cash on hand, cash flows from operations, and borrowings under our revolving credit facility. The objectives of our capital structure strategy are to ensure we maintain adequate liquidity and flexibility. Pursuing and achieving those objectives allow us to support the execution of our operating and strategic plans and weather temporary disruptions in the capital markets and general business environment. Maintaining adequate liquidity is a function of our unrestricted Cash and cash equivalents and our available borrowing capacity. Maintaining flexibility in our capital structure is a function of, among other things, the amount of debt maturities in any given year, the options for debt prepayments without onerous penalties, and limiting restrictive terms and maintenance covenants in our debt agreements. Consistent with these objectives, inJune 2019 , we redeemed$100 million of the outstanding principal amount of the 2024 Notes using cash on hand and capacity under our revolving credit facility. Pursuant to the terms of the 2024 Notes, this optional redemption was made at a price of 101.917%, which resulted in a total cash outlay of approximately$102 million . As a result of this redemption, we recorded a$2.3 million Loss on early extinguishment of debt in the second quarter of 2019. InSeptember 2019 , we issued$500 million of the 2028 Notes at par and$500 million of the 2030 Notes at par (the "New Notes"), which resulted in approximately$983 million in net proceeds from the public offering. We used the net proceeds from the offering of the New Notes to fund the purchase of equity and vested stock appreciation rights from management investors of our home health and hospice segment, redeem$400 million of our 2024 Notes as described below, and repay borrowings under our revolving credit facility. InNovember 2019 , we redeemed$400 million of the outstanding principal amount of our 2024 Notes. Pursuant to the terms of the 2024 Notes, this optional redemption was made at a price of 100.958%, which resulted in a total cash outlay of approximately$404 million . As a result of this redemption, we recorded a$5.4 million Loss on early extinguishment of debt in the fourth quarter of 2019. Also inNovember 2019 , we amended our existing credit agreement to, among other things, increase the size of our revolving credit facility from$700 million to$1 billion and extend the agreement's maturity by two years to 2024. We have been disciplined in creating a capital structure that is flexible with no significant debt maturities prior to 2023. We continue to have a strong, well-capitalized balance sheet, including a substantial portfolio of owned real estate, and we have significant availability under our revolving credit facility. We continue to generate strong cash flows from operations, and we have significant flexibility with how we choose to invest our cash and return capital to shareholders. See Note 10, Long-term Debt, to the accompanying consolidated financial statements. 60
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Current Liquidity As ofDecember 31, 2019 , we had$94.8 million in Cash and cash equivalents. This amount excludes$64.8 million in restricted cash ($57.4 million included in Restricted cash and$7.4 million included in Other long-term assets in our consolidated balance sheet) and$76.1 million of restricted marketable securities (included in Other long-term assets in our consolidated balance sheet). Our restricted assets pertain primarily to obligations associated with our captive insurance company, as well as obligations we have under agreements with joint venture partners. See Note 4,Cash and Marketable Securities , to the accompanying consolidated financial statements. In addition to Cash and cash equivalents, as ofDecember 31, 2019 , we had approximately$916 million available to us under our revolving credit facility. Our credit agreement governs the substantial majority of our senior secured borrowing capacity and contains a leverage ratio and an interest coverage ratio as financial covenants. Our leverage ratio is defined in our credit agreement as the ratio of consolidated total debt (less up to$300 million of cash on hand) to Adjusted EBITDA for the trailing four quarters. In calculating the leverage ratio under our credit agreement, we are permitted to use pro forma Adjusted EBITDA, the calculation of which includes historical income statement items and pro forma adjustments resulting from (1) the dispositions and repayments or incurrence of debt and (2) the investments, acquisitions, mergers, amalgamations, consolidations and operational changes from acquisitions to the extent such items or effects are not yet reflected in our trailing four-quarter financial statements. Our interest coverage ratio is defined in our credit agreement as the ratio of Adjusted EBITDA to consolidated interest expense, excluding the amortization of financing fees, for the trailing four quarters. As ofDecember 31, 2019 , the maximum leverage ratio requirement per our credit agreement was 4.50x and the minimum interest coverage ratio requirement was 3.0x, and we were in compliance with these covenants. Based on Adjusted EBITDA for 2019 and the interest rate in effect under our credit agreement during the three-month period endedDecember 31, 2019 , if we had drawn on the first day and maintained the maximum amount of outstanding draws under our revolving credit facility for the entire year, we would still be in compliance with the maximum leverage ratio and minimum interest coverage ratio requirements. We do not face near-term refinancing risk, as the amounts outstanding under our credit agreement do not mature until 2024, and our bonds all mature in 2023 and beyond. See the "Contractual Obligations" section below for information related to our contractual obligations as ofDecember 31, 2019 . We acquired a significant portion of our home health and hospice business when we purchasedEHHI Holdings, Inc. ("EHHI") onDecember 31, 2014 . In the acquisition, we acquired all of the issued and outstanding equity interests of EHHI, other than equity interests contributed toEncompass Health Home Health Holdings, Inc. ("Holdings"), a subsidiary ofEncompass Health and an indirect parent of EHHI, by certain sellers in exchange for shares of common stock of Holdings. Those sellers were members of EHHI management, and they contributed a portion of their shares of common stock of EHHI, valued at approximately$64 million on the acquisition date, in exchange for approximately 16.7% of the outstanding shares of common stock of Holdings. At any time afterDecember 31, 2017 , each management investor has the right (but not the obligation) to have his or her shares of Holdings stock repurchased byEncompass Health for a cash purchase price per share equal to the fair value. Specifically, up to one-third of each management investor's shares of Holdings stock may be sold prior toDecember 31, 2018 ; two-thirds of each management investor's shares of Holdings stock may be sold prior toDecember 31, 2019 ; and all of each management investor's shares of Holdings stock may be sold thereafter. At any time afterDecember 31, 2019 ,Encompass Health will have the right (but not the obligation) to repurchase all or any portion of the shares of Holdings stock owned by one or more management investors for a cash purchase price per share equal to the fair value. The fair value is determined using the product of the trailing twelve-month adjusted EBITDA measure for Holdings and a specified median market price multiple based on a basket of public home health companies and transactions, after adding cash and deducting indebtedness that includes the outstanding principal balance under any intercompany notes. InFebruary 2018 , each management investor exercised the right to sell one-third of his or her shares of Holdings stock toEncompass Health , representing approximately 5.6% of the outstanding shares of the common stock of Holdings. OnFebruary 21, 2018 ,Encompass Health settled the acquisition of those shares upon payment of approximately$65 million in cash. InJuly 2019 , we received additional exercise notices, representing approximately 5.6% of the outstanding shares of the common stock of Holdings. InSeptember 2019 ,Encompass Health settled the acquisition of those shares upon payment of approximately$163 million in cash. As ofDecember 31, 2019 , the fair value of those outstanding shares of Holdings owned by management investors is approximately$208 million . InJanuary 2020 , we received additional exercise notices, representing approximately 4.3% of the outstanding shares of the common stock of Holdings. InFebruary 2020 ,Encompass Health settled the acquisition of those shares upon payment of approximately$162 million in cash. Upon settlement of these exercises, approximately$46 million of the shares of Holdings held by two management investors remained outstanding. OnFebruary 20, 2020 ,Encompass Health entered into exchange agreements (each, an "Exchange Agreement") with these two management investors, pursuant to which they have the right to exchange all of the remaining shares of Holdings 61
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held by them for shares of common stock ofEncompass Health (the "EHC Shares"). Each of the Exchange Agreements provides that the management investor must deliver a written exchange notice (an "Exchange Notice") toEncompass Health in order to exchange his or her remaining shares of Holdings for EHC Shares. Each Exchange Agreement further provides that the number of EHC Shares to be delivered to the management investor is to be determined by dividing the fair value of the shares of Holdings held by the management investor on the date of the Exchange Agreement by the last reported sales price ofEncompass Health's common stock on theNew York Stock Exchange (the "NYSE") on the date of delivery of the Exchange Notice. OnFebruary 20, 2020 ,Encompass Health received an Exchange Notice from each of the management investors. Based on the last sales price ofEncompass Health's common stock on the NYSE onFebruary 20, 2020 ,Encompass Health anticipates delivering an aggregate of approximately 561,000 EHC Shares, less than 0.6% of the total number of outstanding shares of theEncompass Health's common stock, to the management investors. The settlement of the exchanges is expected to occur prior to the end of the first quarter of 2020.Encompass Health anticipates issuing the EHC Shares from its treasury shares. See also Note 12, Redeemable Noncontrolling Interests, to the accompanying consolidated financial statements. In conjunction with the EHHI acquisition, we granted stock appreciation rights ("SARs") based on Holdings common stock to certain members of EHHI management at closing. Half of the SARs vested onDecember 31, 2018 with the remainder vesting onDecember 31, 2019 . Upon exercise, each SAR must be settled for cash in the amount by which the per share fair value of Holdings' common stock on the exercise date exceeds the per share fair value on the grant date. InFebruary 2019 , members of the management team exercised a portion of their vested SARs for approximately$13 million in cash. InJuly 2019 , members of the management team exercised the remainder of the vested SARs, which resulted in cash distributions of approximately$55 million . As ofDecember 31, 2019 , the fair value of the remaining 115,545 SARs is approximately$101 million , all of which is included in Other current liabilities in the accompanying consolidated balance sheet. InJanuary 2020 , members of the management team exercised the remaining SARs and inFebruary 2020 , we settled those awards upon payment of approximately$101 million in cash. See also Note 14, Share-Based Payments, to the accompanying consolidated financial statements. We anticipate we will continue to generate strong cash flows from operations that, together with availability under our revolving credit facility, will allow us to invest in growth opportunities and continue to improve our existing business. We also will continue to consider additional shareholder value-enhancing strategies such as repurchases of our common stock and distribution of common stock dividends, including the potential growth of the quarterly cash dividend on our common stock, recognizing that these actions may increase our leverage ratio. See also the "Authorizations forReturning Capital to Stakeholders" section of this Item. See Item 1A, Risk Factors, for a discussion of risks and uncertainties facing us. Sources and Uses of Cash The following table shows the cash flows provided by or used in operating, investing, and financing activities for the years endedDecember 31, 2019 , 2018, and 2017 (in millions): For the Year Ended December 31, 2019 2018 2017
Net cash provided by operating activities
(657.4 ) (424.5 ) (283.0 )
Net cash provided by (used in) financing
activities 48.2 (321.2 ) (359.9 )
Increase in cash, cash equivalents, and
restricted cash $ 26.1 $ 16.7 $ 15.4
2019 Compared to 2018
Operating activities. The decrease in Net cash provided by operating activities
during 2019 compared to 2018 primarily resulted from the payment to management
investors of our home health and hospice segment for vested stock appreciation
rights, the settlement payment associated with the investigation conducted by
the United States Department of Justice , and an increase in Accounts receivable
due to volume increases in both segments during 2019. See Note 18, Contingencies
and Other Commitments, to the accompanying consolidated financial statements.
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Investing activities. The increase in Net cash used in investing activities during 2019 compared to 2018 resulted primarily from the acquisition of Alacare, as described in Note 2, Business Combinations, to the accompanying consolidated financial statements, and an increase in purchases of property and equipment during 2019. Financing activities. The increase in Net cash provided by financing activities during 2019 compared to 2018 primarily resulted from the public offering of the New Notes inSeptember 2019 offset by cash used for principal payments on net debt, repurchases of common stock, and the purchase of equity interests held by the home health and hospice management team during the third quarter of 2019. See also See Note 10, Long-term Debt, and Note 12, Redeemable Noncontrolling Interests, to the accompanying consolidated financial statements. Contractual Obligations Our consolidated contractual obligations as ofDecember 31, 2019 are as follows (in millions): 2025 and Total 2020 2021-2022 2023-2024 thereafter Long-term debt obligations: Long-term debt, excluding revolving credit facility and finance lease obligations (a)$ 2,633.5 $ 18.3 $ 41.5 $ 1,236.8 $ 1,336.9 Revolving credit facility 45.0 - - 45.0 - Interest on long-term debt (b) 840.0 135.8 269.3 230.2 204.7 Finance lease obligations (c) 640.5 50.4 94.4 90.0 405.7 Operating lease obligations (d) 384.2 57.5 98.6 75.1 153.0 Purchase obligations (e) 143.0 61.4 56.8 17.7 7.1 Other long-term liabilities (f)(g) 3.3 0.3 0.4 0.4 2.2 Total$ 4,689.5 $ 323.7 $ 561.0 $ 1,695.2 $ 2,109.6 (a) Included in long-term debt are amounts owed on our bonds payable and other notes payable. These borrowings are further explained in Note 10,
Long-term Debt, to the accompanying consolidated financial statements.
(b) Interest on our fixed rate debt is presented using the stated interest
rate. Interest expense on our variable rate debt is estimated using the
rate in effect as of
agreement and bonds is included to their respective ultimate maturity
dates. Interest related to finance lease obligations is excluded from this
line (see Note 7, Leases, and Note 10, Long-term Debt, to the accompanying
consolidated financial statements). Amounts exclude amortization of debt
discounts, amortization of loan fees, or fees for lines of credit that
would be included in interest expense in our consolidated statements of
operations.
(c) Amounts include interest portion of future minimum finance lease payments.
(d) Our inpatient rehabilitation segment leases approximately 14% of its
hospitals as well as other property and equipment under operating leases
in the normal course of business. Our home health and hospice segment
leases relatively small office spaces in the localities it serves, space
for its corporate office, and other equipment under operating leases in
the normal course of business. Amounts include interest portion of future
minimum operating lease payments. For more information, see Note 7,
Leases, to the accompanying consolidated financial statements.
(e) Purchase obligations include agreements to purchase goods or services that
are enforceable and legally binding on
all significant terms, including: fixed or minimum quantities to be
purchased; fixed, minimum, or variable price provisions; and the
approximate timing of the transaction. Purchase obligations exclude
agreements that are cancelable without penalty. Our purchase obligations
primarily relate to software licensing and support and medical equipment.
Purchase obligations are not recognized in our consolidated balance sheet.
(f) Because their future cash outflows are uncertain, the following noncurrent
liabilities are excluded from the table above: general liability,
professional liability, and workers' compensation risks, noncurrent
amounts related to third-party billing audits, SARs, and deferred income
taxes. As discussed above, the remaining SARs were exercised and settled
during the first quarter of 2020. For more information, see Note 11,
Self-Insured Risks, Note 14, Share-Based
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Payments, and Note 18, Contingencies and Other Commitments, to the accompanying consolidated financial statements. (g) The table above does not include Redeemable noncontrolling interests of
amounts of any related cash outflows. As discussed above, a portion of the
outstanding shares of Holdings were exercised and settled during the first
quarter of 2020. See Note 12, Redeemable Noncontrolling Interests, to the
accompanying consolidated financial statements.
Our capital expenditures include costs associated with our hospital refresh program, de novo projects, capacity expansions, technology initiatives, and building and equipment upgrades and purchases. During the year endedDecember 31, 2019 , we made capital expenditures of approximately$404 million for property and equipment, intangible assets, and capitalized software. These expenditures in 2019 are exclusive of approximately$232 million in net cash related to our acquisition activity. During 2020, we expect to spend approximately$440 million to$510 million for capital expenditures. Approximately$155 million to$165 million of this budgeted amount is considered nondiscretionary expenditures, which we may refer to in other filings as "maintenance" expenditures. In addition, we expect to spend approximately$50 million to$100 million on home health and hospice acquisitions during 2020. Actual amounts spent will be dependent upon the timing of construction projects and acquisition opportunities for our home health and hospice business. Authorizations forReturning Capital to Stakeholders InOctober 2018 ,February 2019 , andMay 2019 , our board of directors declared cash dividends of$0.27 per share that were paid inJanuary 2019 ,April 2019 , andJuly 2019 , respectively. OnJuly 23, 2019 , our board of directors approved an increase in our quarterly dividend and declared a cash dividend of$0.28 per share, that was paid onOctober 15, 2019 . OnOctober 25, 2019 , our board of directors declared a cash dividend of$0.28 per share, that was paid onJanuary 15, 2020 to stockholders of record onJanuary 2, 2020 . We expect quarterly dividends to be paid in January, April, July, and October. However, the actual declaration of any future cash dividends, and the setting of record and payment dates as well as the per share amounts, will be at the discretion of our board of directors after consideration of various factors, including our capital position and alternative uses of funds. Cash dividends are expected to be funded using cash flows from operations, cash on hand, and availability under our revolving credit facility. OnOctober 28, 2013 , we announced our board of directors authorized the repurchase of up to$200 million of our common stock, which amount was subsequently increased to$250 million . OnJuly 24, 2018 , our board approved resetting the aggregate common stock repurchase authorization to$250 million . As ofDecember 31, 2019 , approximately$204 million remained under this authorization. The repurchase authorization does not require the repurchase of a specific number of shares, has an indefinite term, and is subject to termination at any time by our board of directors. Subject to certain terms and conditions, including a maximum price per share and compliance with federal and state securities and other laws, the repurchases may be made from time to time in open market transactions, privately negotiated transactions, or other transactions, including trades under a plan established in accordance with Rule 10b5-1 under the Securities Exchange Act of 1934, as amended. During 2019, we repurchased 0.8 million shares of our common stock in the open market for approximately$46 million under this repurchase authorization using cash on hand. Future repurchases under this authorization generally are expected to be funded using a combination of cash on hand and availability under our$1 billion revolving credit facility. Adjusted EBITDA Management believes Adjusted EBITDA as defined in our credit agreement is a measure of our ability to service our debt and our ability to make capital expenditures. We reconcile Adjusted EBITDA to Net income and to Net cash provided by operating activities. We use Adjusted EBITDA on a consolidated basis as a liquidity measure. We believe this financial measure on a consolidated basis is important in analyzing our liquidity because it is the key component of certain material covenants contained within our credit agreement, which is discussed in more detail in Note 10, Long-term Debt, to the accompanying consolidated financial statements. These covenants are material terms of the credit agreement. Noncompliance with these financial covenants under our credit agreement-our interest coverage ratio and our leverage ratio-could result in our lenders requiring us to immediately repay all amounts borrowed. If we anticipated a potential covenant violation, we would seek relief from our lenders, which would have some cost to us, and such relief might be on terms less favorable to us than those in our existing credit agreement. In addition, if we cannot satisfy these financial covenants, we would be prohibited under our credit agreement from engaging in certain activities, such as incurring additional indebtedness, paying common stock dividends, making certain payments, and acquiring and disposing of assets. Consequently, Adjusted EBITDA is critical to our assessment of our liquidity. 64
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In general terms, the credit agreement definition of Adjusted EBITDA, therein referred to as "Adjusted Consolidated EBITDA," allows us to add back to consolidated Net income interest expense, income taxes, and depreciation and amortization and then add back to consolidated Net income (1) all unusual or nonrecurring items reducing consolidated Net income (of which only up to$10 million in a year may be cash expenditures), (2) any losses from discontinued operations, (3) non-ordinary course fees, costs and expenses incurred with respect to any litigation or settlement, (4) share-based compensation expense, (5) costs and expenses associated with changes in the fair value of marketable securities, (6) costs and expenses associated with the issuance or prepayment debt and acquisitions, and (7) any restructuring charges not in excess of 20% of Adjusted Consolidated EBITDA. We also subtract from consolidated Net income all unusual or nonrecurring items to the extent they increase consolidated Net income. Under the credit agreement, the Adjusted EBITDA calculation does not require us to deduct net income attributable to noncontrolling interests or gains on fair value adjustments of hedging and equity instruments, disposal of assets, and development activities. It also does not allow us to add back losses on fair value adjustments of hedging instruments or unusual or nonrecurring cash expenditures in excess of$10 million . These items and amounts, in addition to the items falling within the credit agreement's "unusual or nonrecurring" classification, may occur in future periods, but can vary significantly from period to period and may not directly relate to, or be indicative of, our ongoing liquidity or operating performance. Accordingly, the Adjusted EBITDA calculation presented here includes adjustments for them. Adjusted EBITDA is not a measure of financial performance under generally accepted accounting principles inthe United States of America , and the items excluded from Adjusted EBITDA are significant components in understanding and assessing financial performance. Therefore, Adjusted EBITDA should not be considered a substitute for Net income or cash flows from operating, investing, or financing activities. Because Adjusted EBITDA is not a measurement determined in accordance with GAAP and is thus susceptible to varying calculations, Adjusted EBITDA, as presented, may not be comparable to other similarly titled measures of other companies. Revenues and expenses are measured in accordance with the policies and procedures described in Note 1, Summary of Significant Accounting Policies, to the accompanying consolidated financial statements. Our Adjusted EBITDA for the years endedDecember 31, 2019 , 2018, and 2017 was as follows (in millions): Reconciliation of Net Income to Adjusted EBITDA
For the Year Ended December 31,
2019 2018 2017
Net income $ 445.8 $ 375.4 $ 350.2
Loss (income) from discontinued operations, net
of tax, attributable to Encompass Health 0.6 (1.1 ) 0.4
Provision for income tax expense 115.9 118.9 145.8
Interest expense and amortization of debt
discounts and fees 159.7 147.3 154.4
Loss on early extinguishment of debt 7.7 - 10.7
Government, class action, and related
settlements - 52.0 -
Net noncash loss on disposal of assets 11.1 5.7 4.6
Depreciation and amortization 218.7 199.7 183.8
Stock-based compensation expense 114.4 85.9 47.7
Net income attributable to noncontrolling
interests (87.1 ) (83.1 ) (79.1 )
Transaction costs 2.1 1.0 -
Gain on consolidation of Yuma (19.2 ) - -
SARs mark-to-market impact on noncontrolling
interests (5.0 ) (2.6 ) -
Change in fair market value of equity securities (0.8 ) 1.9 -
Tax reform impact on noncontrolling interests - - 4.6
Payroll taxes on SARs exercise 1.0 - -
Adjusted EBITDA $ 964.9 $ 901.0 $ 823.1
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Reconciliation of Net Cash Provided by Operating Activities to Adjusted EBITDA
For the Year Ended December 31,
2019 2018 2017
Net cash provided by operating activities $ 635.3 $ 762.4 $ 658.3
Interest expense and amortization of debt
discounts and fees 159.7 147.3 154.4
Equity in net income of nonconsolidated
affiliates 6.7 8.7 8.0
Net income attributable to noncontrolling
interests in continuing operations (87.1 ) (83.1 ) (79.1 )
Amortization of debt-related items (4.5 ) (4.0 ) (8.7 )
Distributions from nonconsolidated affiliates (6.6 ) (8.3 ) (8.6 )
Current portion of income tax expense 75.9 128.0 85.0
Change in assets and liabilities 180.1 (46.0 ) 7.4
Tax reform impact on noncontrolling interests - - 4.6
Cash used in operating activities of
discontinued operations 4.4 (0.8 ) 0.6
Transaction costs 2.1 1.0 -
SARs mark-to-market impact on noncontrolling
interests (5.0 ) (2.6 ) -
Change in fair market value of equity securities (0.8 ) 1.9 -
Payroll taxes on SARs exercise 1.0 - -
Other 3.7 (3.5 ) 1.2
Adjusted EBITDA $ 964.9 $ 901.0 $ 823.1
Growth in Adjusted EBITDA in 2019 compared to 2018 resulted primarily from
revenue growth. For additional information see the "Results of Operations" and
"Segment Results of Operations" sections of this Item.
Off-Balance Sheet Arrangements
In accordance with the definition under SEC rules, the following qualify as
off-balance sheet arrangements:
• any obligation under certain guarantees or contracts;
• a retained or contingent interest in assets transferred to an
unconsolidated entity or similar entity or similar arrangement thatserves as credit, liquidity, or market risk support to that entity for
such assets;
• any obligation under certain derivative instruments; and
• any obligation under a material variable interest held by the
registrant in an unconsolidated entity that provides financing,
liquidity, market risk, or credit risk support to the registrant, or
engages in leasing, hedging, or research and development services with
the registrant.
As of December 31, 2019 , we do not have any material off-balance sheet
arrangements.
As part of our ongoing business, we do not participate in transactions that
generate relationships with unconsolidated entities or financial partnerships,
such as entities often referred to as structured finance or special purpose
entities ("SPEs"), which would have been established for the purpose of
facilitating off-balance sheet arrangements or other contractually narrow or
limited purposes. As of December 31, 2019 , we are not involved in any
unconsolidated SPE transactions.
Critical Accounting Estimates
Our consolidated financial statements are prepared in accordance with GAAP. In
connection with the preparation of our financial statements, we are required to
make assumptions and estimates about future events and apply judgments that
affect the reported amounts of assets, liabilities, revenue, expenses, and the
related disclosures. We base our assumptions, estimates, and judgments on
historical experience, current trends, and other factors we believe to be
relevant at the time we prepared our consolidated financial statements. On a
regular basis, we review the accounting policies, assumptions, estimates, and
judgments to ensure our consolidated financial statements are presented fairly
and in accordance with GAAP. However,
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because future events and their effects cannot be determined with certainty,
actual results could differ from our assumptions and estimates, and such
differences could be material.
Our significant accounting policies are discussed in Note 1, Summary of
Significant Accounting Policies, to the accompanying consolidated financial
statements. We believe the following accounting estimates are the most critical
to aid in fully understanding and evaluating our reported financial results, as
they require our most difficult, subjective, or complex judgments, resulting
from the need to make estimates about the effect of matters that are inherently
uncertain. We have reviewed these critical accounting estimates and related
disclosures with the audit committee of our board of directors.
Revenue Recognition
We recognize net operating revenue in the reporting period in which we perform
the service based on our best estimate of the transaction price for the type of
service provided to the patient. Our estimate of the transaction price includes
estimates of price concessions for such items as contractual allowances
(principally for patients covered by Medicare, Medicare Advantage, Medicaid, and
other third-party payors), potential adjustments that may arise from payment and
other reviews, and uncollectible amounts. See Note 1, Summary of Significant
Accounting Policies, "Net Operating Revenues," to the accompanying consolidated
financial statements of this report for a complete discussion of our revenue
recognition policies.
Our patient accounting systems calculate contractual allowances on a
patient-by-patient basis based on the rates in effect for each primary
third-party payor. Certain other factors that are considered and could influence
the estimated transaction price are assumed to remain consistent with the
experience for patients discharged in similar time periods for the same payor
classes, and additional adjustments are provided to account for these factors.
Management continually reviews the revenue transaction price estimation process
to consider and incorporate updates to laws and regulations and the frequent
changes in managed care contractual terms that result from contract
renegotiations and renewals. In addition, laws and regulations governing the
Medicare and Medicaid programs are complex and subject to interpretation. If
actual results are not consistent with our assumptions and judgments, we may be
exposed to gains or losses that could be material.
Due to complexities involved in determining amounts ultimately due under
reimbursement arrangements with third-party payors, which are often subject to
interpretation and review, we may receive reimbursement for healthcare services
authorized and provided that is different from our estimates, and such
differences could be material. However, we continually review the amounts
actually collected in subsequent periods in order to determine the amounts by
which our estimates differed. Historically, such differences have not been
material from either a quantitative or qualitative perspective.
The collection of outstanding receivables from third-party payors and patients
is our primary source of cash and is critical to our operating performance. Our
primary collection risks relate to patient responsibility amounts and claims
reviews conducted by MACs or other contractors.
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The table below shows a summary of our net accounts receivable balances as ofDecember 31, 2019 and 2018. Information on the concentration of total patient accounts receivable by payor class can be found in Note 1, Summary of Significant Accounting Policies, "Accounts Receivable," to the accompanying consolidated financial statements. As of December 31, 2019 2018 (In Millions) Current: 0 - 30 Days$ 385.6 $ 362.5 31 - 60 Days 45.2 43.7 61 - 90 Days 25.4 18.4 91 - 120 Days 12.7 10.0 120 + Days 29.8 25.3 Patient accounts receivable 498.7 459.9 Other accounts receivable 7.4 7.8 506.1 467.7 Noncurrent patient accounts receivable 152.1 155.5 Accounts receivable$ 658.2 $ 623.2 Changes in general economic conditions (such as increased unemployment rates or periods of recession), business office operations, payor mix, or trends in federal or state governmental and private employer healthcare coverage could affect our collection of accounts receivable. Our collection risks include patient accounts for which the primary insurance carrier has paid the amounts covered by the applicable agreement, but patient responsibility amounts (deductibles and co-payments) remain outstanding, pre-payment claim reviews by our respective MACs, and reimbursement claims audits by governmental or other payors and their agents. As ofDecember 31, 2019 and 2018,$144.5 million and$149.3 million of our patient accounts receivable represented denials that were under review or audit in our inpatient rehabilitation segment. If actual results are not consistent with our assumptions and judgments, we may be exposed to gains or losses that could be material. See Note 1, Summary of Significant Accounting Policies, "Net Operating Revenues" and "Accounts Receivable," to the accompanying consolidated financial statements of this report. Self-Insured Risks We are self-insured for certain losses related to professional liability, general liability, and workers' compensation risks. Although we obtain third-party insurance coverage to limit our exposure to these claims, a substantial portion of our professional liability, general liability, and workers' compensation risks are insured through a wholly owned insurance subsidiary. See Note 11, Self-Insured Risks, to the accompanying consolidated financial statements for a more complete discussion of our self-insured risks. Our self-insured liabilities contain uncertainties because management must make assumptions and apply judgment to estimate the ultimate cost of reported claims and claims incurred but not reported as of the balance sheet date. Our reserves and provisions for professional liability, general liability, and workers' compensation risks are based largely upon semi-annual actuarial calculations prepared by third-party actuaries. Periodically, we review our assumptions and the valuations provided by third-party actuaries to determine the adequacy of our self-insurance reserves. The following are certain of the key assumptions and other factors that significantly influence our estimate of self-insurance reserves: historical claims experience; trending of loss development factors; trends in the frequency and severity of claims; coverage limits of third-party insurance; demographic information; statistical confidence levels; medical cost inflation; payroll dollars; and hospital patient census. The time period to resolve claims can vary depending upon the jurisdiction, the nature, and the form of resolution of the claims. The estimation of the timing of payments beyond a year can vary significantly. In addition, if current and future claims differ from historical trends, our estimated reserves for self-insured claims may be significantly affected. Our self-insurance reserves are not discounted. 68
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Given the number of factors used to establish our self-insurance reserves, we believe there is limited benefit to isolating any individual assumption or parameter from the detailed computational process and calculating the impact of changing that single item. Instead, we believe the sensitivity in our reserve estimates is best illustrated by changes in the statistical confidence level used in the computations. Using a higher statistical confidence level increases the estimated self-insurance reserves. The following table shows the sensitivity of our recorded self-insurance reserves to the statistical confidence level (in millions): Net self-insurance reserves as ofDecember 31, 2019 : As reported, with 50% statistical confidence level 130.9 With 70% statistical confidence level 139.9 We believe our efforts to improve patient safety and overall quality of care, as well as our efforts to reduce workplace injuries, have helped contain our ultimate claim costs. See Note 11, Self-Insured Risks, to the accompanying consolidated financial statements for additional information. We believe our self-insurance reserves are adequate to cover projected costs. Due to the considerable variability that is inherent in such estimates, there can be no assurance the ultimate liability will not exceed management's estimates. If actual results are not consistent with our assumptions and judgments, we may be exposed to gains or losses that could be material.Goodwill Absent any impairment indicators, we evaluate goodwill for impairment as ofOctober 1st of each year. We test goodwill for impairment at the reporting unit level and are required to make certain subjective and complex judgments on a number of matters, including assumptions and estimates used to determine the fair value of our inpatient rehabilitation and home health and hospice reporting units. We assess qualitative factors in each reporting unit to determine whether it is necessary to perform the quantitative goodwill impairment test. The quantitative impairment test is required only if we conclude it is more likely than not a reporting unit's fair value is less than its carrying amount. If, based on our qualitative assessment, we were to believe we must perform the quantitative goodwill impairment test, we would determine the fair value of the applicable reporting unit using generally accepted valuation techniques including the income approach and the market approach. We would validate our estimates under the income approach by reconciling the estimated fair value of the reporting units determined under the income approach to our market capitalization and estimated fair value determined under the market approach. Values from the income approach and market approach would then be evaluated and weighted to arrive at the estimated aggregate fair value of the reporting units. The income approach includes the use of each reporting unit's projected operating results and cash flows that are discounted using a weighted-average cost of capital that reflects market participant assumptions. The projected operating results use management's best estimates of economic and market conditions over the forecasted period including assumptions for pricing and volume, operating expenses, and capital expenditures. Other significant estimates and assumptions include cost-saving synergies and tax benefits that would accrue to a market participant under a fair value methodology. The market approach estimates fair value through the use of observable inputs, including the Company's stock price. See Note 1, Summary of Significant Accounting Policies, "Goodwill and Other Intangibles," and Note 8,Goodwill and Other Intangible Assets, to the accompanying consolidated financial statements for additional information. The following events and circumstances are certain of the qualitative factors we consider in evaluating whether it is more likely than not the fair value of a reporting unit is less than its carrying amount: • Macroeconomic conditions, such as deterioration in general economic
conditions, limitations on accessing capital, or other developments in
equity and credit markets;
• Industry and market considerations and changes in healthcare
regulations, including reimbursement and compliance requirements under
the Medicare and Medicaid programs;
• Cost factors, such as an increase in labor, supply, or other costs;
• Overall financial performance, such as negative or declining cash flows
or a decline in actual or forecasted revenue or earnings;
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• Other relevant company-specific events, such as material changes in
management or key personnel or outstanding litigation;
• Material events, such as a change in the composition or carrying amount
of each reporting unit's net assets, including acquisitions and
dispositions;
• Consideration of the relationship of our market capitalization to our
book value, as well as a sustained decrease in our share price; and
• Length of time since most recent qualitative analysis.
In the fourth quarter of 2019, we performed our annual evaluation of goodwill and determined no adjustment to impair goodwill was necessary. If actual results are not consistent with our assumptions and estimates, we may be exposed to goodwill impairment charges. However, at this time, we continue to believe our inpatient rehabilitation and home health and hospice reporting units are not at risk for any impairment charges. Income Taxes We provide for income taxes using the asset and liability method. We also evaluate our tax positions and establish assets and liabilities in accordance with the applicable accounting guidance on uncertainty in income taxes. See Note 1, Summary of Significant Accounting Policies, "Income Taxes," and Note 16, Income Taxes, to the accompanying consolidated financial statements for a more complete discussion of income taxes and our policies related to income taxes. The application of income tax law is inherently complex. Laws and regulations in this area are voluminous and are often ambiguous. We are required to make many subjective assumptions and judgments regarding our income tax exposures. Interpretations of and guidance surrounding income tax laws and regulations change over time. As such, changes in our subjective assumptions and judgments can materially affect amounts recognized in our consolidated financial statements. The ultimate recovery of certain of our deferred tax assets is dependent on the amount and timing of taxable income we will ultimately generate in the future, as well as other factors. A high degree of judgment is required to determine the extent a valuation allowance should be provided against deferred tax assets. On a quarterly basis, we assess the likelihood of realization of our deferred tax assets considering all available evidence, both positive and negative. Our operating performance in recent years, the scheduled reversal of temporary differences, our forecast of taxable income in future periods in each applicable tax jurisdiction, our ability to sustain a core level of earnings, and the availability of prudent tax planning strategies are important considerations in our assessment. Our forecast of future earnings includes assumptions about patient volumes, payor reimbursement, labor costs, hospital operating expenses, and interest expense. Based on the weight of available evidence, we determine if it is more likely than not our deferred tax assets will be realized in the future. Our liability for unrecognized tax benefits contains uncertainties because management is required to make assumptions and to apply judgment to estimate the exposures associated with our various filing positions which are periodically audited by tax authorities. In addition, our effective income tax rate is affected by changes in tax law, the tax jurisdictions in which we operate, and the results of income tax audits. During the year endedDecember 31, 2019 , we increased our valuation allowance by$4.7 million . As ofDecember 31, 2019 , we had a remaining valuation allowance of$38.4 million which primarily related to state NOLs. At the state jurisdiction level, we determined it was necessary to maintain a valuation allowance due to uncertainties related to our ability to utilize a portion of the NOLs before they expire. The amount of the valuation allowance has been determined for each tax jurisdiction based on the weight of all available evidence, as described above, including management's estimates of taxable income for each jurisdiction in which we operate over the periods in which the related deferred tax assets will be recoverable. While management believes the assumptions included in its forecast of future earnings are reasonable and it is more likely than not the net deferred tax asset balance as ofDecember 31, 2019 will be realized, no such assurances can be provided. If management's expectations for future operating results on a consolidated basis or at the state jurisdiction level vary from actual results due to changes in healthcare regulations, general economic conditions, or other factors, we may need to increase our valuation allowance, or reverse amounts recorded currently in the valuation allowance, for all or a portion of our deferred tax assets. Similarly, future adjustments to our valuation allowance may be necessary if the timing of future tax deductions is different than currently expected. Our income tax expense in future periods will be reduced or increased to the extent of offsetting decreases or increases, respectively, in our valuation allowance in the period when the change in circumstances occurs. These changes could have a significant impact on our future earnings. 70
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Assessment of Loss Contingencies We have legal and other contingencies that could result in significant losses upon the ultimate resolution of such contingencies. See Note 1, Summary of Significant Accounting Policies, "Litigation Reserves," and Note 18, Contingencies and Other Commitments, to the accompanying consolidated financial statements for additional information. We have provided for losses in situations where we have concluded it is probable a loss has been or will be incurred and the amount of loss is reasonably estimable. A significant amount of judgment is involved in determining whether a loss is probable and reasonably estimable due to the uncertainty involved in determining the likelihood of future events and estimating the financial statement impact of such events. If further developments or resolution of a contingent matter are not consistent with our assumptions and judgments, we may need to recognize a significant charge in a future period related to an existing contingent matter. Business Combinations We account for acquisitions of entities that qualify as business combinations under the acquisition method of accounting. Under the acquisition method of accounting, the total consideration is allocated to the tangible and identifiable intangible assets acquired and liabilities assumed based on their estimated fair values at the acquisition date. The excess of the purchase price over the fair values of these identifiable assets and liabilities is recorded as goodwill. During the measurement period, which may be up to one year from the acquisition date, we may record adjustments to the assets acquired and liabilities assumed with the corresponding offset to goodwill. In determining the fair value of assets acquired and liabilities assumed in a business combination, we primarily use the income and multi-period excess earnings approaches to estimate the value of our most significant acquired intangible assets. Both income approaches utilize projected operating results and cash flows and include significant assumptions such as base revenue, revenue growth rate, projected EBITDA margin, discount rates, rates of increase in operating expenses, and the future effective income tax rates. The valuations of our significant acquired businesses have been performed by a third-party valuation specialist under our management's supervision. We believe that the estimated fair value assigned to the assets acquired and liabilities assumed is based on reasonable assumptions and estimates that marketplace participants would use. However, such assumptions are inherently uncertain and actual results could differ from those estimates. Future changes in our assumptions or the interrelationship of those assumptions may result in purchase price allocations that are different than those recorded in recent years. Acquisition related costs are not considered part of the consideration paid and are expensed as operating expenses as incurred. Contingent consideration, if any, is measured at fair value initially on the acquisition date as well as subsequently at the end of each reporting period until the contingency is resolved and settlement occurs. Subsequent adjustments to contingent considerations are recorded in our consolidated statements of operations. We include the results of operations of the businesses acquired as of the beginning of the acquisition dates. Recent Accounting Pronouncements For information regarding recent accounting pronouncements, see Note 1, Summary of Significant Accounting Policies, to the accompanying consolidated financial statements. Item 7A. Quantitative and Qualitative Disclosures about Market Risk Our primary exposure to market risk is to changes in interest rates on our variable rate long-term debt. We use a sensitivity analysis model to evaluate the impact of interest rate changes on our variable rate debt. As ofDecember 31, 2019 , our primary variable rate debt outstanding related to$45.0 million in advances under our revolving credit facility and$265.2 million outstanding under our term loan facilities. Assuming outstanding balances were to remain the same, a 1% increase in interest rates would result in an incremental negative cash flow of approximately$2.7 million over the next 12 months, while a 1% decrease in interest rates would result in an incremental positive cash flow of approximately$2.7 million over the next 12 months. 71
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The fair value of our fixed rate debt is determined using inputs, including quoted prices in nonactive markets, that are observable either directly or indirectly, or Level 2 inputs within the fair value hierarchy, and is summarized as follows (in millions):
December 31, 2019 December 31, 2018
Financial Instrument: Book Value Market Value Book Value Market Value
5.125% Senior Notes due 2023
Carrying Value $ 297.3 $ - $ 296.6 $ -
Unamortized debt discount and fees 2.7 - 3.4 -
Principal amount 300.0 306.6 300.0 298.5
5.75% Senior Notes due 2024
Carrying Value 697.3 - 1,194.7 -
Unamortized debt discount and fees 2.7 - 5.3 -
Principal amount 700.0 708.8 1,200.0 1,200.0
5.75% Senior Notes due 2025
Carrying Value 345.6 - 345.0 -
Unamortized debt discount and fees 4.4 - 5.0 -
Principal amount 350.0 369.7 350.0 339.5
4.50% Senior Notes due 2028
Carrying Value 491.7 - - -
Unamortized debt discount and fees 8.3 - - -
Principal amount 500.0 519.4 - -
4.75% Senior Notes due 2030
Carrying Value 491.7 - - -
Unamortized debt discount and fees 8.3 - - -
Principal amount 500.0 520.0 - -
Foreign operations, and the related market risks associated with foreign
currencies, are currently, and have been, insignificant to our financial
position, results of operations, and cash flows.
See also Note 10, Long-term Debt, to the accompanying consolidated financial
statements.
Item 8. Financial Statements and Supplementary Data
Our consolidated financial statements and related notes are filed together with
this report. See the index to financial statements on page F-1 for a list of
financial statements filed with this report.
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