Back to GetFilings.com



Table of Contents
Index to Financial Statements

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, DC 20549

 


 

FORM 10-K

 

ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)

OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the fiscal years ended December 31, 2003 and 2002,

including a restatement of previously issued consolidated financial statements

for the fiscal years ended December 31, 2001 and 2000

 

Commission File Number 1-10315

 


 

HealthSouth Corporation

(Exact Name of Registrant as Specified in its Charter)

 

Delaware   63-0860407

(State or Other Jurisdiction of

Incorporation or Organization)

  (I.R.S. Employer Identification No.)

One HealthSouth Parkway

Birmingham, Alabama

  35243
(Address of Principal Executive Offices)   (Zip Code)

 

Registrant’s Telephone Number, Including Area Code:    (205) 967-7116

 


 

Securities Registered Pursuant to Section 12(b) of the Act:

 

None

 

Securities Registered Pursuant to Section 12(g) of the Act:

 

Common Stock, $.01 Par Value

 


 

Indicate by check mark whether the registrant (1) has filed all Reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such Reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  ¨    No  x

 

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein and will not be contained, to the best of the registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.    ¨

 

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act). Yes   x    No  ¨

 

As of May 31, 2005, there were outstanding 397,063,445 shares of common stock of the registrant, net of treasury shares. As of June 30, 2004, the aggregate market value of common stock held by nonaffiliates was approximately $2.3 billion. For purposes of the foregoing calculation only, executive officers and directors of the registrant have been deemed to be affiliates.

 

Documents Incorporated by Reference:    None

 

 


Table of Contents
Index to Financial Statements

TABLE OF CONTENTS

          Page

Cautionary Statement Regarding Forward-Looking Statements    ii
PART I          
Item 1.    Business    1
Item 2.    Properties    42
Item 3.    Legal Proceedings    43
Item 4.    Submission of Matters to a Vote of Security Holders    53
PART II          
Item 5.    Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities    54
Item 6.    Selected Financial Data    56
Item 7.    Management’s Discussion and Analysis of Financial Condition and Results of Operations    59
Item 7A.    Quantitative and Qualitative Disclosures About Market Risk    116
Item 8.    Financial Statements and Supplementary Data    117
Item 9.    Changes in and Disagreements with Accountants on Accounting and Financial Disclosure    117
Item 9A.    Controls and Procedures    117
Item 9B.    Other Information    121
PART III          
Item 10.    Directors and Executive Officers of the Registrant    122
Item 11.    Executive Compensation    132
Item 12.    Security Ownership of Certain Beneficial Owners and Management    146
Item 13.    Certain Relationships and Related Transactions    148
Item 14.    Principal Accountant Fees and Services    158
PART IV          
Item 15.    Exhibits, Financial Statement Schedules, and Reports on Form 8-K    161

 

i


Table of Contents
Index to Financial Statements

CAUTIONARY STATEMENT REGARDING FORWARD-LOOKING STATEMENTS

 

This annual report contains historical information, as well as forward-looking statements that involve known and unknown risks and relate to future events, our future financial performance, or our projected business results. In some cases, you can identify forward-looking statements by terminology such as “may,” “will,” “should,” “expects,” “plans,” “anticipates,” “believes,” “estimates,” “predicts,” “targets,” “potential,” or “continue” or the negative of these terms or other comparable terminology. Such forward-looking statements are necessarily estimates based upon current information and involve a number of risks and uncertainties. Actual events or results may differ materially from the results anticipated in these forward-looking statements as a result of a variety of factors. While it is impossible to identify all such factors, factors that could cause actual results to differ materially from those estimated by us include:

 

    each of the factors discussed in Item 1, Business, “Risk Factors;”

 

    the outcome of continuing investigations by the Department of Justice and other governmental agencies regarding our financial reporting and related activity;

 

    the outcome of pending litigation filed against us, including class action litigation alleging violations of federal securities laws by us;

 

    significant changes in our management team;

 

    unreliability of our previously issued financial statements;

 

    responses to our restatement of previously issued financial statements;

 

    our ability to successfully refinance our existing indebtedness as it becomes due;

 

    our ability to continue to operate in the ordinary course and manage our relationships with our patients, lenders, bondholders, vendors, suppliers, and employees;

 

    changes or delays in or suspension of reimbursement for our services by governmental or private payors;

 

    changes in the regulations of the health care industry at either or both of the federal and state levels;

 

    changes in reimbursement for health care services we provide;

 

    competitive pressures in the health care industry and our response to those pressures;

 

    our ability to obtain and retain favorable arrangements with third-party payors;

 

    our ability to attract and retain nurses, therapists, and other health care professionals in a highly competitive environment with often severe staffing shortages; and

 

    general conditions in the economy and capital markets.

 

The cautionary statements referred to in this section also should be considered in connection with any subsequent written or oral forward-looking statements that may be issued by us or persons acting on our behalf. We undertake no duty to update these forward-looking statements, even though our situation may change in the future. Furthermore, we cannot guarantee future results, events, levels of activity, performance, or achievements.

 

ii


Table of Contents
Index to Financial Statements

SPECIAL NOTE ABOUT THIS REPORT

 

This annual report is our first regular periodic report covering periods after September 30, 2002. Readers should be aware that several aspects of this annual report differ from other annual reports. First, this report is for the annual reporting periods ended December 31, 2003 and 2002. Second, because of the gap in our public reporting and the significant changes we have made to our business in the interim, most of the information relating to our business, current directors, current officers, and related matters is primarily for the period between December 31, 2003 and the date of this filing. Third, this report contains a restatement of our previously issued consolidated financial statements for 2001 and 2000 in addition to initial consolidated financial statements for 2003 and 2002.

 

PART I

 

Item 1. Business

 

General

 

HealthSouth is the largest provider of ambulatory surgery and rehabilitative health care services in the United States, with approximately 1,300 facilities and 40,000 full- and part-time employees. As used in this report, the terms “HealthSouth,” “we,” “us,” “our,” and the “company” refer to HealthSouth Corporation and its subsidiaries, unless otherwise stated or indicated by context. In addition, we use the term “HealthSouth Corporation” to refer to HealthSouth Corporation alone wherever a distinction between HealthSouth Corporation and its subsidiaries is required or aids in the understanding of this filing.

 

HealthSouth Corporation was organized as a Delaware corporation in February 1984. Our principal executive offices are located at One HealthSouth Parkway, Birmingham, Alabama 35243, and the telephone number of our principal executive offices is (205) 967-7116.

 

Significant Events Since Our Last Regular Periodic Report

 

It has been more than two years since our last annual or quarterly periodic filing. In the interim, our employees, investors, and partners have experienced profound turmoil and change. Despite these challenges, we have stabilized operations, cooperated with federal investigators, and in some cases reached settlements with government agencies. Moreover, we have identified and partially remedied deficient operational and accounting controls, made significant positive changes to our management team and board of directors, and worked to restore our credibility. In addition, we have transformed our corporate culture into one premised on integrity, transparency, honesty, accountability, and regulatory compliance. In short, we are working to put the past behind us.

 

Below is a summary of significant events that have occurred since the filing of our quarterly report for the period ended September 30, 2002. We encourage you to read this summary together with the discussions contained in this Item, “Risk Factors,” and in Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations, which highlight additional considerations about HealthSouth.

 

Governmental Investigations

 

As described more fully below, we recently settled a lawsuit brought by the United States Securities and Exchange Commission (the “SEC”) relating to our financial reporting practices prior to March 2003. Investigations by the criminal division of the United States Department of Justice (the “DOJ”) and the United States Attorney’s Office for the Northern District of Alabama are ongoing. We also were the subject of an investigation by the DOJ’s civil division regarding our participation in federal health care programs that was recently concluded, although the DOJ’s civil division continues to review certain self-disclosures made by us to

 

1


Table of Contents
Index to Financial Statements

the Office of Inspector General (the “OIG”) of the United States Department of Health and Human Services (“HHS”). As reflected in the following timeline, we became aware of these investigations beginning in late 2002 and early 2003.

 

    September 17, 2002—The SEC’s Division of Enforcement notified us that it was conducting an investigation of trading in our securities that occurred prior to an August 27, 2002 press release concerning the impact of new Medicare billing guidance on our expected earnings.

 

    February 5, 2003—The United States District Court for the Northern District of Alabama issued a subpoena requiring us to provide various documents in connection with a criminal investigation of us and certain of our directors, officers, and employees being conducted by the United States Attorney for the Northern District of Alabama.

 

    March 18, 2003—Agents from the Federal Bureau of Investigation (the “FBI”) executed a search warrant at our headquarters and were provided access to a number of financial records and other materials. The agents simultaneously served a grand jury subpoena on us on behalf of the DOJ’s criminal division. Some of our employees also received subpoenas.

 

    March 19, 2003—The SEC filed a lawsuit in the United States District Court for the Northern District of Alabama against us and our then-Chairman and Chief Executive Officer, Richard M. Scrushy. The lawsuit alleges we overstated earnings by at least $1.4 billion since 1999, and that this overstatement occurred because Mr. Scrushy insisted we meet or exceed earnings expectations established by Wall Street analysts.

 

    April 10, 2003—The DOJ’s civil division notified us that it was expanding its civil fraud investigation of HealthSouth into allegations we submitted various fraudulent Medicare cost reports.

 

Public disclosure of these investigations and the SEC’s lawsuit precipitated a number of events that had an immediate and substantial negative impact on our business, financial condition, results of operations, and cash flows. These events, which began within weeks of the SEC’s lawsuit, are summarized below:

 

    The SEC ordered a two-day halt in trading of our securities.

 

    The New York Stock Exchange (“NYSE”) delisted our common stock.

 

    Our lenders froze the line of credit under our $1.25 billion credit agreement, substantially impairing our liquidity, and subsequently claimed we were in default under that agreement.

 

    Our lenders instituted a payment blockage that, among other things, prohibited us from making an approximately $350 million payment due April 1, 2003 to certain bondholders.

 

    Certain bondholders delivered notices of technical default.

 

    A number of lawsuits were filed against us and some of our current and former employees, officers, and directors in the United States District Court for the Northern District of Alabama, generally purporting to be class actions under the federal securities laws on behalf of those who purchased our common stock and other securities during a period beginning February 25, 1998 and ending March 19, 2003.

 

    Approximately 14 insurance companies, including the primary carriers for our director and officer liability policy, filed complaints against us in an attempt to rescind or deny coverage under various insurance policies.

 

As described more fully below, as of the filing date of this annual report:

 

   

We have settled with the DOJ’s civil division and other parties regarding their allegations that we submitted various fraudulent Medicare cost reports and committed certain other violations of federal health care program requirements. Although this settlement does not cover all similar claims that have been or could be brought against us, it settles the primary known claims that have been pending against us relating to our participation in federal health care programs. The DOJ’s civil division continues to

 

2


Table of Contents
Index to Financial Statements
 

review certain self-disclosures made by us to the OIG. For additional information about this settlement, see this Item, “Medicare Program Settlement.”

 

    We have settled with the SEC regarding its allegations that we violated and/or aided and abetted violations of the antifraud, reporting, books-and-records, and internal controls provisions of the federal securities laws. For additional information about this settlement, see this Item, “SEC Settlement.”

 

    We have successfully amended our publicly traded senior notes and senior subordinated notes and cured all defaults existing prior to those amendments.

 

    We have amended and restated our $1.25 billion credit agreement, thereby curing any defaults of that credit agreement existing prior to such amendment and restatement. Our amended and restated credit agreement consists of a $315 million term loan, a $250 million revolving line of credit, and $150 million in letter of credit facilities. It is secured by substantially all of HealthSouth Corporation’s assets and the stock of HealthSouth Corporation’s first-tier subsidiaries.

 

    Our stock continues to be traded on the over-the-counter “Pink Sheets” market under the symbol HLSH, although we plan to apply for listing of our stock on either the NYSE or the National Association of Securities Dealers, Inc. Automated Quotation National Market System (“NASDAQ”) once we achieve compliance with the SEC’s periodic disclosure requirements, which we anticipate will occur in 2006.

 

    We continue to provide federal law enforcement officials and other federal investigators, including the DOJ’s civil and criminal division and the SEC, with our cooperation as they work to conclude their investigations.

 

Still, developments relating to governmental investigations and responses to those investigations by us and by others will continue to create various risks and uncertainties that could materially and adversely affect our business, financial condition, results of operations, and cash flows.

 

Our Response to the Crisis

 

On March 19, 2003, the date the SEC announced its lawsuit against us, our board of directors placed our then-Chairman and Chief Executive Officer, Richard M. Scrushy, and our then-Chief Financial Officer, William T. Owens, on administrative leave. Their employment was subsequently terminated. Also on March 19, 2003, the board of directors elected Joel C. Gordon, a HealthSouth director since 1996, as interim Chairman of the Board, and Robert P. May, a HealthSouth director since 2002, as interim Chief Executive Officer.

 

On March 22, 2003, our board directed a special committee of the board of directors (the “Special Audit Review Committee”) to conduct an independent forensic investigation of accounting irregularities at HealthSouth and to consider any related matters that it concluded deserved review or comment. Our board of directors selected Jon F. Hanson, then one of only two board members who had not served as a director when the principal events under investigation occurred, to conduct the committee’s inquiry. Neither Mr. Hanson nor the committee’s legal counsel or accounting advisors had any relationships with HealthSouth, our board of directors, our employees, or others with whom we conducted business that would limit an objective inquiry regarding our financial reporting irregularities.

 

By early April 2003, we had taken several important steps to stabilize our business and operations, obtain vital management assistance and coordinate our legal strategy, including the following:

 

    We retained Alvarez & Marsal, Inc. to help stabilize our business operations and address financial and liquidity concerns.

 

    We retained Skadden, Arps, Slate, Meagher & Flom LLP to serve as lead coordinating counsel with respect to corporate legal and litigation matters.

 

3


Table of Contents
Index to Financial Statements
    We established a special committee of our board of directors, consisting of all of our then-current directors other than Messrs. Scrushy and Owens, to manage the business and affairs of HealthSouth, as explained further below.

 

    We dismissed Ernst & Young LLP as our independent auditor.

 

    Our Special Audit Review Committee, through its legal counsel, engaged a forensic auditing team from PricewaterhouseCoopers LLP to assist in its investigation.

 

We subsequently engaged:

 

    Credit Suisse First Boston to evaluate financial restructuring alternatives,

 

    Joele Frank, Wilkinson Brimmer Katcher to manage our public communications,

 

    Grant Thornton LLP, Callaway Partners, LLC, KPMG LLP, and American Appraisal Associates to assist in the reconstruction of our financial accounts,

 

    Deloitte Consulting LLP to assist us in connection with our project management efforts with respect to our financial account reconstruction, Deloitte & Touche LLP to assist us in connection with our efforts to comply with the requirements of Section 404 of the Sarbanes-Oxley Act of 2002, and Deloitte & Touche LLP and Deloitte Consulting LLP to assist us with our efforts to improve our internal controls, and

 

    PricewaterhouseCoopers LLP to replace Ernst & Young LLP as our independent auditor.

 

Board, Management, and Internal Controls and Reporting Improvements

 

With our crisis response team in place, we immediately began the difficult tasks of identifying weaknesses in our governance, accounting, reporting, compliance, and management functions, and developing a plan for restructuring HealthSouth to remedy those weaknesses for the long term. Some of these efforts are summarized below.

 

Our New Board of Directors

 

On April 4, 2003, we created a special committee of our board of directors (the “Special Committee”). Our board of directors delegated to the Special Committee, to the fullest extent permitted by Delaware law, all authority that may be delegated to the Special Committee, and authorized the Special Committee, to the fullest extent permitted by Delaware law, to exercise all of the powers and authority of the board of directors in the management of the business and affairs of HealthSouth when the board of directors is not in session. The Special Committee currently consists of all members of the board of directors except Mr. Scrushy, who has refused our requests to resign as a director. Mr. Owens resigned from our board of directors on October 19, 2003 and was never a member of the Special Committee.

 

The transition of our board of directors continued with our announcement on December 2, 2003 that we had adopted a transition plan pursuant to which five long-standing members of our board of directors would voluntarily leave the board. In accordance with this plan, the following directors voluntarily resigned from the board: George H. Strong (effective December 15, 2003), Charles W. Newhall III (effective December 15, 2003), Larry D. Striplin, Jr. (effective April 2, 2004), C. Sage Givens (effective April 15, 2004), and John S. Chamberlin (effective August 19, 2004).

 

Of our current board of directors, seven members were added since March 2003: Steven R. Berrard (effective January 31, 2004), Edward A. Blechschmidt (effective January 31, 2004), Jay Grinney (effective May 10, 2004), Leo I. Higdon, Jr. (effective August 17, 2004), John E. Maupin, Jr. (effective August 17, 2004), Charles M. Elson (effective September 9, 2004), and Yvonne Curl (effective November 18, 2004). In addition,

 

4


Table of Contents
Index to Financial Statements

eight members of our current board of directors qualify as “independent directors” under our Corporate Governance Guidelines. Lee S. Hillman, who joined our board of directors effective September 9, 2003, voluntarily resigned from the board effective February 18, 2005. In addition, Joel C. Gordon retired from our board of directors effective May 10, 2005 pursuant to our mandatory director retirement policy. See Item 10, Directors and Executive Officers of the Registrant, for more information about our directors, including the name of each independent director.

 

The Special Committee has overseen the formulation and implementation of our turnaround strategy. Following the events of March 2003, the Special Committee installed a crisis response and interim management team and worked closely with that team to reduce costs, stabilize operations, and negotiate with our bondholders and other creditors. The Special Committee was also instrumental in identifying and hiring key executives, including our chief executive officer, and directing our negotiations with the various parties with which we have successfully reached settlement, including the DOJ and the SEC, which settlements are described later in this Item. The Special Committee, whose membership has changed over time along with changes to our board of directors, continues to oversee our management team and we anticipate that the business and affairs of the company will continue to be managed under the direction of the Special Committee until we are able to hold an annual meeting of our stockholders, at which point we anticipate the Special Committee will be abolished and these duties returned to our board of directors.

 

Our New Management Team

 

Since March 2003, we have recruited a new management team of highly qualified professionals, including the following new members of our executive management team:

 

    Jay Grinney—President and Chief Executive Officer

 

    Michael D. Snow—Executive Vice President and Chief Operating Officer

 

    John L. Workman—Executive Vice President and Chief Financial Officer

 

    John Markus—Executive Vice President and Chief Compliance Officer

 

    Gregory L. Doody—Executive Vice President, General Counsel and Secretary

 

    James C. Foxworthy—Executive Vice President and Chief Administrative Officer

 

    Joseph T. Clark—President, Surgery Centers Division

 

    Karen Davis—President, Diagnostic Division

 

    Diane L. Munson—President, Outpatient Division

 

    Mark J. Tarr—President, Inpatient Division

 

Except for Ms. Davis and Mr. Tarr, none of the members of our executive management team has been employed by HealthSouth in the past. In addition to our executive management team, we have substantially replaced and expanded the management of our accounting and finance, internal audit, and compliance functions, and we have replaced or added key management personnel in each of our divisions.

 

Corporate Governance Improvements

 

Since March 2003, we have revised our Corporate Governance Guidelines and charters for all five of the standing committees of our board of directors (the Audit Committee, Compensation Committee, Corporate Compliance Committee, Finance Committee, and Nominating/Corporate Governance Committee). Our revised guidelines and charters meet or exceed the requirements of the Sarbanes-Oxley Act of 2002. Our revised guidelines and charters require three-quarters of the members of our board of directors to meet the criteria for independence set forth in our new Corporate Governance Guidelines. Our new Corporate Governance Guidelines

 

5


Table of Contents
Index to Financial Statements

also create a new position of non-executive chairman of the board, limit the number of terms any director may serve, and impose limitations on the number of outside directorships our directors may hold. Additionally, non-management directors meet regularly, with the chairman of the board presiding at those meetings, and all transactions with related parties must receive the prior approval of our board of directors. Our revised guidelines and charters are available at our website, www.healthsouth.com. We will provide to any person, without charge, upon request, a copy of our revised guidelines and charters. Requests for a copy may be made in writing to the following address: Corporate Compliance Office, HealthSouth Corporation, P.O. Box 380243, Birmingham, Alabama 35238.

 

Internal Control Improvements

 

As discussed in Item 9A, Controls and Procedures, our new management team and advisors have determined that our financial systems and internal controls historically have been ineffective. Given the state of our internal controls, we hired a large group of accounting professionals and consultants to assist us with a substantive reconstruction of our historical accounting records so that we could prepare restated financial statements for 2001 and 2000 and initial financial statements for 2003 and 2002. In addition, we have engaged in, and are continuing to engage in, substantial efforts to improve our internal control over financial reporting and disclosure controls and procedures related to substantially all areas of our financial statements and disclosures. These efforts include the following:

 

    We have transformed our corporate culture into one premised on integrity, transparency, honesty, accountability, and regulatory compliance.

 

    Effective December 17, 2003, we commenced the reorganization of our internal audit department. We hired a new Senior Vice President—Internal Audit with more than 25 years of experience in reorganizing and leading audit departments. We have significantly expanded our internal audit department by adding 20 employees, with the majority of those employees being Certified Public Accountants, Certified Fraud Examiners, and/or Certified Internal Auditors. Our internal audit department now has access to all company records and systems, including the general ledger, and reports independently to the Audit Committee of our board of directors.

 

    We have reorganized and are committing substantial resources to our finance and accounting departments. We have replaced substantially all of our senior finance and accounting employees and have implemented a new organizational structure for those departments. We have segregated duties to mitigate the risk of one employee being able to manipulate financial transactions or to falsify entries to or approvals of any accounting records.

 

    We continue to work to improve our disclosure controls and procedures. As recommended by the SEC, we have completed and distributed a formal disclosure controls and procedures policy and formed a Disclosure Committee made up of members of our executive management team and other employees who play a substantial role in our public disclosure process.

 

    We engaged Deloitte & Touche LLP and Deloitte Consulting LLP to assist us in connection with our efforts to improve our internal control processes and Deloitte & Touche LLP to assist us in our efforts to comply with the requirements of Section 404 of the Sarbanes-Oxley Act of 2002.

 

We are also upgrading our information systems. For example, we plan to complete an upgrade of our inpatient division’s patient accounting system and computing infrastructure by October 2006. We have already completed the upgrade of our surgery centers division’s patient accounting system. We are nearing completion of the modernization of the clinical computing infrastructure in our outpatient division. In addition, we have installed a new Radiology Information System and Picture Archiving and Communication System in seven of our diagnostic facilities in Alabama, and we are currently reviewing opportunities for these systems in our other diagnostic centers. We plan to use these new technologies to automate the interface of our patient accounting systems to our general ledger, to create tangible operating efficiencies, and to improve accounts receivable collection.

 

6


Table of Contents
Index to Financial Statements

Corporate Compliance Improvements

 

Since March 2003, we have adopted a revised compliance program, including revised Standards of Business Conduct, to reinforce our dedication to compliance with all laws and regulations and good corporate governance. We have incorporated elements of the Standards of Business Conduct into a formal compliance training program which is required to be completed by all employees. We require each HealthSouth employee to sign a written acknowledgment that the employee has completed the program and agrees to be bound by the Standards of Business Conduct.

 

In addition to revising our compliance program, we have instituted several important compliance-related organizational changes. First, we engaged an independent third party to receive calls made to our compliance hotline. By outsourcing this function, the Corporate Compliance Committee seeks to create an environment that encourages the reporting of inappropriate or suspicious conduct without the fear of reprisal. Additionally, we hired John Markus as our Executive Vice President and Chief Compliance Officer. Mr. Markus is an attorney with more than 13 years of experience in corporate compliance. We are committing substantial financial resources to our corporate compliance department on a yearly basis, including the creation of a dedicated regulatory compliance audit staff. We have also established a compliance steering committee that includes all members of our executive management team and have appointed compliance officers for each of our operating divisions.

 

Results of Forensic Audit Review and Restatement and Reclassification of Previously Issued Consolidated Financial Statements

 

As mentioned above, the Special Audit Review Committee, through its legal counsel, retained PricewaterhouseCoopers LLP to assist in a forensic review of our historical accounting and financial reporting. Furthermore, we engaged Grant Thornton LLP, Callaway Partners, LLC, KPMG LLP, and American Appraisal Associates to assist in reconstructing our financial records.

 

In the course of reviewing our historical accounting and financial reporting and reconstructing our financial records:

 

    We evaluated numerous accounting entries, including those identified by PricewaterhouseCoopers LLP’s forensic team as fraudulent.

 

    We assessed the potential impact of historical accounting practices that were not in accordance with generally accepted accounting principles in the United States (“GAAP”).

 

    We identified material weaknesses in our internal controls and began remediating those material weaknesses.

 

    We identified shortfalls in information technology and financial systems and began implementing several enhancements to those systems.

 

    We identified and implemented accounting policies, including policies relating to revenue recognition, consolidation, long-lived assets, and goodwill and intangible assets.

 

The Special Audit Review Committee completed its review in May 2004 and provided a copy of the report of its findings to us on May 28, 2004. We furnished the report to the SEC in a Form 8-K on June 1, 2004. In June 2005, we completed the reconstruction of our accounting records for periods from January 1, 2000 to December 31, 2003. PricewaterhouseCoopers LLP has completed its audits of our 2003 and 2002 consolidated financial statements, as well as the reaudits of our 2002 and 2001 consolidated financial statements, and its report accompanies this annual report.

 

In our restated consolidated financial statements for 2001 and 2000, we restate our earnings, write down property and equipment, goodwill, and other intangible assets, and make other adjustments from our previously

 

7


Table of Contents
Index to Financial Statements

issued consolidated financial statements. These adjustments include a cumulative net reduction to shareholders’ equity of $3.9 billion as of December 31, 2001, a reduction in previously reported net income of $393.6 million for 2001 and $642.7 million for 2000. Adjustments to our January 1, 2000 previously reported retained earnings balance approximated $3.0 billion. In addition, we reduced net goodwill and other intangible assets recognized in our previously issued consolidated financial statements from $2.7 billion to $1.4 billion as of December 31, 2001. We also adjusted the net carrying values of property and equipment recognized in our previously issued consolidated financial statements from $2.8 billion to $1.8 billion as of December 31, 2001. The following chart summarizes the net impact of the restatement adjustments on our previously reported revenues, net income, and net income per share:

 

     Year Ended
December 31, 2001


    Year Ended
December 31, 2000


 
     As Previously
Reported


   As Restated

    As Previously
Reported


   As Restated

 
     (in thousands, except per
share amounts)
    (in thousands, except per
share amounts)
 

Revenues(1)

   $ 4,380,477    $ 3,553,057     $ 4,195,115    $ 3,498,836  

Net income (loss)

   $ 202,387    $ (191,225 )   $ 278,465    $ (364,243 )

Net income (loss) per share

                              

Basic

   $ 0.52    $ (0.49 )   $ 0.72    $ (0.94 )

Diluted

   $ 0.51    $ (0.49 )   $ 0.71    $ (0.94 )

(1) Includes reclassification of discontinued operations.

 

For more information regarding the restatement of our 2001 and 2000 consolidated financial statements, see Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations, and Note 2, Restatement and Reclassification of Previously Issued Consolidated Financial Statements, to our accompanying consolidated financial statements.

 

Financial Restructuring

 

The response of our lenders and other creditors to the governmental investigations regarding our financial reporting and related activities forced us to take immediate steps to increase our liquidity, including implementing severe cost reductions and entering into protracted negotiations with our lenders and other creditors to expand our credit options.

 

Cost Reductions

 

During 2003 and 2004, we aggressively pursued cost reduction activities in non-patient care areas, including the elimination of non-clinical corporate positions, the completion of several non-core asset sales that resulted in total sale proceeds of $271 million, the completion of lease buyouts that resulted in annual savings in lease obligations, and the tightening of spending controls, including a reduction in non-critical capital expenditures. See this Item, “Our Business—Operational Agenda” for a description of our continuing efforts to reduce overhead.

 

Consent Solicitations for Publicly Traded Debt

 

On March 16, 2004, we announced that we were soliciting consents seeking approval of proposed amendments to, and waivers under, the indentures governing all of our public debt. We solicited these consents to resolve issues relating to our inability to provide current financial statements, to increase our ability to incur indebtedness under certain circumstances, and to obtain waivers of all alleged and potential defaults under the respective indentures governing our public debt.

 

8


Table of Contents
Index to Financial Statements

On June 24, 2004, we announced that we had closed our consent solicitations and executed seven supplemental indentures, bringing us into compliance on all of our $2.6 billion in public debt. Accordingly, we have classified this debt as long-term at December 31, 2003. We paid $80 million in consent fees for all of our debt issues covered by the consent solicitations.

 

For more information regarding our consent solicitations, see Item 4, Submission of Matters to a Vote of Security Holders, and Note 10, Long-term Debt, to our accompanying consolidated financial statements.

 

Amended and Restated Credit Agreement

 

On March 23, 2003, our line of credit was frozen under the $1.25 billion credit agreement with JPMorgan Chase Bank, which serves as administrative agent, Wachovia Bank, N.A., UBS Warburg LLC, Deutsche Bank AG, and Bank of America, N.A. On March 27, 2003, we received notice that we were in default under this agreement. We commenced negotiations with our lenders to resolve the default. On March 21, 2005, we amended and restated our credit agreement, thereby curing any defaults of the credit agreement that existed prior to such amendment and restatement. Our amended and restated credit agreement consists of a $315 million term loan, a $250 million revolving line of credit, and $150 million in letter of credit facilities. It is secured by substantially all of HealthSouth Corporation’s assets and the stock of HealthSouth Corporation’s first-tier subsidiaries. For additional information about our amended and restated credit agreement, see Note 10, Long-term Debt, to our accompanying consolidated financial statements.

 

Senior Subordinated Credit Agreement

 

As a result of the default under our $1.25 billion credit agreement, our lenders instituted a payment blockage that prohibited us from making an approximately $350 million payment of principal and interest due to holders of our 3.25% Convertible Subordinated Debentures due April 1, 2003. On January 16, 2004, we repaid these bonds ($344 million in the aggregate) from the net proceeds of a $355 million loan arranged by Credit Suisse First Boston. This loan has an interest rate of 10.375% per annum, payable quarterly, with a 7-year maturity, callable after the third year with a premium. We also issued a warrant to the lender to purchase 10 million shares of our common stock. The warrant has a term of 10 years from the date of issuance and an exercise price of $6.50 per share. For additional information about our senior subordinated credit agreement, see Note 10, Long-term Debt, to our accompanying consolidated financial statements.

 

Term Loan Agreement

 

On June 15, 2005, we entered into a $200 million term loan agreement with a consortium of financial institutions, JPMorgan Chase Bank, N.A., as Administrative Agent (“JPMorgan”), and Citicorp North America, Inc., as Syndication Agent. Pursuant to the term loan agreement, we obtained a new senior unsecured term facility consisting of term loans in an aggregate principal amount of $200 million. The term loans initially bear interest at a rate of LIBOR (adjusted for statutory reserve requirements) plus 5% per year (the “Initial Rate”). Thereafter, they will bear interest, at our option, at a rate of (1) the Initial Rate or (2) 4% per year plus the higher of (x) JPMorgan’s prime rate and (y) the Federal Funds Rate plus 0.5%. The term loans mature in full on June 15, 2010.

 

The proceeds of the term loans, together with cash on hand, were used to repay our $245 million 6.875% Senior Notes due June 15, 2005 and to pay fees and expenses related to the term loans. For additional information about our term loan agreement, see Note 10, Long-term Debt, to our accompanying consolidated financial statements.

 

9


Table of Contents
Index to Financial Statements

Status of Long-Term Indebtedness and Liquidity

 

Our long-term debt as of December 31, 2003 is summarized in the following table.

 

Source


   Outstanding
Debt (Face)(1)


   Interest
Rate(2)


    2004
Annual Interest
Expense (Actual)(3)


     ($ in thousands)          ($ in thousands)

Advances under $1.25 billion revolving credit agreement

   $ 315,000    Variable     $ 16,828
    

        

Bonds Payable—

                   

3.25% Convertible Subordinated Debentures due 2003(4)

     344,150    3.250 %     36,466

6.875% Senior Notes due 2005(5)

     245,000    6.875 %     16,844

7.375% Senior Notes due 2006

     180,300    7.375 %     13,297

7.000% Senior Notes due 2008(6)

     250,000    7.000 %     17,500

8.500% Senior Notes due 2008

     343,000    8.500 %     29,155

10.750% Senior Subordinated Notes due 2008

     319,260    10.750 %     34,320

6.500% Convertible Subordinated Debentures due 2011

     6,311    6.500 %     410

8.375% Senior Notes due 2011(7)

     347,700    8.375 %     29,120

7.625% Senior Notes due 2012(7)

     908,700    7.625 %     69,288

8.750% Convertible Senior Subordinated Notes due 2015

     14,447    8.750 %     1,075
    

        

       2,958,868            247,475
    

        

Hospital Revenue Bond Payable

     2,400    Variable       28

Notes Payable

     19,818    Varies       1,695

Noncompete Agreements Payable

     4,663    Varies       126

Capital Lease Obligations

     229,909    Varies       15,473
    

        

Total

   $ 3,530,658          $ 281,625
    

        


(1) Note 10, Long-term Debt, to our accompanying consolidated financial statements, presents outstanding long-term debt at its net book value, which, because of discounts or premiums, differs from the face amounts shown in this table. This table excludes $59 million in letter of credit obligations.
(2) Interest rate represents the stated interest rate, not the effective interest rate. The range of interest rates for the following categories varies as follows: Notes Payable (2.3% to 10.5%), Noncompete Agreements Payable (2.3% to 7.1%), and Capital Lease Obligations (6.0% to 12.0%).
(3) This table does not include amortization of debt discount.
(4) The 3.25% Convertible Subordinated Debentures due 2003 were repaid on January 16, 2004 with the proceeds of a seven year $355 million senior subordinated credit agreement, bearing interest at a rate of 10.375% per annum. The table above combines 2004 actual annual interest expense from the 3.25% Convertible Subordinated Debentures due 2003 ($466,000) with 2004 actual annual interest expense from the senior subordinated credit agreement ($36 million).
(5) These notes were repaid on June 15, 2005 with cash and the proceeds from a $200 million term loan agreement that matures in 2010.
(6) Holders have the option to require us to repurchase these notes on January 15, 2007.
(7) Holders have the option to require us to repurchase these notes on January 2, 2009.

 

10


Table of Contents
Index to Financial Statements

Our long-term debt as of December 31, 2004 is summarized in the following chart.

 

Source


  Outstanding
Debt (Face)(1)


  Interest
Rate(2)


    2005
Annual Interest
Expense (Estimated)(3)


    ($ in thousands)         ($ in thousands)

Advances under $1.25 billion revolving credit agreement(4)

  $ 315,000   Variable     $ 18,305
   

       

Bonds Payable—

                 

6.875% Senior Notes due 2005(5)

    245,000   6.875 %     16,642

7.375% Senior Notes due 2006

    180,300   7.375 %     13,297

7.000% Senior Notes due 2008(6)

    250,000   7.000 %     17,500

8.500% Senior Notes due 2008

    343,000   8.500 %     29,155

10.750% Senior Subordinated Notes due 2008

    319,260   10.750 %     34,320

6.500% Convertible Subordinated Debentures due 2011

    6,311   6.500 %     410

8.375% Senior Notes due 2011(7)

    347,700   8.375 %     29,120

10.375% Senior Subordinated Credit Agreement due 2011

    355,000   10.375 %     36,831

7.625% Senior Notes due 2012(7)

    908,700   7.625 %     69,288

8.750% Convertible Senior Subordinated Notes
due 2015
(8)

    11,573   8.750 %     918
   

       

      2,966,844           247,481
   

       

Hospital Revenue Bond Payable

    1,400   Variable       8

Notes Payable

    14,919   Varies       1,268

Noncompete Agreements Payable

    2,021   Varies       81

Capital Lease Obligations

    195,682   Varies       13,101
   

       

Total

  $ 3,495,866         $ 280,244
   

       


(1) Note 10, Long-term Debt, to our accompanying consolidated financial statements, presents outstanding long-term debt at its net book value, which, because of discounts or premiums, differs from the face amounts shown in this table. This table excludes $106 million in letter of credit obligations.
(2) Interest rate represents the stated interest rate, not the effective interest rate. The range of interest rates for the following categories varies as follows: Notes Payable (2.3% to 10.5%), Noncompete Agreements Payable (2.3% to 7.1%), and Capital Lease Obligations (6.0% to 12.0%). For advances under our $1.25 billion credit agreement, the 2005 annual interest expense was estimated using the 6.25% rate that was in effect on December 31, 2004.
(3) This table does not include amortization of debt discount.
(4) In March 2005 we amended and restated this agreement. Our amended and restated credit agreement consists of a $315 million term loan, a $250 million revolving line of credit, and $150 million in letter of credit facilities. We estimated 2005 annual interest expense using the 5.59% rate that was in effect on June 15, 2005, although that rate may change.
(5) These notes were repaid on June 15, 2005 with cash and the proceeds from a $200 million term loan agreement that matures in 2010. We estimated 2005 annual interest expense using the 8.22% rate that was in effect on June 15, 2005, although that rate may change.
(6) Holders have the option to require us to repurchase these notes on January 15, 2007.
(7) Holders have the option to require us to repurchase these notes on January 2, 2009.
(8) We made a sinking fund payment on these notes in April 2005. The current principal balance of these notes is $10.1 million.

 

11


Table of Contents
Index to Financial Statements

As of May 31, 2005, the maturity schedule for (1) the indebtedness set forth in the table above under the caption “Bonds Payable” and (2) the indebtedness related to our amended and restated credit agreement (assuming the maturity for the amended and restated credit agreement is extended to 2010), is as follows:

 

LOGO

 

If all noteholders were to exercise their options to require us to repurchase their notes in 2007 and 2009, the maturity schedule would be as follows:

 

LOGO

 

As of December 31, 2004, we had approximately $346 million in available cash and cash equivalents. We also had approximately $244 million in “restricted cash,” which is cash we cannot use because of various obligations we have under lending agreements, partnership agreements, and other arrangements primarily related to our captive insurance company. As of December 31, 2003, we had $472.8 million in available cash and cash equivalents and $174.9 million in restricted cash. For more information about our liquidity, please see Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations, “Liquidity and Capital Resources,” Note 1, Summary of Significant Accounting Policies, Note 3, Liquidity, and Note 10, Long-term Debt, to our accompanying consolidated financial statements.

 

Medicare Program Settlement

 

The Civil DOJ Settlement

 

On January 23, 2002, the United States intervened in four lawsuits filed against us under the federal civil False Claims Act. These so-called “qui tam” (i.e., whistleblower) lawsuits were transferred to the Western District of Texas and were consolidated under the caption United States ex rel. Devage v. HealthSouth Corp., et al., No. 98-CA-0372 (DWS) (W.D. Tex. San Antonio).

 

On April 10, 2003, the United States informed us that it was expanding its investigation to review whether fraudulent accounting practices affected our previously submitted Medicare cost reports.

 

On December 30, 2004, we entered into a global settlement agreement (the “Settlement Agreement”) with the United States. This settlement was comprised of (1) the claims consolidated in the Devage case, which related to claims for reimbursement for outpatient physical therapy services rendered to Medicare, the TRICARE Management Activity (“TRICARE”), or United States Department of Labor (“DOL”) beneficiaries, (2) the submission of claims to Medicare for costs relating to our allegedly improper accounting practices, (3) the submission of other unallowable costs included in our Medicare Home Office Cost

 

12


Table of Contents
Index to Financial Statements

Statements and in our individual provider cost reports, and (4) certain other conduct (collectively, the “Covered Conduct”). The parties to this global settlement include us and the United States acting through the DOJ’s civil division, the OIG, the DOL through the Employment Standards Administration’s Office of Workers’ Compensation Programs, Division of Federal Employees’ Compensation (“OWCP-DFEC”), TRICARE, and certain other individuals and entities which had filed civil suits against us and/or our affiliates (those other individuals and entities, the “Relators”).

 

Pursuant to the Settlement Agreement, we agreed to make cash payments to the United States in the aggregate amount of $325 million, plus accrued interest from November 4, 2004 at an annual rate of 4.125%. The United States agreed, in turn, to pay the Relators the portion of the Settlement Amount due to the Relators pursuant to the terms of the Settlement Agreement. We made an initial payment of $75 million (plus interest) to the United States on January 3, 2005, with the remaining balance of $250 million (plus interest) to be paid in quarterly installments over three years. We made our first quarterly payment of approximately $22.3 million (including interest) on March 31, 2005.

 

The Settlement Agreement provides for our release by the United States from any civil or administrative monetary claim the United States had or may have had relating to Covered Conduct that occurred on or before December 31, 2002 (with the exception of Covered Conduct for certain outlier payments, for which the release date is extended to September 30, 2003). The Settlement Agreement also provides for our release by the Relators from all claims based upon any transaction or incident occurring prior to December 30, 2004, including all claims that have been or could have been asserted in each Relator’s civil action, and from any civil monetary claim the United States had or may have had for the Covered Conduct that is pled in each Relator’s civil action.

 

The Settlement Agreement also provides for the release of HealthSouth by the OIG and OWCP-DFEC, and the agreement by the OIG and OWCP-DFEC to refrain from instituting, directing, or maintaining any administrative action seeking exclusion from Medicare, Medicaid, the FECA Program, the TRICARE Program and other federal health care programs, as applicable, for the Covered Conduct. The DOJ’s civil division continues to review certain self-disclosures made by us to the OIG.

 

The Administrative Settlement Agreement

 

In connection with the Settlement Agreement, we entered into a separate settlement agreement (the “Administrative Settlement Agreement”) with the Centers for Medicare & Medicaid Services (“CMS”) acting on behalf of HHS, to resolve issues associated with various Medicare cost reporting practices.

 

Subject to certain exceptions and the terms and conditions of the Administrative Settlement Agreement, the Administrative Settlement Agreement provides for the release of HealthSouth by CMS from any obligations related to any cost statements or cost reports that had or could have been submitted to CMS or its fiscal intermediaries by HealthSouth for cost reporting periods ended on or before December 31, 2003. The Administrative Settlement Agreement provides that all covered cost reports be closed and considered final and settled.

 

Financial Consequences of the Civil DOJ Settlement and the Administrative Settlement Agreement

 

As described in Note 21, Medicare Program Settlement, to our accompanying consolidated financial statements, the total known cost of settlement is $347.7 million, which is comprised of the $325 million cash settlement to be paid to the United States, $19.7 million representing uncollectible amounts due arising from cost reports submitted for the fiscal years ended December 31, 2003 and prior, as well as unallowable costs in the covered cost reports, and $3 million in associated legal fees.

 

The December 2004 Corporate Integrity Agreement

 

On December 30, 2004, we entered into a new corporate integrity agreement (“CIA”) with the OIG. This new CIA has an effective date of January 1, 2005 and a term of five years from that effective date. It incorporates

 

13


Table of Contents
Index to Financial Statements

a number of compliance program changes already implemented by us and requires, among other things, that not later than 90 days after the effective date we:

 

    form an executive compliance committee (made up of our Chief Compliance Officer and other executive management members), which shall participate in the formulation and implementation of HealthSouth’s compliance program;

 

    require certain independent contractors to abide by our Standards of Business Conduct;

 

    provide general compliance training to all HealthSouth personnel as well as specialized training to personnel responsible for billing, coding, and cost reporting relating to federal health care programs;

 

    report and return any overpayments received from federal health care programs;

 

    notify the OIG of any new investigations or legal proceedings initiated by a governmental entity involving an allegation of fraud or criminal conduct against HealthSouth;

 

    notify the OIG of the purchase, sale, closure, establishment, or relocation of any facility furnishing items or services that are reimbursed under federal health care programs; and

 

    submit regular reports to the OIG regarding our compliance with the CIA.

 

On April 28, 2005, we submitted an implementation report to the OIG stating that we had, within the 90-day time frame, materially complied with the initial requirements of this new CIA.

 

The CIA also requires that we engage an Independent Review Organization (“IRO”) to assist us in assessing and evaluating: (1) our billing, coding, and cost reporting practices with respect to our inpatient rehabilitation facilities (“IRFs”), (2) our billing and coding practices for outpatient items and services furnished by outpatient departments of our inpatient facilities and through other HealthSouth outpatient rehabilitation facilities; and (3) certain other obligations pursuant to the CIA and the Settlement Agreement. We have engaged PricewaterhouseCoopers LLP to serve as our IRO.

 

Failure to meet our obligations under our CIA could result in stipulated financial penalties. Failure to comply with material terms, however, could lead to exclusion from further participation in federal health care programs, including Medicare and Medicaid, which currently account for a substantial portion of our revenues.

 

SEC Settlement

 

On June 6, 2005, the SEC approved a settlement (the “SEC Settlement”) with us relating to the actions filed by the SEC on March 19, 2003 captioned SEC v. HealthSouth Corporation and Richard M. Scrushy, No. CV-03-J-0615-S (N.D. Ala.) (the “SEC Litigation”).

 

That lawsuit alleges that HealthSouth and our former Chairman and Chief Executive Officer, Richard M. Scrushy, violated and/or aided and abetted violations of the antifraud, reporting, books-and-records, and internal controls provisions of the federal securities laws. On April 3, 2003, the SEC filed an amended complaint adding additional charges against Mr. Scrushy. On May 7, 2003, the SEC Litigation was stayed pending the resolution of any criminal charges against Mr. Scrushy or notification that Mr. Scrushy would not be criminally charged.

 

Under the terms of the SEC Settlement, we have agreed, without admitting or denying the SEC’s allegations, to be enjoined from future violations of certain provisions of the securities laws. We have also agreed to:

 

    pay a $100 million civil penalty and disgorgement of $100 to the SEC in the following installments: $12,500,100 by October 15, 2005, $12.5 million by April 15, 2006, $25 million by October 15, 2006; $25 million by April 15, 2007, and $25 million by October 15, 2007;

 

14


Table of Contents
Index to Financial Statements
    retain a qualified governance consultant to perform a review of the adequacy and effectiveness of our corporate governance systems, policies, plans, and practices;

 

    either (1) retain a qualified accounting consultant to perform a review of the effectiveness of our material internal accounting control structure and policies, as well as the effectiveness and propriety of our processes, practices, and policies for ensuring our financial data is accurately reported in our filed consolidated financial statements, or (2) within 60 days of filing with the SEC audited consolidated financial statements for the fiscal year ended December 31, 2005, provide to the SEC all communications between our independent auditor and our management and/or Audit Committee from the date of the judgment until such report concerning our internal accounting controls is finalized;

 

    provide reasonable training and education to certain of our officers and employees to minimize the possibility of future violations of the federal securities laws;

 

    continue to cooperate with the SEC and the DOJ in their respective ongoing investigations; and

 

    create, staff, and maintain the position of Inspector General within HealthSouth, which position shall have the responsibility of reporting any indications of violations of law or of HealthSouth’s procedures, insofar as they are relevant to the duties of the Audit Committee, to the Audit Committee.

 

The SEC Settlement also provides that we must treat the amounts ordered to be paid as civil penalties as penalties paid to the government for all purposes, including all tax purposes, and that we will not be able to be reimbursed or indemnified for such payments through insurance or any other source, or use such payments to set off or reduce any award of compensatory damages to plaintiffs in related securities litigation pending against us.

 

In connection with the SEC Settlement, we consented to the entry of a final judgment in the SEC Litigation (which judgment was entered by the United States District Court for the Northern District of Alabama, Southern Division) to implement the terms of the SEC Settlement. However, Mr. Scrushy remains a defendant in the SEC Litigation.

 

For additional information about the SEC Settlement, see Note 22, SEC Settlement, to our accompanying consolidated financial statements.

 

Our Business

 

We have spent two years responding to the various legal, financial, and operational challenges summarized above. We are now in the first year of a multi-year turnaround plan. We are primarily focused on continuing to evaluate our business, the broader health care market, and the specific geographic markets we serve, with the goal of repositioning HealthSouth as a leading provider of post-acute care and select ambulatory services. To this end, we are planning to expand the post-acute care services provided at or complementary to our inpatient facilities, such as long-term acute care, skilled nursing, and home health services. In addition, we plan to reposition the focus of our outpatient facilities (surgery, outpatient rehabilitation, and diagnostic) into key markets, and look for expansion and growth opportunities in those markets. We also have received inquiries from parties interested in acquiring our diagnostic division. As we continue to develop our strategic plan, we will evaluate the role of each division, including the diagnostic division, in that plan. Even if consistent with our strategic plan, an important consideration in our decision to divest any material asset from our portfolio would be whether the transaction would help to deleverage the company.

 

Industry Trends

 

As a provider of rehabilitative health care, ambulatory surgery, and diagnostic services, our revenues and growth are affected by trends in health care spending. According to estimates published by CMS’s Office of the Actuary, the health care sector is growing faster than the overall economy. In 2004, the total U.S. gross domestic

 

15


Table of Contents
Index to Financial Statements

product is estimated to be $11.7 trillion. Total national health care spending comprised $1.8 trillion, or 15.4% of that figure. While the United States Department of Commerce reports that the overall economy is estimated to have grown at an average rate of 5.2% per year since 1990, health care spending has increased by an average of 7% per year over that same time period. CMS estimates that by 2014 total national health care expenditures will have increased to $3.6 trillion, which will represent 18.7% of the projected U.S. gross domestic product.

 

Demographic factors contribute to long-term growth projections in health care spending. According to the U.S. Census Bureau’s 2004 interim projections, there were approximately 35 million Americans aged 65 or older. The number of Americans aged 65 or older is expected to increase to approximately 40 million by 2010 and approximately 54 million by 2020. By 2030, the number of Americans aged 65 or older is expected to reach approximately 70 million, or 20% of the U.S. population.

 

We believe that the aging of the U.S. population and the continuing growth in health care spending will increase demand for the types of services we provide. First, many of the health conditions associated with aging—such as strokes and heart attacks, neurological disorders, and diseases and injuries to the muscles, bones, and joints—will increase the demand for ambulatory surgery and rehabilitative services. Second, pressure from payors to provide efficient, high-quality health care services is forcing many procedures traditionally performed in acute care facilities out of the acute care environment.

 

Operating Divisions

 

We believe that demographics, regulation, payor pressures to reduce cost, technological advancements, and increased quality requirements will continue to fuel demand for the services we provide. We believe we can take advantage of these health care trends in the markets we currently occupy as well as leverage our size and expertise to expand our services and increase our influence in key markets.

 

We currently provide various patient care services through four primary operating divisions and certain other services through a fifth operating division, which together correspond to our five reporting segments. Although we have no current plans to change our operating divisions, we are continually evaluating and looking to optimize our operational structure and the mix of services we provide, which may lead to future changes in our operating divisions. Our consolidated net operating revenues were $3.96 billion for the fiscal year ended December 31, 2003 and $3.96 billion for the fiscal year ended December 31, 2002. We had a diversified payor mix across all our reporting segments, with Medicare representing the highest percentage of revenues.

 

For additional information regarding our business segments and related information, see Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations, “Segment Results of Operations,” and Note 24, Segment Reporting, to our accompanying consolidated financial statements.

 

Inpatient

 

We are the nation’s largest provider of inpatient rehabilitation services. Our inpatient division operates IRFs and long-term acute care hospitals (“LTCHs”) and provides treatment on both an inpatient and outpatient basis. Our inpatient facilities are located in 28 states, with a concentration of facilities in Texas, Pennsylvania, Florida, Tennessee, and Alabama. We also have facilities in Puerto Rico and Australia.

 

As of December 31, 2004, our inpatient division operated 94 freestanding IRFs (65 of which are wholly owned and 29 of which are jointly owned), 1 wholly owned acute care hospital where we ceased providing acute care services in favor of inpatient rehabilitation services, and 3 satellite facilities with inpatient beds. As of December 31, 2004, we operated 9 LTCHs (8 of which are wholly owned and 1 of which is jointly owned), 7 of which are freestanding and 2 of which are hospital-within-hospital facilities. We also operated 2 satellite facilities with LTCH beds. One of our LTCHs was not certified as an LTCH by CMS until April 2005, although it received patients in 2004 and was reimbursed by Medicare as an acute care hospital. Our inpatient division also

 

16


Table of Contents
Index to Financial Statements

provides outpatient services through 152 facilities (128 of which are wholly owned and 24 of which are jointly owned) located within our IRFs or in satellite facilities near our IRFs. In addition to HealthSouth facilities, our inpatient division operates 13 inpatient facilities, 11 outpatient facilities, and 2 gamma knives through management contracts.

 

Our IRFs provide services to patients who require intensive inpatient rehabilitative care. Inpatient rehabilitation patients typically experience significant physical disabilities due to various conditions, such as head injury, spinal cord injury, stroke, certain orthopedic problems, and neuromuscular disease. Our IRFs provide the medical, nursing, therapy, and ancillary services required to comply with local, state, and federal regulations, as well as accreditation standards of the Joint Commission on Accreditation of Healthcare Organizations (the “JCAHO”) and, for some facilities, the Commission on Accreditation of Rehabilitation Facilities. The outpatient services offered by our inpatient division generally differ from those offered by our outpatient division (described below) based on patient diagnosis.

 

Although the market for inpatient rehabilitation services is highly competitive, it is also highly fragmented. This fragmentation creates potential consolidation opportunities for us. In addition, because of our size, we believe we differentiate ourselves from our competitors in the following ways:

 

    Quality. Our IRFs provide a broad base of clinical experience from which we have developed clinical best practices and protocols. We believe these clinical best practices and protocols help ensure the delivery of consistently high quality rehabilitative services across all of our IRFs. To measure the quality of our services, we assess patients using the Functional Independence Measure (“FIM”). FIM is the most widely accepted functional assessment measure in use in the rehabilitation industry. It is used to assess the progress of inpatient rehabilitation from admission to discharge. Our inpatient admission FIM scores tend to be lower than the industry average, which means that our patients are in a worse condition at admission compared to patients at other IRFs. The change in our FIM scores between admission and discharge tends to be higher than the industry average. This means that our patients’ improvement from the time of admission to discharge is on average higher than those of other IRFs.

 

    Cost Effectiveness. Our size also helps us provide inpatient rehabilitative services on a very cost-effective basis. Specifically, because of our large number of inpatient facilities, we can utilize standardized staffing models and take advantage of certain supply chain efficiencies. We continue to try to reduce our costs by leveraging our size.

 

    Technology. As a market leader in inpatient rehabilitation, we have devoted substantial resources to creating and leveraging rehabilitative technology. For example, we have developed an innovative therapeutic device called the “AutoAmbulator,” which can help advance the rehabilitative process for patients who experience difficulty walking.

 

Our inpatient division’s payor mix is weighted toward government-funded sources, including Medicare. For the year ended December 31, 2003, Medicare represented 70.6% of the inpatient division’s net operating revenue, which totaled $2 billion. For the year ended December 31, 2002, Medicare represented 64% of the inpatient division’s net operating revenue, which totaled $1.9 billion.

 

On May 7, 2004, CMS issued a final rule, effective July 1, 2004, that stipulates revised classification criteria that a facility is required to meet to be considered an IRF by Medicare. This is known as the “75% Rule.” The 75% Rule is discussed in more detail in this Item, “Sources of Revenue.” The 75% Rule, as revised, generally provides that to be considered an IRF, and to receive reimbursement for services under the IRF prospective payment system methodology, 75% of a facility’s total patient population must require intensive rehabilitation services associated with treatment of at least one of 13 designated medical conditions. As a practical matter, this means that to maintain our current level of revenue from our IRFs we will need to reduce the number of non-qualifying patients treated at our IRFs and replace them with qualifying patients, establish other sources of revenues at our IRFs, or both. The revised 75% Rule will be phased in over a period that began on July 1, 2004 and will end (i.e., full compliance will be required) for cost reporting periods beginning on or after July 1, 2007.

 

17


Table of Contents
Index to Financial Statements

In January 2005, CMS suspended enforcement of the revised 75% Rule in response to a provision of the Consolidated Appropriations Act of 2005, enacted as Public Law 108-447, that directed CMS not to change the status of certain IRFs for their failure to comply with the revised 75% Rule until the Secretary of HHS made a determination based on the recently issued report by the Government Accountability Office (the “GAO”). On June 21, 2005, CMS issued a notice announcing that it will proceed with implementing the revised 75% Rule as set forth in its previously issued final rule. The notice states that CMS has determined it has already been taking the steps that the GAO recommended to improve how facilities are classified as an IRF and that the revised classification criteria for IRFs contained in the revised 75% Rule are not inconsistent with the recommendations in the GAO report. Accordingly, the June 21 notice lifts the suspension of enforcement of the revised 75% Rule.

 

Anticipating that CMS would implement the revised 75% Rule as previously adopted, our inpatient division has been reducing certain types of non-qualifying admissions in order to achieve compliance with the rule. As discussed in greater detail in Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations, we project this reduction in census, unless mitigated, will have a materially adverse impact on our inpatient division’s revenues. To reduce the potential negative impact on our inpatient division’s revenues, we are considering the following mitigation strategies:

 

    Refocus Marketing. The revised 75% Rule reduces the number of patients seeking treatment for orthopedic and other diagnostic conditions that we can accept at our IRFs. Consequently, we will begin focusing our marketing efforts on neurologists, neurosurgeons, and internists who can refer patients that require treatment for one of the 13 designated medical conditions identified by the revised 75% Rule, such as spinal cord injury, brain injury, and various neurological disorders.

 

    Broaden Services. To make up for a potentially reduced inpatient rehabilitation patient census, we plan to increase the number of other post-acute care services performed at or complementary to our IRFs, such as long-term acute care, skilled nursing, and home health services.

 

    Reduce Costs. We plan to aggressively reduce our costs in proportion to any decline in patient census at our IRFs.

 

    Enhance Coding Accuracy. During the phase-in period, patients with primary diagnoses that do not meet one of the 13 designated medical conditions under the revised 75% Rule can still qualify if they have certain related conditions. We are therefore working to enhance our coding accuracy to ensure that we are capturing all qualifying related conditions.

 

In addition to the specific mitigation strategies discussed above, we are participating with the rest of the industry to help educate various governmental agencies and policy makers about the efficacy of inpatient rehabilitative care in an attempt to broaden the 13 designated medical conditions under the revised 75% Rule. Because we receive a significant percentage of our revenues from our inpatient division, and because our inpatient division receives a significant percentage of its revenues from Medicare, our inability to achieve compliance with and mitigate the revised 75% Rule could have a material adverse effect on our business, financial condition, results of operations, and cash flows.

 

Surgery Centers

 

We operate the largest network of ambulatory surgery centers (“ASCs”) in the United States. As of December 31, 2004, our surgery centers division provided ambulatory surgery services through 177 freestanding ASCs and 3 surgical hospitals in 36 states, with a concentration of centers in California, Texas, Florida, North Carolina, and Pennsylvania.

 

Our ASCs provide the facilities and medical support staff necessary for physicians to perform non-emergency surgical procedures. Our typical ASC is a freestanding facility with two to six fully equipped

 

18


Table of Contents
Index to Financial Statements

operating and procedure rooms and ancillary areas for reception, preparation, recovery, and administration. Each of our ASCs is licensed by the state and certified as a provider under federal programs, including specifically Medicare and Medicaid. Our ASCs are available for use only by licensed physicians, oral surgeons, and podiatrists. To ensure consistent quality of care, each of our ASCs has a medical advisory committee of three to ten physicians that implements quality control procedures and reviews the professional credentials of physicians applying for medical staff privileges at the center. In addition, all but a few unique specialty centers are certified by the JCAHO.

 

Like most other ASCs, the majority of our centers are owned in partnership with surgeons and other physicians who perform procedures at the centers. As a result of increased competition in the ASC market and other factors, physicians are demanding increased equity participation in ASCs. Consequently, we expect an increasing level of physician equity participation in our ASCs, and thus our percentage ownership of centers within our ASC portfolio will decline over time. Currently, our ownership interest in centers within our ASC portfolio varies from 20% to 100%. Our average ownership is over 50%.

 

A critical component of this division’s performance depends upon our ability to periodically provide physicians who use our ASCs with the opportunity to purchase ownership interests in our ASCs. This so-called “resyndication” of ownership interests is important because it enables us to increase the ownership participation of physicians who use our ASCs as well as attract new physicians to our ASCs. Our ability to resyndicate ASC ownership interests has been limited to date because, until recently, we have not been able to produce reliable financial statements. We have completed resyndications for 19 ASCs since July 2004 when we began the resyndication process, and we anticipate we will complete another 15 to 20 resyndications in the remaining months of 2005. We have assembled a dedicated team of accountants, attorneys, and other specialists to expedite this effort.

 

Our surgery centers division has a diversified payor mix with managed care and other discount plans representing the highest percentage. For the year ended December 31, 2003, managed care and other discount plans represented 51.6% of the division’s net operating revenue, which totaled $920.1 million. For the year ended December 31, 2002, managed care and other discount plans represented 52.7% of the division’s net operating revenue, which totaled $926.4 million.

 

The ASC market continues to grow, due in part to improved anesthesia, new instrumentation, financial incentives for physicians, payor pressure to reduce costs, and other factors. Because the market is highly fragmented, however, it is highly competitive. We plan to combat this competition (1) by increasing our concentration in specific markets, (2) by leveraging the size of our network to realize improved operating efficiencies, increased marketing opportunities, and better payor contracting, and (3) using technology such as standardized e-coding to improve division performance.

 

Outpatient

 

We are the largest operator of outpatient rehabilitation facilities in the United States. As of December 31, 2004, our outpatient division provided outpatient therapy through 765 HealthSouth facilities (706 of which are wholly owned and 59 of which are jointly owned) and 39 facilities managed under contract by us. These facilities are located in 44 states, with a concentration of centers in Florida, Texas, New Jersey, New York, and Missouri.

 

Our outpatient rehabilitation facilities are staffed by physical therapists, occupational therapists, and other clinicians and support personnel, depending on the services provided at a particular location, and are open at hours designed to accommodate the needs of the patient population being served and the local demand for services. Our centers offer a range of rehabilitative health care services, including physical therapy and occupational therapy, with a particular focus on orthopedic, sports-related, work-related, hand and spine injuries, and various neurological/neuromuscular conditions.

 

19


Table of Contents
Index to Financial Statements

Our outpatient division has a diversified payor mix with managed care and other discount plans representing the highest percentage. For the year ended December 31, 2003, managed care and other discount plans represented 45.3% of the division’s net operating revenue, which totaled $587.0 million. For the year ended December 31, 2002, managed care and other discount plans represented 43.5% of the division’s net operating revenue, which totaled $663.6 million.

 

Diagnostic

 

We are the second largest operator of freestanding diagnostic imaging centers in the United States. As of December 31, 2004, our diagnostic division operated 96 diagnostic centers (80 of which are wholly owned and 16 of which are jointly owned) in 26 states and the District of Columbia, with a concentration of centers in Texas, Washington, D.C., Alabama, Georgia, and Florida. Our diagnostic centers provide outpatient diagnostic imaging services, including MRI services, CT services, X-ray services, ultrasound services, mammography services, nuclear medicine services, and fluoroscopy. We do not provide all services at all sites, although approximately 75% of our diagnostic centers are multi-modality centers offering multiple types of service.

 

Our diagnostic centers provide outpatient diagnostic procedures performed by experienced radiological technologists. After the diagnostic procedure is completed, the images are reviewed by radiologists who have contracted with us. Those radiologists prepare an interpretation which is then delivered to the referring physician.

 

Our diagnostic division has a diversified payor mix with managed care and other discount plans representing the highest percentage. For the year ended December 31, 2003, managed care and other discount plans represented 63.4% of the division’s net operating revenue, which totaled $279.6 million. For the year ended December 31, 2002, managed care and other discount plans represented 56.9% of the division’s net operating revenue, which totaled $305.9 million.

 

Although the market for diagnostic services is highly competitive, we are expanding our focus on referring physicians outside of the orthopedic specialty to broaden our base of referrals. We also have received inquiries from parties interested in acquiring our diagnostic division. As we continue to develop our strategic plan, we will evaluate the role of each division, including the diagnostic division, in that plan. Even if consistent with our strategic plan, an important consideration in our decision to divest any material asset from our portfolio would be whether the transaction would help to deleverage the company.

 

Corporate and Other

 

This division is managed directly from our corporate office. It comprises all revenue producing activities that do not fall within one of the four operating divisions discussed above, including our medical centers, other patient care services, and certain non-patient care services.

 

    Medical Centers. In 2001, we operated five acute care hospitals, four of which we owned and one of which we operated under a management contract. Between 2001 and December 31, 2004, we sold two hospitals, shut down the hospital we previously operated under a management contract (we took ownership of that hospital in 2002), and ceased providing acute care services at one hospital in favor of inpatient rehabilitation services. We are exploring a sale of our only remaining acute care hospital, which has 219 licensed beds and is located in Birmingham, Alabama, as well as our “Digital Hospital,” which is currently under construction in Birmingham, Alabama. As of December 31, 2004, we had invested $190 million in the Digital Hospital project and estimate it will require an additional $200 million to complete. We have not signed a definitive agreement with respect to either hospital and there can be no assurance any sale will take place. See Note 7, Property and Equipment, to our accompanying consolidated financial statements, for a discussion of the significant impairment charge we recognized in 2003 relating to the Digital Hospital, as well as the additional impairment charge we plan to recognize in 2004.

 

20


Table of Contents
Index to Financial Statements
    Other Patient Care Services. In some markets we provide other limited patient care services, including operation of a gamma knife radiosurgery center and physician management services. The gamma knife treats conditions such as benign and malignant brain tumors, without any incision or physical entry into the brain. We evaluate market opportunities on a case-by-case basis in determining whether to provide additional services of these types. We may provide these services as a complement to our facility-based businesses or as stand-alone businesses.

 

    Non-Patient Care Services. We also provide certain services that do not involve the provision of patient care, including the operation of the conference center located at our corporate campus, operation of medical office buildings, various corporate marketing activities, our clinical research activities, and other services that are generally intended to complement our patient care activities.

 

    Corporate Functions. All our corporate departments and related overhead are contained within this division. These departments, which include among others accounting, communications, compliance, human resources, information technology, internal audit, legal, payor strategies, reimbursement, tax, and treasury, provide support functions to our operating divisions.

 

For the year ended December 31, 2003, the division’s net operating revenue totaled $228.3 million. For the year ended December 31, 2002, the division’s net operating revenue totaled $215.9 million.

 

Operational Agenda

 

We have established a multi-year operational agenda that is divided into the following focus areas:

 

Revenue. Our current strategy is to grow our revenues by expanding the post-acute care services provided at or complementary to our inpatient facilities, such as long-term acute care, skilled nursing, and home health services. We also plan to reposition the focus of our outpatient facilities (surgery, outpatient rehabilitation, and diagnostic) into key markets, and look for expansion and growth opportunities in those markets. In addition, we hope to mitigate the impact of the 75% Rule using a combination of the four mitigation strategies discussed in this Item, “Our Business – Inpatient.” We are also considering ways to increase revenues through improved managed care contract modeling and consolidated sales and marketing efforts.

 

Cost. We have substantially reduced unnecessary overhead expense and closed or sold under-performing facilities. We will continue to work to reduce costs by reorganizing and flattening each operating division, implementing standardized labor management metrics and performance expectations, and streamlining our supply chain. In addition, we are closely monitoring our business and will, when necessary, close or sell additional under-performing facilities.

 

Infrastructure. We have invested significant resources to evaluate and improve our financial, reporting, and compliance infrastructure, and will continue to invest heavily in our infrastructure throughout this turnaround period. Although our infrastructure needs improvement in many areas, we are specifically focused on implementing required internal controls (e.g., compliance with Section 404 of the Sarbanes-Oxley Act of 2002), enhancing our financial infrastructure (e.g., improving financial and operational reporting and establishing a formal capital expenditure process, formal budget process, and revised levels of authority), enhancing our management reporting capabilities (e.g., standardizing our monthly reporting and analysis, standardizing our financial projections and implementing a faster month-end close), developing regulatory compliance programs, enhancing our information systems (e.g. upgrading our patient accounting systems), and implementing an information technology strategic plan.

 

Quality. We are working to develop strong quality assurance programs within our facilities and divisions. We plan to supplement these programs by establishing a robust company-wide quality agenda that will include standardized division-specific quality metrics and improved clinical information through the use of technology.

 

21


Table of Contents
Index to Financial Statements

People. We have replaced our executive management team and a number of other management personnel, and we plan to continue investing heavily in recruiting new employees to HealthSouth. We are also looking at ways to increase retention and employee development, as well as overall employee relations, and we have developed a human resources strategic plan. Our goal is to build a culture of integrity, transparency, diversity, and excellence, while simplifying and flattening our organizational structure.

 

Competition

 

Inpatient

 

Our IRFs and LTCHs compete primarily with rehabilitation units and skilled nursing units within acute care hospitals in the markets we serve. In addition, we face competition from large privately and publicly held companies such as Rehabcare Group, Inc., Select Medical Corporation, and Kindred Healthcare, Inc.

 

Some of these competitors may have greater patient referral support and financial and personnel resources in particular markets than we do. We believe we compete successfully within the marketplace based upon our size, reputation for quality, competitive prices, and positive rehabilitation outcomes.

 

Surgery Centers

 

We face competition from other providers of ambulatory surgical care in developing ASC joint ventures, acquiring existing centers, attracting patients, and negotiating managed care contracts in each of our markets. There are several publicly held companies, divisions or subsidiaries of publicly held companies, and several private companies that operate ASCs. Further, many physician groups develop ASCs without a corporate partner, utilizing consultants who typically perform these services for a fee and who may not require an equity interest in the ongoing operations of the center.

 

We believe that we compete effectively in this market because of our size, experience, and reputation for providing quality care. Our limited access to capital makes it more difficult for us to develop or acquire new ASCs, however, which puts us at a competitive disadvantage in certain markets.

 

Outpatient

 

Our outpatient rehabilitation facilities compete directly or indirectly with the physical and occupational therapy departments of hospitals, physician-owned therapy clinics, other private therapy clinics, and chiropractors. We also face competition from large privately held and publicly held physical therapy companies such as U.S. Physical Therapy, Inc. and Benchmark Medical, Inc., as well as mid-sized regional companies. It is particularly difficult to compete with physician-owned therapy clinics because physicians have traditionally been our customers, rather than our competitors. Consequently, in addition to competing with those physicians who offer physical therapy services as in-office ancillary services, we lose them as a referral source.

 

Some of these competitors may have greater patient referral support and financial and personnel resources in particular markets than we do. We believe we compete successfully within the marketplace based upon our reputation for quality, competitive prices, positive rehabilitation outcomes, and innovative programs.

 

Diagnostic

 

The market for diagnostic services is highly fragmented and highly competitive. Many physicians and physician groups have opened diagnostic facilities as an in-office ancillary service. Our diagnostic centers also compete with local hospitals, other multi-center imaging companies, and local independent diagnostic centers.

 

22


Table of Contents
Index to Financial Statements

Other Competition

 

In some states where we operate, the construction or expansion of facilities, the acquisition of existing facilities, or the introduction of new beds or services may be subject to review by and prior approval of state regulatory agencies under a “Certificate of Need” program. Certificate of Need laws often require the reviewing agency to determine the public need for additional or expanded health care facilities and services. Certificate of Need programs generally require approvals for capital expenditures involving IRFs, LTCHs, acute care hospitals, and ASCs if such capital expenditures exceed certain thresholds. We potentially face competition any time we initiate a Certificate of Need project or seek to acquire an existing facility or Certificate of Need. This competition may arise either from competing national or regional companies or from local hospitals or other providers which file competing applications or oppose the proposed Certificate of Need project. The necessity for these approvals serves as a barrier to entry and has the potential to limit competition by creating a franchise to provide services to a given area. We have generally been successful in obtaining Certificates of Need or similar approvals when required, although there can be no assurance that we will achieve similar success in the future.

 

We rely significantly on our ability to attract, develop, and retain physicians, therapists, and other clinical personnel for our facilities. We compete for these professionals with other health care companies, hospitals, and potential clients and partners. In addition, changes in health care regulations have enabled physicians to open facilities in direct competition with us, which has increased the choices for such professionals and therefore made it more difficult and/or expensive for us to hire the necessary personnel for our facilities.

 

Sources of Revenues

 

We receive payment for patient care services from the federal government (primarily under the Medicare program), state governments (under their respective Medicaid or similar programs), managed care plans, private insurers, and directly from patients. In addition, we receive payment for non-patient care activities from various sources. The following table identifies the sources and relative mix of our revenues for the periods stated:

 

       Year Ended December 31,

 

Source


     2003

    2002

    2001

    2000

 
                   (Restated)     (Restated)  

Medicare

     42.7 %   37.8 %   31.4 %   29.1 %

Medicaid

     2.1 %   2.4 %   2.6 %   2.6 %

Workers’ compensation

     9.4 %   10.7 %   12.1 %   12.5 %

Managed care and other discount plans

     31.3 %   33.0 %   32.9 %   31.8 %

Other third party payors

     9.4 %   10.8 %   14.6 %   17.0 %

Other income

     5.1 %   5.3 %   6.4 %   7.0 %
      

 

 

 

       100.0 %   100.0 %   100.0 %   100.0 %
      

 

 

 

 

Medicare is a federal program that provides certain hospital and medical insurance benefits to persons aged 65 and over, some disabled persons, and persons with end-stage renal disease. Medicaid is a jointly administered federal and state program that provides hospital and medical benefits to qualifying individuals who are unable to afford health care.

 

Our facilities generally offer discounts from established charges to certain group purchasers of health care services, including Blue Cross and Blue Shield (“BCBS”), other private insurance companies, employers, HMOs, PPOs, and other managed care plans. These discount programs, which are often negotiated for multi-year terms, limit our ability to increase revenues in response to increasing costs.

 

Patients are generally not responsible for the difference between established gross charges and amounts reimbursed for such services under Medicare, Medicaid, BCBS plans, HMOs, or PPOs, but are responsible to the extent of any exclusions, deductibles, copayments, or coinsurance features of their coverage. The amount of such

 

23


Table of Contents
Index to Financial Statements

exclusions, deductibles, copayments, and coinsurance has been increasing each year. Collection of amounts due from individuals is typically more difficult than from governmental or third-party payors.

 

Medicare Reimbursement

 

Medicare, through statutes and regulations, establishes reimbursement methodologies for various types of health care facilities and services. These methodologies have historically been subject to periodic revisions that can have a substantial impact on existing health care providers. In accordance with authorization from Congress, CMS makes annual upward or downward adjustments to Medicare payment rates in most areas. Frequently, these adjustments can result in decreases in actual dollars per procedure or a freeze on reimbursement despite increases in costs.

 

We expect that Congress and CMS will address reimbursement rates for a variety of care settings over the next several years. Any downward adjustment to rates for the types of facilities that we operate could have a material adverse effect on our business, financial condition, results of operations, and cash flows.

 

A basic summary of current Medicare reimbursement in our service areas follows:

 

Acute Care. As a result of the Social Security Act Amendments of 1983, Congress adopted a prospective payment system (“PPS”) to cover the routine and ancillary operating and capital costs of most Medicare inpatient acute care hospital services. Under this system, the Secretary of HHS has established fixed payment amounts per discharge based on diagnosis-related groups (“DRGs”). With limited exceptions, reimbursement received for inpatient acute care hospital services is limited to the DRG payment rate, regardless of the number of services provided to the patient or the length of the patient’s hospital stay. Under Medicare’s acute care PPS, a hospital may retain the difference, if any, between its DRG payment rate and its operating costs incurred in furnishing inpatient services, and is at risk for any operating costs that exceed its DRG payment rate. We currently operate several hospitals that are reimbursed under Medicare’s acute care PPS. Only one of these hospitals receives significant acute care PPS payments relating to Medicare inpatient services, however. These hospitals can qualify for additional payments available for “outlier” cases that incorporate certain higher cost factors. CMS instituted a change to the cost outlier threshold and reimbursement methodology for acute care facilities effective October 1, 2003. Generally, this change has resulted in lower overall reimbursement to acute care facilities.

 

Inpatient Rehabilitation and the 75% Rule. Historically, freestanding and hospital-based IRFs received cost-based reimbursement from Medicare under an exemption from the acute care PPS. The Balanced Budget Act of 1997 and its implementing regulations replaced the traditional IRF cost-based methodology, however, with a PPS system that recognizes 21 “Rehabilitation Impairment Categories.” This new IRF-PPS became effective on January 1, 2002.

 

To qualify as an IRF under Medicare, a facility must show that 75% of the facility’s patient population requires “intensive rehabilitation services” that fall into a specified list of conditions. When originally promulgated in 1984, that list included ten conditions:

 

    stroke

 

    spinal cord injury

 

    congenital deformity

 

    amputation

 

    major multiple trauma

 

    fracture of the femur (hip fracture)

 

    brain injury

 

24


Table of Contents
Index to Financial Statements
    polyarthritis, including rheumatoid arthritis

 

    neurological disorders

 

    burns

 

On May 7, 2004, CMS issued a final rule revising the 75% Rule that, among other things, modified and expanded the specified list of conditions from 10 to 13. Importantly, CMS replaced the “polyarthritis” condition with three new conditions, and added a separate category for knee or hip joint replacement, which has the effect of significantly limiting the types of patients that qualify as requiring “intensive rehabilitation services.” In anticipation of the considerable difficulty many IRFs will have satisfying the revised 75% Rule, CMS established a phase-in period for compliance, as follows:

 

Cost Reporting Period


   Minimum Qualifying
Patient Mix


    Comorbidities
Apply (Y/N)(1)


  

Patient Mix Affected


July 1, 2004—June 30, 2005

   50 %   Y    Medicare and Total

July 1, 2005—June 30, 2006

   60 %   Y    Medicare and Total

July 1, 2006—June 30, 2007

   65 %   Y    Medicare and Total

July 1, 2007 and Thereafter

   75 %   N    Total

(1) Patients with certain comorbidities (additional health conditions) may count towards the minimum patient mix established by the revised 75% Rule during the phase-in period.

 

Any IRF that fails to meet the requirements of the 75% Rule is subject to reclassification as an acute care hospital. The effect of such reclassification would be to revert Medicare prospective IRF payment rates to lower acute care payment rates. Our inpatient division has begun to reduce or refocus admissions at most locations in an attempt to achieve compliance with the current phase-in schedule for the revised 75% Rule. We estimate that the revised 75% Rule will have a material adverse impact on out inpatient division’s revenues. For additional information about the estimated impact of the revised 75% Rule, see Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations. As discussed in this Item, “Our Business—Inpatient,” we have begun to implement a strategy to mitigate the impact of the revised 75% Rule on our revenues.

 

In January 2005, CMS suspended enforcement of the revised 75% Rule in response to a provision of the Consolidated Appropriations Act of 2005, enacted as Public Law 108-447, that directed CMS not to change the status of certain IRFs for their failure to comply with the revised 75% Rule until the Secretary of HHS made a determination based on the recently issued report by the Government Accountability Office (the “GAO”). On June 21, 2005, CMS issued a notice announcing that it will proceed with implementing the revised 75% Rule as set forth in its previously issued final rule. The notice states that CMS has determined it has already been taking the steps that the GAO recommended to improve how facilities are classified as an IRF and that the revised classification criteria for IRFs contained in the revised 75% Rule are not inconsistent with the recommendations in the GAO report. Accordingly, the June 21 notice lifts the suspension of enforcement of the revised 75% Rule.

 

Because we receive a significant percentage of our revenues from our inpatient division, and because our inpatient division receives a significant percentage of its revenues from Medicare, our inability to achieve compliance with and mitigate the revised 75% Rule could have a material adverse effect on our business, financial condition, results of operations, and cash flows.

 

Although the revised 75% Rule presents our biggest operating risk, other coverage policies can affect our operations. For example, Medicare providers like us can be negatively affected by the adoption of coverage policies, either at the national or local level, that determine whether an item or service is covered and under what clinical circumstances it is considered to be reasonable, necessary, and appropriate. In the absence of a national coverage determination, local Medicare fiscal intermediaries and carriers may specify more restrictive criteria than otherwise would apply nationally. For instance, Cahaba Government Benefit Administrators, the fiscal

 

25


Table of Contents
Index to Financial Statements

intermediary for Alabama, has issued a local coverage determination setting forth very detailed criteria it proposes to use in determining the medical appropriateness of services provided by IRFs. We cannot predict whether other Medicare contractors will adopt additional local coverage determinations or other policies or how these will affect us.

 

On May 25, 2005, CMS published a proposed rule that updates the IRF-PPS for federal fiscal year 2006. The proposed rule (1) increases the market basket payments by 3.1% utilizing a new methodology, (2) incorporates downward adjustments for reimbursement (resulting in an overall decrease of approximately 1.9%) in response to coding changes, (3) reduces the outlier payment threshold for cases with unusually high costs, (4) implements refinements to the Case-Mix Groups, comorbidity tiers, and relative weights, (5) implements new and revised payment adjustments that will be implemented on a budget neutral basis, (6) adopts the new geographic labor market area definitions based on the definitions created by the Office of Management and Budget known as Core-Based Statistical Areas, and (7) incorporates several other modifications to Medicare reimbursement for IRFs. After a notice and comment period, CMS is expected to publish a final rule in the next several months. CMS predicted in its announcement of the proposed rule that overall payments to IRFs nationwide would increase by 2.9% if the proposed rule were implemented. However, the final rule could result in a reduction in our reimbursement from Medicare for care provided in our IRFs.

 

Long Term Acute Care Hospitals. Long Term Acute Care Hospitals (“LTCHs”) provide diagnostic and medical treatment to patients with chronic diseases or complex medical conditions. In order for a facility to qualify as an LTCH, patients discharged from the facility in any given cost reporting year must have an average length-of-stay in excess of 25 days. Currently LTCHs are exempt from acute care PPS and receive Medicare reimbursement on the basis of reasonable costs subject to certain limits. However, this cost-based reimbursement is transitioning to a PPS system over a 5-year period which began for twelve-month periods beginning on or after October 1, 2002. Providers were given the option to transition into the full LTCH-PPS by receiving 100% of the federal payment rate at any time through the transition period. We have elected to receive the full federal payment rate for all of our LTCHs. Under the new LTCH-PPS system, Medicare will classify patients into distinct diagnostic groups (“LTC-DRGs”) based upon specific clinical characteristics and expected resource needs. The LTCH-PPS also provides for an adjustment for differences in area wages as well as a cost of living adjustment for LTCHs located in Alaska or Hawaii.

 

On May 4, 2005, CMS published a proposed rule relating to acute care PPS that will, if finalized, impact LTCH relative weights and LTC-DRG assignments for the period October 1, 2005 through September 30, 2006. On May 6, 2005, CMS published a final rule regarding LTCH-PPS rate updates and policy changes effective for discharges on or after July 1, 2005. The final rule increases LTCH-PPS standard payment rates by 3.4% and adopts revised labor market area definitions based on the Core-Based Statistical Areas designated by the Office of Management and Budget using 2000 census data. The final rule also lowers the eligibility threshold for hospitals to qualify for outlier payments. Although the final rule, which is effective July 1, 2005, will increase Medicare payment rates, the proposed rule, if adopted in its current form and made effective beginning October 1, 2005, will reduce total Medicare payments to us as a result of the impact of the relative weight calculations on our LTCH reimbursement. If the May 4, 2005 proposed rule is adopted in its current form, we estimate it will cause a reduction in inpatient division revenues of approximately $2.3 million for the period affected.

 

Effective July 1, 2004, CMS expanded its interrupted stay policy to include a discharge and readmission to the LTCH within three days, regardless of where the patient is transferred upon discharge. Accordingly, if a patient is readmitted to an LTCH within three days of discharge, Medicare will pay only one LTC-DRG. This expanded, but did not replace, the prior interrupted stay policy which provides that if an LTCH patient is discharged to an acute care hospital, an IRF, or a skilled nursing facility and then is readmitted to the LTCH within a fixed period of time, the entire hospitalization, both before and after the interruption, will be considered one episode of care and thus generate one LTC-DRG payment.

 

Effective October 1, 2004, CMS promulgated regulations altering the separateness and control requirements pertaining to LTCHs which are located within a hospital. Such hospitals within hospitals (“HIHs”) must meet

 

26


Table of Contents
Index to Financial Statements

more stringent requirements as to their independence from the host hospital and further must follow additional HIH requirements based upon the percentage of admittances from the host hospital. These HIH policies are to be phased in over a four-year period which began on October 1, 2004. See this Item, “Regulation—Hospital Within Hospital Rules.” We expect Congress and CMS to conduct a further review of LTCH payment policy. Any changes in program rules or reimbursement levels could adversely affect our LTCH operations.

 

Ambulatory Surgery Centers. ASC services are reimbursed by Medicare based on prospectively determined rates. These rates are not based on DRG’s like acute care hospital services. Rather, they are based upon the classifications of procedures into different payment groups which are based on surgical procedure complexity. Surgical procedures approved by CMS for ASC reimbursement are classified into nine payment groups for facility reimbursement purposes. All approved surgical procedures within the same payment group are reimbursed at a single rate, adjusted by the location of the facility and applicable wage index.

 

On April 29, 2005, CMS posted an interim final rule updating the list of approved surgical procedures. The interim final rule, which becomes effective July 5, 2005, deletes five approved procedures and adds 65 new procedures to the list of approved surgical procedures. Other significant changes in ASC reimbursement are presently being contemplated.

 

The Medicare Prescription Drug, Improvement, and Modernization Act of 2003 (“MMA”) froze Medicare payment rates for ASCs beginning in April 2004 through 2009 and directed HHS to implement a new payment system by 2008. For 2004, ASCs were subject to a 1% Medicare rate reduction, which dropped payment levels to roughly the 2002 rates. The MMA also required HHS to take into account a GAO study of ASCs to be completed by December 31, 2004 (although the GAO missed that deadline and has not provided a revised completion date). That study will examine the costs of providing the same service in the centers versus hospital outpatient departments, the accuracy of ASC payment levels and whether the outpatient prospective payment system would be a good basis for a new ASC payment system. Both the Medicare Payment Advisory Commission (“Med PAC”) and the OIG are recommending greater parity of payments for services performed in hospital outpatient departments (“HOPDs”) and those performed in ASCs. Such parity would likely result in lower payments for certain procedures that receive higher reimbursement in ASCs than in a HOPD, but could result in higher reimbursement for those services currently priced lower in ASCs than in HOPDs. Although Congressional action is required before ASC payment levels could actually be adjusted, further reductions in ASC Medicare reimbursement are possible. Any significant reductions in Medicare reimbursement could have a material adverse effect on our business, financial condition, results of operations, and cash flows.

 

Outpatient Rehabilitation. Our outpatient rehabilitation facilities are certified by Medicare and reimbursed by Medicare on an adjusted fee schedule basis. Under this basis, facilities receive a fixed fee per reimbursable procedure performed. This fee is adjusted by the geographical area in which the facility is located. The Balanced Budget Act of 1997 changed the reimbursement methodology for Medicare Part B therapy services from cost based to fee screen payments. It also established two types of annual per-beneficiary limitations on outpatient therapy services: (1) a $1,500 cap for all outpatient therapy services and speech language pathology services; and (2) a $1,500 cap for all outpatient occupational therapy services. Both of these amounts were indexed for inflation. Subsequent legislation suspended implementation of these caps through 2002. CMS began enforcing the therapy caps on September 1, 2003 (the inflation-adjusted amounts for 2003 are $1,590). The MMA suspended application of the therapy cap from the date of enactment (December 8, 2003) through calendar year 2005. This provision will not be applied retroactively to beneficiaries who exceeded their caps prior to the date of enactment. The therapy caps do not apply to therapy services provided in acute care hospital outpatient departments or outpatient departments of IRFs. At this time, we are unable to quantify the impact of this legislation on our business, financial condition, results of operations, and cash flows.

 

Diagnostic Facilities. Medicare allows diagnostic facilities that are independent of physician practices or hospitals to bill for approved diagnostic procedures as Independent Diagnostic Testing Facilities (“IDTFs”). Such procedures must be performed by licensed or certified nonphysician personnel under appropriate physician

 

27


Table of Contents
Index to Financial Statements

supervision or by physicians in accordance with detailed guidelines. IDTFs are reimbursed for approved tests with required physician orders on the basis of appropriate Current Procedural Terminology (“CPT”) codes under Medicare Part B. CPT reimbursement is geographically adjusted by CMS. Medicare uses the Resource-Based Relative Value Scale (“RBRVS”) fee schedule to pay for services provided in freestanding imaging centers. Each CPT code is assigned a set of relative value units (“RVUs”) that reflects the average time, effort, and practice costs (including a geographic adjustment) involved in performing a given procedure. Medicare payment amounts are based on a procedure’s total RVUs multiplied by a dollar conversion factor. Medicare makes payment determinations for diagnostic radiology procedures and imaging agents based on where the procedure is performed. More specifically, Medicare uses different payment methodologies for procedures performed in a hospital outpatient department versus an IDTF.

 

Hospital Outpatient Surgical Services. The Balanced Budget Act of 1997 authorized CMS to implement the Hospital Outpatient Prospective Payment System (“OPPS”) on July 1, 2000, for certain hospital outpatient services, which excludes diagnostic laboratory services, ambulance services, orthotics, prosthetics, chronic dialysis, screening mammographies, and outpatient rehabilitation services. OPPS payments are based on procedures and common procedure codes grouped by Ambulatory Payment Classifications (“APCs”). Our three surgical hospitals, which provide mostly outpatient surgical services, as well as our one Medical Center, are paid under the OPPS for outpatient surgical services.

 

On November 15, 2004, CMS published the 2005 OPPS final rule. The rule affects Medicare outpatient services furnished on or after January 1, 2005. The rate adjustments to the OPPS will mainly affect the Birmingham Medical Center, and our three surgical hospitals. The changes are expected to increase Medicare outpatient net revenues for these facilities.

 

Medicaid Reimbursement

 

Medicaid programs are jointly funded by the federal and state governments. As the Medicaid program is administered by the individual states under the oversight of CMS in accordance with certain regulatory and statutory guidelines, there are substantial differences in reimbursement methodology and coverage from state to state. Many states have experienced shortfalls in their Medicaid budget and are implementing significant cuts in both reimbursement rates and service coverage. Additionally, certain states control Medicaid expenditures through rationing or restricting certain services. Downward pressure on Medicaid payment rates could cause a decline in revenues.

 

Cost Reports

 

Because of our participation in the Medicare, Medicaid and TRICARE programs, we are required to meet certain financial reporting requirements. Federal and, where applicable, state regulations require the submission of annual cost reports covering the revenue, costs, and expenses associated with the services provided by our inpatient and certain surgery center hospitals to Medicare beneficiaries and Medicaid recipients.

 

Annual cost reports required under the Medicare and Medicaid programs are subject to routine audits, which may result in adjustments to the amounts determined to be ultimately due HealthSouth under these reimbursement programs. These audits are used for determining if any under- or over-payments were made to Medicare and to set payment levels for future years.

 

On December 30, 2004, we announced that HealthSouth had signed an agreement with CMS to resolve issues associated with various Medicare cost reporting practices. Subject to certain exceptions, the settlement provides for the release of HealthSouth by CMS from any obligations related to any cost statements or cost reports which had, or could have been submitted to CMS or its fiscal intermediaries by HealthSouth for cost reporting periods ended on or before December 31, 2003. The settlement provides that all covered federal cost reports be closed and considered final and settled. Open state Medicaid cost reports are still subject to potential audits as described above. See this Item, “Medicare Program Settlement.”

 

28


Table of Contents
Index to Financial Statements

Charge Structure for Uninsured Patients

 

During 2003 and 2004, a great deal of attention was focused on the charge structure and lack of available discounts extended to uninsured patients by health care facilities. Many health care providers have historically been reluctant to grant discounts that would produce charges to uninsured patients below the level of reimbursement provided by Medicare and Medicaid because of regulatory prohibitions on billing Medicare or Medicaid programs more than a provider’s “usual and customary charges.” Recent regulatory guidance has indicated, however, that health care providers may offer free or substantially discounted services to uninsured patients in many circumstances.

 

We cannot predict whether other regulatory or statutory provisions will be enacted by federal or state authorities that would prohibit or otherwise regulate relationships which we have established or may establish with other health care providers or the possibility of materially adverse effects on our business or revenues arising from such future actions. We believe, however, that we will be able to adjust our operations so as to be in compliance with any regulatory or statutory provision that may be applicable.

 

Managed Care and Other Discounted Plans

 

Most of our facilities offer discounts from established charges to certain large group purchasers of health care services, including managed care plans, BCBS, other private insurance companies, and employers. Managed care contracts typically have terms of between one and three years, although we have a number of managed care contracts that automatically renew each year unless a party elects to terminate the contract. While some of our contracts provide for annual rate increases of three to five percent, we cannot provide any assurance that we will continue to receive increases.

 

Regulation

 

The health care industry is subject to significant federal, state, and local regulation that affects our business activities by controlling the reimbursement we receive for services provided, requiring licensure or certification of our facilities, regulating the use of our properties, and controlling our growth.

 

Licensure and Certification

 

Health care facility construction and operation are subject to numerous federal, state, and local regulations relating to the adequacy of medical care, equipment, personnel, operating policies and procedures, maintenance of adequate records, fire prevention, and compliance with building codes and environmental protection laws. Our facilities are subject to periodic inspection by governmental and non-governmental certification authorities to ensure continued compliance with the various standards necessary for facility licensure. All of our inpatient facilities and substantially all of our ASCs are currently required to be licensed. Only a relatively small number of states require licensure for outpatient rehabilitation facilities. Many states do not require diagnostic facilities to be licensed.

 

In addition, facilities must be “certified” by CMS to participate in the Medicare program and generally must be certified by Medicaid state agencies to participate in Medicaid programs. All of our inpatient facilities participate in (or are awaiting the assignment of a provider number to participate in) the Medicare program. Approximately 94% of our outpatient therapy facilities (including outpatient rehabilitation facilities and other outpatient facilities) currently participate in, or are awaiting the assignment of a provider number to participate in, Medicare programs. Substantially all of our ASCs and diagnostic centers are certified (or are awaiting certification) under the Medicare program. Our Medicare-certified facilities undergo periodic on-site surveys in order to maintain their certification.

 

Failure to comply with applicable certification requirements may make our facilities ineligible for Medicare or Medicaid reimbursement. In addition, Medicare or Medicaid may seek retroactive reimbursement from

 

29


Table of Contents
Index to Financial Statements

noncompliant facilities or otherwise impose sanctions on noncompliant facilities. Non-governmental payors often have the right to terminate provider contracts if a facility loses its Medicare or Medicaid certification. We have developed operational systems to oversee compliance with the various standards and requirements of the Medicare program and have established ongoing quality assurance activities; however, given the complex nature of governmental health care regulations, there can be no assurance that Medicare, Medicaid, or other regulatory authorities will not allege instances of noncompliance.

 

Certificates of Need

 

In some states where we operate, the construction or expansion of facilities, the acquisition of existing facilities, or the introduction of new beds or services may be subject to review by and prior approval of state regulatory agencies under a “Certificate of Need” program. Certificate of Need laws often require the reviewing agency to determine the public need for additional or expanded health care facilities and services. Certificate of Need programs generally require approvals for capital expenditures involving IRFs, LTCHs, acute care hospitals, and ASCs if such capital expenditures exceed certain thresholds. Most states do not require such approvals for outpatient rehabilitation, occupational health, or diagnostic facilities and services. However, any time a Certificate of Need is required, we must obtain it before acquiring, opening, or expanding a health care facility or starting a new health care program.

 

False Claims Act

 

Over the past several years, an increasing number of health care providers have been accused of violating the federal False Claims Act. That act prohibits the knowing presentation of a false claim to the United States government, and provides for penalties equal to three times the actual amount of any overpayments plus up to $11,000 per claim. In addition, the False Claims Act allows private persons, known as “relators,” to file complaints under seal and provides a period of time for the government to investigate such complaints and determine whether to intervene in them and take over the handling of all or part of such complaints. Because of the sealing provisions of the False Claims Act, it is possible for health care providers to be subject to False Claims Act suits for extended periods of time without notice of such suits or an opportunity to respond to them. Because we perform thousands of similar procedures a year for which we are reimbursed by Medicare and other federal payors and there is a relatively long statute of limitations, a billing error or cost reporting error could result in significant civil or criminal penalties under the False Claims Act or other laws. We have recently entered into a substantial settlement of claims under the False Claims Act. See this Item, “Medicare Program Settlement.” We remain a named defendant in certain unsealed suits under the False Claims Act where the United States did not intervene. See Item 3, Legal Proceedings, “Certain Regulatory Actions.”

 

Corporate Integrity Agreement

 

As described in this Item, “Medicare Program Settlement,” we entered into a new corporate integrity agreement (“CIA”) in December 2004, which is effective for five years beginning January 1, 2005. Failure to comply with our new CIA could lead to severe penalties such as exclusion from further participation in federal health care programs, including Medicare and Medicaid, which currently account for a substantial portion of our revenues. Failure to meet lesser requirements of our new CIA could result in stipulated financial penalties. See Note 21, Medicare Program Settlement, for a description of the accounting treatment of the settlement relating to this CIA. On April 28, 2005, we submitted an implementation report to the OIG stating that we had, within the 90-day time frame, materially complied with the initial requirements of this new CIA.

 

As part of our ongoing dialogue with the OIG, we have, over the past two years, submitted disclosures detailing various activities involving HealthSouth and certain third parties. We have summarized several transactions that are currently being reviewed by the DOJ’s civil division under Item 13, Certain Relationships and Related Transactions, “Other Transactions.”

 

30


Table of Contents
Index to Financial Statements

Relationships with Physicians and Other Providers

 

The Anti-Kickback Law. Various state and federal laws regulate relationships between providers of health care services, including employment or service contracts and investment relationships. Among the most important of these restrictions is a federal criminal law prohibiting (a) the offer, payment, solicitation, or receipt of remuneration by individuals or entities to induce referrals of patients for services reimbursed under the Medicare or Medicaid programs or (b) the leasing, purchasing, ordering, arranging for, or recommending the lease, purchase, or order of any item, good, facility, or service covered by such programs (the “Anti-Kickback Law”). In addition to federal criminal sanctions, including penalties of up to $50,000 for each violation plus tripled damages for improper claims, violators of the Anti-Kickback Law may be subject to exclusion from the Medicare and/or Medicaid programs. In 1991, the OIG issued regulations describing compensation arrangements that are not viewed as illegal remuneration under the Anti-Kickback Law (the “1991 Safe Harbor Rules”). The 1991 Safe Harbor Rules create certain standards (“Safe Harbors”) for identified types of compensation arrangements that, if fully complied with, assure participants in the particular arrangement that the OIG will not treat that participation as a criminal offense under the Anti-Kickback Law or as the basis for an exclusion from the Medicare and Medicaid programs or the imposition of civil sanctions.

 

The OIG closely scrutinizes health care joint ventures involving physicians and other referral sources for compliance with the Anti-Kickback Law. In 1989, the OIG published a Fraud Alert that outlined questionable features of “suspect” joint ventures, and has continued to rely on such Fraud Alert in later pronouncements. We currently operate some of our rehabilitation hospitals and outpatient rehabilitation facilities as general partnerships, limited partnerships or limited liability companies (collectively, “partnerships”) with third-party investors, including other institutional health care providers but also including, in a number of cases, physician investors. Some of these partners may be deemed to be in a position to make or influence referrals to our facilities. Those partnerships that are providers of services under the Medicare program, and their limited partners, are subject to the Anti-Kickback Law. A number of the relationships we have established with physicians and other health care providers do not fit within any of the Safe Harbors. The 1991 Safe Harbor Rules do not expand the scope of activities that the Anti-Kickback Law prohibits, nor do they provide that failure to fall within a Safe Harbor constitutes a violation of the Anti-Kickback Law; however, the OIG has indicated that failure to fall within a Safe Harbor may subject an arrangement to increased scrutiny. While we do not believe that our rehabilitation facility partnerships engage in activities that violate the Anti-Kickback Law, there can be no assurance that such violations may not be asserted in the future, nor can there be any assurance that our defense against any such assertion would be successful.

 

Most of our ASCs are owned by partnerships, which include as partners physicians who perform surgical or other procedures at such centers. HHS has promulgated four categories of safe harbors under the Anti-Kickback Law for ASCs (the “ASC Safe Harbors”). Under the ASC Safe Harbors, ownership by a referring physician in a freestanding ASC will be protected if a number of conditions are satisfied. The conditions include the following:

 

    The center must be ASC certified to participate in the Medicare program and its operating and recovery room space must be dedicated exclusively to the ASC and not a part of a hospital (although such space may be leased from a hospital if such lease meets the requirements of the safe harbor for space rental).

 

    Each investor must be either (a) a physician who derived at least one-third of his or her medical practice income for the previous fiscal year or 12-month period from performing procedures on the list of Medicare-covered procedures for ASCs, (b) a hospital, or (c) a person or entity not in a position to make or influence referrals to the center, nor to provide items or services to the center, nor employed by the center or any investor.

 

    Unless all physician-investors are members of a single specialty, each physician-investor must perform at least one-third of his or her procedures at the center each year. (This requirement is in addition to the requirement that the physician-investor has derived at least one-third of his or her medical practice income for the past year from performing procedures.)

 

31


Table of Contents
Index to Financial Statements
    Physician-investors must have fully informed their referred patients of the physician’s investment interest.

 

    The terms on which an investment interest is offered to an investor are not related to the previous or expected volume of referrals, services furnished, or the amount of business otherwise generated from that investor to the entity.

 

    Neither the center nor any other investor may loan funds to or guarantee a loan for an investor if the investor uses any part of such loan to obtain the investment interest.

 

    The amount of payment to an investor in return for the investment interest is directly proportional to the amount of the capital investment (including the fair market value of any pre-operational services rendered) of that investor.

 

    All physician-investors, any hospital-investor, and the center agree to treat patients receiving medical benefits or assistance under the Medicare or Medicaid programs.

 

    All ancillary services performed at the center for beneficiaries of federal health care programs must be directly and integrally related to primary procedures performed at the center and may not be billed separately.

 

    No hospital-investor may include on its cost report or any claim for payment from a federal health care program any costs associated with the center.

 

    The center may not use equipment owned by or services provided by a hospital-investor unless such equipment is leased in accordance with an agreement that complies with the equipment rental safe harbor and such services are provided in accordance with a contract that complies with the personal services and management contracts safe harbor.

 

    No hospital-investor may be in a position to make or influence referrals directly or indirectly to any other investor or the center.

 

Because we invest in each partnership that owns an ASC and often provide management and other services to the ASC, our arrangements with physician investors do not fit within the terms of the ASC Safe Harbors. In addition, because we do not control the medical practices of our physician investors or control where they perform surgical procedures, in some of our ASCs, the quantitative tests described above have not been met and/or will not be met in the future, and that certain other conditions of the ASC Safe Harbors have not been or will not be satisfied. We cannot assure you that all physician-investors will perform, or have performed, one-third of their procedures at the ASC or have informed or will inform their referred patients of their investment interests. Accordingly, there can be no assurance that the ownership interests in some of our ASCs will not be challenged under the Anti-Kickback Law.

 

Some of our diagnostic centers are also owned or operated by partnerships that include radiologists as partners. While those ownership interests are not directly covered by the Safe Harbor Rules, we do not believe that such arrangements violate the Anti-Kickback Law because radiologists are typically not in a position to make referrals to diagnostic centers. In addition, our mobile lithotripsy operations are conducted by partnerships in which urologists are limited partners. Because such urologists are in a position to, and do, perform lithotripsy procedures utilizing our lithotripsy equipment, we believe that the same analysis underlying the ASC Safe Harbor should apply to ownership interests in lithotripsy equipment held by urologists. There can be no assurance, however, that the Anti-Kickback Law will not be interpreted in a manner contrary to our beliefs with respect to diagnostic and lithotripsy services.

 

We have entered into management agreements to manage many of our facilities that are owned by partnerships in which physicians have invested. A number of these agreements incorporate a percentage-based management fee. Although there is a safe harbor for personal services and management contracts, this safe harbor requires, among other things, that the aggregate compensation paid to the manager over the term of the

 

32


Table of Contents
Index to Financial Statements

agreement be set in advance. Because our management fee may be based on a percentage of revenues, the fee arrangement may not meet this requirement. However, we believe that our management arrangements satisfy the other requirements of the safe harbor for personal services and management contracts and that they comply with the Anti-Kickback Law. The OIG has taken the position that percentage-based management agreements are not protected by a safe harbor, and consequently, may violate the Anti-Kickback Law. On April 15, 1998, the OIG issued Advisory Opinion 98-4 which reiterates this proposition. This opinion focused on areas the OIG considers problematic in a physician practice management context, including financial incentives to increase patient referrals, no safeguards against overutilization and incentives to increase the risk of abusive billing. The opinion reiterated that proof of intent to violate the Anti-Kickback Law is the central focus of the OIG. We have implemented programs designed to safeguard against overbilling and otherwise achieve compliance with the Anti-Kickback Law and other laws, but we cannot assure you that the OIG would find our compliance programs to be adequate.

 

While several federal court decisions have aggressively applied the restrictions of the Anti-Kickback Law, they provide little guidance as to the application of the Anti-Kickback Law to our partnerships, and we cannot provide any assurances that a federal or state agency charged with enforcement of the Anti-Kickback Law and similar laws might not claim that some of our partnerships have violated or are violating the Anti-Kickback Law. Such a claim could adversely affect relationships we have established with physicians or other health care providers or result in the imposition of penalties on us or on particular HealthSouth facilities. Any conviction of a partnership for violations of the Anti-Kickback Law would have severe consequences on that partnership’s ability to be a viable entity and our ability to attract physician investors to other partnerships and could result in substantial fines as well as our exclusion from Medicare and Medicaid. Moreover, even the assertion of a violation of the Anti-Kickback Law by one or more of our partnerships could have a material adverse effect upon our business, financial condition, results of operations, or cash flows.

 

Stark Prohibitions. The so-called “Stark II” provisions of the Omnibus Budget Reconciliation Act of 1993 amend the federal Medicare statute to prohibit the making by a physician of referrals for “designated health services” including physical therapy, occupational therapy, radiology services or radiation therapy, to an entity in which the physician has an investment interest or other financial relationship, subject to certain exceptions. Such prohibition took effect on January 1, 1995 and applies to all of our partnerships with physician partners and to our other financial relationships with physicians. Final Regulations for Phase II Stark Regulations were published in the Federal Register on March 26, 2004 and had an effective date of July 26, 2004. The final regulations substantially clarified recruitment arrangements among health care facilities, individual physicians and group practices and addressed compensation arrangements with physicians.

 

Ambulatory surgery is not identified as a “designated health service” under Stark II, and we do not believe the statute is intended to cover ambulatory surgery services. The Phase I Final Stark Regulations expressly clarify that the provision of designated health services in an ASC is excepted from the referral prohibition of Stark II if payment for such designated health services is included in the ambulatory surgery center payment rate. Likewise, the Stark regulations expressly provide that a referral for designated health services does not include a request by a radiologist for diagnostic radiology services if the request results from a consultation initiated by another physician and the tests or services are furnished by or under the supervision of a radiologist. As a result, we believe that radiologists may enter into joint ventures for diagnostic imaging centers without violating Stark II in most circumstances.

 

Our lithotripsy units frequently operate on hospital campuses, and it is possible to conclude that such services are “inpatient and outpatient hospital services”—a category of designated health services under Stark II. CMS had indicated that lithotripsy services provided at a hospital would constitute “inpatient and outpatient hospital services” and thus would be subject to Stark II. However, a federal court decision does not support this interpretation. On January 3, 2003, CMS withdrew its appeal of Judge Henry Kennedy’s decision in American Lithotripsy Society and Urology Society of America v. Thompson, made in the Federal District Court for the District of Columbia. The Court of Appeals accepted the withdrawal, and, accordingly, the District Court

 

33


Table of Contents
Index to Financial Statements

decision is final. This order permanently enjoined CMS from implementing and enforcing its Stark II regulation declaring lithotripsy a “designated health service.” If Congress passes revised legislation on this topic, CMS adopts additional regulations or is otherwise successful in re-asserting its position on lithotripsy services and Stark, we would be forced to restructure many of our relationships for lithotripsy services at substantial cost.

 

While we do not believe that our financial relationships with physicians violate the Stark II statute or the associated regulations, no assurances can be given that a federal or state agency charged with enforcement of the Stark II statute and regulations or similar state laws might not assert a contrary position or that new federal or state laws governing physician relationships, or new interpretations of existing laws governing such relationships, might not adversely affect relationships we have established with physicians or result in the imposition of penalties on us or on particular HealthSouth facilities. Even the assertion of a violation could have a material adverse effect upon our business, financial condition, or results of operations. In addition, a number of states have passed or are considering statutes which prohibit or limit physician referrals of patients to facilities in which they have an investment interest. Any actual or perceived violation of these state statutes could have a material adverse effect on business, financial condition, results of operations, and cash flows.

 

HIPAA

 

The Health Insurance Portability and Accountability Act of 1996 (“HIPAA”) broadened the scope of certain fraud and abuse laws by adding several criminal provisions for health care fraud offenses that apply to all health benefit programs. HIPAA also added a prohibition against incentives intended to influence decisions by Medicare beneficiaries as to the provider from which they will receive services. In addition, HIPAA created new enforcement mechanisms to combat fraud and abuse, including the Medicare Integrity Program, and an incentive program under which individuals can receive up to $1,000 for providing information on Medicare fraud and abuse that leads to the recovery of at least $100 of Medicare funds. Federal enforcement officials now have the ability to exclude from Medicare and Medicaid any investors, officers, and managing employees associated with business entities that have committed health care fraud, even if the officer or managing employee had no knowledge of the fraud.

 

HIPAA also contains certain administrative simplification provisions that require the use of uniform electronic data transmission standards for certain health care claims and payment transactions submitted or received electronically. HHS has issued regulations implementing the HIPAA administrative simplification provisions and compliance with these regulations became mandatory for our facilities on October 16, 2003. HHS has agreed to accept noncompliant Medicare claims, for an unspecified time, to assist providers that are not yet able to process compliant transactions. However, this extension may be terminated by HHS and is not binding on private payors. We believe that the cost of compliance with these regulations has not had and is not expected to have a material adverse effect on our business, financial condition, results of operations, and cash flows.

 

HIPAA also requires HHS to adopt standards to protect the privacy and security of individually identifiable health-related information. HHS released regulations containing privacy standards in December 2000 and published revisions to the regulations in August 2002. Compliance with these regulations became mandatory on April 14, 2003. The privacy regulations regulate the use and disclosure of individually identifiable health-related information, whether communicated electronically, on paper, or orally. The regulations also provide patients with significant new rights related to understanding and controlling how their health information is used or disclosed. HHS released security regulations on February 20, 2003. The security regulations became mandatory on April 20, 2005 and require health care providers to implement administrative, physical, and technical practices to protect the security of individually identifiable health information that is maintained or transmitted electronically. The privacy regulations and security regulations could impose significant costs on our facilities in order to comply with these standards.

 

Penalties for violations of HIPAA include civil and criminal monetary penalties. In addition, there are numerous legislative and regulatory initiatives at the federal and state levels addressing patient privacy concerns.

 

34


Table of Contents
Index to Financial Statements

Facilities will continue to remain subject to any federal or state privacy-related laws that are more restrictive than the privacy regulations issued under HIPAA. These statutes vary and could impose additional penalties.

 

EMTALA

 

Our acute care hospital in Birmingham, Alabama and two of our surgical hospitals are subject to the Emergency Medical Treatment and Active Labor Act (“EMTALA”). This federal law requires any hospital that participates in the Medicare program to conduct an appropriate medical screening examination of every person who presents to the hospital’s emergency room for treatment and, if the patient is suffering from an emergency medical condition, to either stabilize that condition or make an appropriate transfer of the patient to a facility that can handle the condition. The obligation to screen and stabilize emergency medical conditions exists regardless of a patient’s ability to pay for treatment. There are severe penalties under EMTALA if a hospital fails to screen or appropriately stabilize or transfer a patient or if the hospital delays appropriate treatment in order to first inquire about the patient’s ability to pay. Penalties for violations of EMTALA include civil monetary penalties and exclusion from participation in the Medicare program. In addition, an injured patient, the patient’s family, or a medical facility that suffers a financial loss as a direct result of another hospital’s violation of the law can bring a civil suit against the hospital.

 

Hospital Within Hospital Rules

 

Effective October 1, 2004, CMS enacted final regulations that provide if a long term acute care “hospital within hospital” has Medicare admissions from its host hospital that exceed 25% (or an adjusted percentage for certain rural or Metropolitan Statistical Area dominant hospitals) of its Medicare discharges for its cost-reporting period, the LTCH will receive an adjusted payment for its Medicare patients of the lesser of (a) the otherwise full payment under the LTCH-PPS or (b) the full payment that Medicare would pay under the acute care PPS. In determining whether an LTCH meets the 25% criterion, patients transferred from the host hospital that have already qualified for outlier payments at the acute host facility would not count as part of the host hospital’s allowable percentage. Cases admitted from the host hospital before the LTCH crosses the 25% threshold will be paid under the LTCH-PPS. Under the final regulation, this “25% Rule” is set to phase in over a four year period which began on October 1, 2004.

 

Additionally, other excluded hospitals or units of a host hospital, such as inpatient rehabilitation facilities and/or units, must meet certain HIH requirements in order to maintain their excluded status and not be subject to Medicare’s acute care PPS.

 

The majority of our IRFs and LTCHs are freestanding facilities. As such, many of HealthSouth’s facilities are not subject to these rules. HealthSouth’s “hospital within hospital” LTCH or inpatient competitors or their referral sources could refer a certain number of patients to free-standing facilities for LTCH or inpatient rehabilitation services, and HealthSouth facilities may benefit from increased referrals.

 

Risk Management and Insurance

 

We insure a substantial portion of our professional, general liability, and workers’ compensation risks through a self-insured retention program implemented through HCS, Ltd., which is our wholly-owned offshore captive insurance subsidiary. HCS provides our first layer of insurance coverage for professional and general liability risks (up to $6 million per claim and $60 million in the aggregate per year) and workers’ compensation claims (between $250,000 and $1 million per claim, depending upon the state). We maintain professional and general liability insurance with unrelated commercial carriers for losses in excess of amounts insured by HCS. HealthSouth and HCS maintained reserves for professional, general liability, and workers’ compensation risks that totaled $208.1 million, net of insurance recoverables, at December 31, 2003. Management considers such reserves, which are based on actuarially determined estimates, to be adequate for those liability risks. However, there can be no assurance that the ultimate liability will not exceed management’s estimates.

 

35


Table of Contents
Index to Financial Statements

We also maintain directors and officers, property, and other typical insurance coverages with unrelated commercial carriers. See Item 3, “Insurance Coverage Litigation,” for a description of various lawsuits that have been filed to contest coverage under certain directors and officers insurance policies.

 

Employees

 

As of December 31, 2004, we employed approximately 40,000 individuals, of whom approximately 28,000 were full-time employees. We are subject to various state and federal laws that regulate wages, hours, benefits, and other terms and conditions relating to employment. Except for approximately 65 employees at one IRF (about 15% of that facility’s workforce), none of our employees are represented by a labor union. We are not aware of any current activities to organize our employees at other facilities. We believe our relationship with our employees is satisfactory. Like most health care providers, we have experienced labor costs rising faster than the general inflation rate. In some markets, nurse and other medical support personnel availability has become a significant operating issue to health care providers. To address this challenge, we are implementing initiatives to improve retention, recruiting, compensation programs, and productivity. The shortage of nurses and other medical support personnel, including physical therapists, may require us to increase utilization of more expensive temporary personnel.

 

Available Information

 

Our website address is www.healthsouth.com. We make available through our website the following documents, free of charge: our annual reports (Form 10-K), our quarterly reports (Form 10-Q), our current reports (Form 8-K), and any amendments we file with respect to any such reports promptly after we electronically file such material with, or furnish it to, the SEC. Please note, however, that with the exception of current reports and this annual report, we have not filed periodic reports with the SEC for periods after September 30, 2002, and we have previously cautioned that the financial information contained in previously filed reports should not be relied upon. In addition to the information that is available on our website, you may read and copy any materials we file with or furnish to the SEC at the SEC’s Public Reference Room at 100 F Street, N.E., Room 1580, Washington, D.C. 20549. You may obtain information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330. The SEC also maintains a website, www.sec.gov, which includes reports, proxy, and information statements, and other information regarding us and other issuers that file electronically at the SEC.

 

36


Table of Contents
Index to Financial Statements

RISK FACTORS

 

Our business, operations, and financial condition are subject to various risks. Some of these risks are described below, and you should take such risks into account in evaluating HealthSouth or any investment decision involving HealthSouth. This section does not describe all risks that may be applicable to our company, our industry, or our business, and it is intended only as a summary of certain material risk factors. More detailed information concerning the risk factors described below is contained in other sections of this annual report.

 

Risks Related to Pending Governmental Investigations and Litigation

 

Any adverse outcome of continuing investigations being conducted by the DOJ and other governmental agencies could have a material adverse effect on us.

 

While we are fully cooperating with the DOJ and other governmental authorities in their investigations, we cannot predict the outcome of those investigations. Such investigations could have a material adverse effect on us, the trading prices of our securities, and our ability to raise additional capital. If we are convicted of a crime, certain contracts and licenses that are material to our operations could be revoked which would materially and adversely affect our business, financial condition, results of operations, and cash flows.

 

Several lawsuits have been filed against us involving our accounting practices and other related matters and the outcome of these lawsuits may have a material adverse effect on our business, financial condition, results of operations, and cash flows.

 

A number of class action, derivative, and individual lawsuits have been filed against us, as well as certain of our past and present officers and directors, relating to, among other things, allegations of numerous violations of securities laws. We cannot predict the outcome of these lawsuits. Substantial damages or other monetary remedies assessed against us could have a material adverse effect on our business, financial condition, results of operations, and cash flows. See Item 3, Legal Proceedings, for a discussion of these lawsuits.

 

Although we have entered into a recent settlement with various government agencies and other parties regarding our participation in federal health care programs, we remain a defendant in litigation relating to our participation in federal health care programs, and the outcome of these lawsuits may have a material adverse effect on our business, financial condition, results of operations, and cash flows.

 

Qui tam actions brought under the False Claims Act are sealed by the court at the time of filing. The only parties privy to the information contained in the complaint are the relator, the federal government, and the court. Therefore, it is possible that additional qui tam actions have been filed against us that we are unaware of or which we have been ordered by the court not to discuss until the court lifts the seal from the case. Thus, it is possible that we are subject to liability exposure under the False Claims Act based on qui tam actions other than those discussed in this report.

 

CMS has been granted authority to suspend payments, in whole or in part, to Medicare providers if CMS possesses reliable information that an overpayment, fraud, or willful misrepresentation exists. If CMS suspects that payments are being or have been made as the result of fraud or misrepresentation, CMS may suspend payment at any time without providing us with prior notice. The initial suspension period is limited to 180 days. However, the payment suspension period can be extended almost indefinitely if the matter is under investigation by the OIG or the DOJ. Therefore, we are unable to predict if or when we may be subject to a suspension of payments by the Medicare and/or Medicaid programs, the possible length of the suspension period or the potential cash flow impact of a payment suspension. Any such suspension would adversely impact our business, financial condition, results of operations, and cash flows.

 

37


Table of Contents
Index to Financial Statements

If the OIG determines we have violated federal laws governing kickbacks and self-referrals, it could impose substantial civil money penalties on us and could seek to exclude our provider entities from participation in the federal health care programs which would severely impact our financial condition and ability to continue operations.

 

If the OIG determines that we have violated the Anti-Kickback Law, the OIG may commence administrative proceedings to impose penalties under the Civil Monetary Penalties Law of up to three times the amount of damages and $11,000 per claim for each false or fraudulent claim allegedly submitted by us. If the OIG determines that we have violated the federal Stark statute’s general prohibition on physician self-referrals (42 U.S.C. § 1395nn), it may impose a civil money penalty of up to $15,000 per service billed in violation of the statute.

 

The OIG has been granted the authority to exclude persons or entities from participation in the federal health care programs for a variety of reasons, including: (1) committing an act in violation of the Anti-Kickback Law, (2) submitting a false or fraudulent claim, (3) submitting a claim for services rendered in violation of the physician self-referral statute, or (4) violating any other provision of the Civil Monetary Penalties Law. Thus, if the OIG believes that we have submitted false or fraudulent claims, paid or received kickbacks, submitted claims in violation of the physician self-referral law, or committed any other act in violation of the Civil Monetary Penalties Law, the OIG could move to exclude our provider entities from participation in the federal health care programs.

 

Limitations of our director and officer liability insurance and potential indemnification obligations could have a material adverse effect on our business, financial condition, results of operations, and cash flows.

 

As discussed in Item 3, Legal Proceedings, several of our current and former directors and officers have been sued based on allegations that they participated in accounting fraud and other illegal activities. Several of our insurance carriers have filed lawsuits against us and are attempting to have our directors’ and officers’ liability policies that provide coverage for those claims voided or cancelled or have advised us that they do not intend to provide coverage with respect to those pending actions. If the insurance companies are successful in rescinding or denying coverage to us and/or some of our current and former directors and officers, our ability to reach a settlement with plaintiffs in the securities, derivative, and other litigation could be adversely affected. The failure to reach a settlement could have a material adverse effect on our business, financial condition, results of operations, and cash flows.

 

Under our bylaws and certain indemnification agreements, we may have an obligation to indemnify our current and former officers and directors. The failure of our policies to cover expenses incurred or liabilities imposed in connection with the pending actions against certain of our past and present directors and officers who we may be required to indemnify may have a material adverse effect on our business, financial condition, results of operations, and cash flows.

 

Risks Related to Our Financial Condition

 

Our substantial indebtedness may severely limit cash flow available for our operations and could impair our ability to service debt or obtain additional financing, if necessary.

 

We are highly leveraged. As of December 31, 2004, we had $3.5 billion of long-term debt outstanding, all of which we will need to repay or refinance by 2015, including $675.3 million of which we will need to repay or refinance at various times through 2007 (assuming noteholders exercise their options to require us to repurchase notes in 2007). The substantial amount of payments due on our outstanding debt and other payment obligations could, among other things:

 

    limit our ability to obtain additional financing,

 

    limit our flexibility in planning for, or reacting to, changes in our business and the industry,

 

38


Table of Contents
Index to Financial Statements
    place us at a competitive disadvantage relative to our competitors with less debt,

 

    render us more vulnerable to general adverse economic and industry conditions, and

 

    require us to dedicate a substantial portion of our cash flow to service our debt.

 

Our ability to satisfy interest payment obligations on our outstanding debt will depend largely on our future performance. Although we believe we have a solid core business and we have implemented a business plan to position HealthSouth for a successful restructuring, we are subject to numerous contingent liabilities and are subject to prevailing economic conditions and to financial, business, and other factors beyond our control. As a result, we cannot assure you that we will be able to generate sufficient cash flow to service our interest payment obligations under our outstanding debt, or that cash flows, future borrowings, or equity financing will be available for the payment or refinancing of our debt. To the extent we are not successful in repaying or negotiating renewals of our borrowings or in arranging new financing, our business and results of operations will be materially and adversely affected.

 

We have significant cash obligations relating to government settlements that, in addition to our indebtedness, may limit cash flow available for our operations and could impair our ability to service debt or obtain additional financing, if necessary.

 

In addition to being highly leveraged, we have significant cash obligations we must meet in the near future as a result of recent settlements with various federal agencies. Specifically, we will be paying the remaining balance of our $325 million settlement in quarterly installments over the next three years to satisfy our obligations under a settlement described in Item 1, Business, “Medicare Program Settlement.” Furthermore, we will pay $100 million to the SEC in five installments over a two year period beginning in the fourth quarter of 2005, as described in Item 1, Business, “SEC Settlement.”

 

We have determined that our internal controls are currently ineffective. The lack of internal controls could adversely affect our financial condition and ability to carry out our strategic business plan.

 

As discussed in Item 9A, Controls and Procedures, our new management team, under the supervision and with the participation of our chief executive officer and chief financial officer, conducted an evaluation of the effectiveness of the design and operation of HealthSouth’s internal controls. They concluded that, as of December 31, 2003, HealthSouth’s disclosure controls and procedures were not effective. In addition, based on work to date, our management, including the chief executive officer and chief financial officer, has concluded that, as of December 31, 2003, HealthSouth’s internal control over financial reporting was not effective. In addition, based on our preliminary assessments to date, we have concluded that our internal control over financial reporting as of December 31, 2004 is not effective. Although we have made substantial improvements in our internal controls, if we are unsuccessful in our focused effort to permanently and effectively remedy the weaknesses in our financial reporting mechanisms and internal controls and to establish and maintain effective corporate governance practices, our financial condition and ability to carry out our strategic business plan, our ability to report our financial condition and results of operations accurately and in a timely manner, and our ability to earn and retain the trust of our patients, physician partners, employees, and security holders could be adversely affected.

 

Risks Related to Our Business

 

The continuing time, effort, and expense relating to internal and external investigations, the restatement of historical financial statements, and the development and implementation of improved internal controls and procedures, may have an adverse effect on our business.

 

In addition to the challenges of the various government investigations and extensive litigation we face, our new management team has spent considerable time and effort dealing with internal and external investigations

 

39


Table of Contents
Index to Financial Statements

involving our historical accounting and internal controls, and in developing and implementing accounting policies and procedures, disclosure controls and procedures, and corporate governance policies and procedures. The significant time and effort spent may have adversely affected our operations and may continue to do so in the future.

 

Current and prospective investors, patients, physician partners, and employees may react adversely to the restatement of our historical financial statements and our inability to file in a timely manner all of our SEC filings.

 

Our future success depends in large part on the support of our current and future investors, patients, physician partners, and employees. The restatement of our historical financial statements and our inability to file on a timely basis all of our SEC filings has caused negative publicity about us, has resulted in the delisting of our common stock from the NYSE, and has, and may continue to have, a negative impact on the market price of our securities. In addition, the restatement of our historical financial statements and our inability to file all of our SEC filings in a timely manner could cause current and future patients and physician partners to lose confidence in our company, which may affect their willingness to provide care for us or receive care from us. Finally, employees and prospective employees may factor in these considerations relating to our stability and the value of any equity incentives in their decision-making regarding employment opportunities.

 

If we fail to comply with the extensive laws and government regulations applicable to us, we could suffer penalties or be required to make significant changes to our operations.

 

We are required to comply with extensive and complex laws and regulations at the federal, state, and local government levels. These laws and regulations relate to, among other things:

 

    licensure, certification, and accreditation,

 

    coding and billing for services,

 

    relationships with physicians and other referral sources, including physician self-referral, and anti-kickback laws,

 

    adequacy and quality of medical care,

 

    quality of medical equipment and services,

 

    qualifications, maintenance, and security issues associated with medical records,

 

    operating policies and procedures, and

 

    addition of facilities and services.

 

In the future, changes in these laws and regulations could subject our current or past practices to allegations of impropriety or illegality or could require us to make changes in our investment structure, facilities, equipment, personnel, services, capital expenditure programs, operating procedures, and contractual arrangements.

 

If we fail to comply with applicable laws and regulations, we could be subjected to liabilities, including (1) criminal penalties, (2) civil penalties, including monetary penalties and the loss of our licenses to operate one or more of our facilities, and (3) exclusion or suspension of one or more of our facilities from participation in the Medicare, Medicaid, and other federal and state health care programs.

 

If we fail to comply with our new Corporate Integrity Agreement, we could be subject to severe sanctions.

 

In December 2004, we entered into a new corporate integrity agreement with the OIG to promote our compliance with the requirements of Medicare, Medicaid, and all other federal health care programs. Under that agreement, which is effective for five years from January 1, 2005, we are subject to certain administrative

 

40


Table of Contents
Index to Financial Statements

requirements and are subject to review of certain Medicare reimbursement procedures by an Independent Review Organization. Our failure to comply with the material terms of the corporate integrity agreement could lead to suspension or exclusion from further participation in federal health care programs, including Medicare and Medicaid, which currently account for a substantial portion of our revenues. Any of these sanctions would have a material adverse effect on our business, financial condition, results of operations, and cash flows.

 

Reductions or changes in reimbursement from government or third party payors could adversely affect our operating results.

 

We derive a substantial portion of our net operating revenues from the Medicare and Medicaid programs. In 2003, 42.7% of our consolidated net operating revenues were derived from Medicare, 2.1% were derived from Medicaid, 31.3% were derived from managed care and other plans, 9.4% were derived from workers’ compensation payors, and 14.5% were derived from other revenue sources. There are increasing pressures from many payors to control health care costs and to reduce or limit increases in reimbursement rates for medical services. Our operating results could be adversely affected by changes in laws or regulations governing the Medicare and Medicaid programs. See this Item, “Sources of Revenue.”

 

Historically, Congress and some state legislatures have periodically proposed significant changes in the health care system. Many of these changes have resulted in limitations on and, in some cases, significant reductions in the levels of, payments to health care providers for services under many government reimbursement programs. See this Item, “Regulation” for a discussion of potential changes to the health care system that could materially and adversely affect our business, financial condition, results of operations, and cash flows.

 

In particular, the revised 75% Rule, which is discussed in this Item, “Sources of Revenues,” is the single biggest operating risk we face. Our inpatient division has begun to deny admissions of certain types of patients at several locations in an attempt to ensure compliance with the revised 75% Rule. We project this reduction in census, unless mitigated, will have a materially adverse impact on the inpatient segment’s revenues. We previously estimated that the revised 75% Rule could negatively impact our net operating revenues by $95 million to $100 million in 2005. Our inpatient division is taking steps to mitigate the impact of the revised 75% Rule, and we previously estimated the impact to our net operating revenues to be approximately $50 million to $55 million when our mitigation strategies are taken into consideration. In the second quarter of 2005, as many of our facilities approach the end of their cost reporting years, we have seen a greater than anticipated decline in inpatient volumes, a significant portion of which is attributable to the revised 75% Rule. Accordingly, the financial impact estimated could be greater than previously disclosed.

 

Our relationships with third-party payors, such as HMOs and PPOs, are generally governed by negotiated agreements. These agreements set forth the amounts we are entitled to receive for our services. We could be adversely affected in some of the markets where we operate if we are unable to negotiate and maintain favorable agreements with third-party payors.

 

The adoption of more restrictive Medicare coverage policies at the national and/or local levels could have an adverse impact on our ability to obtain Medicare reimbursement for inpatient rehabilitation services.

 

Medicare providers also can be negatively affected by the adoption of coverage policies, either at the national or local levels, describing whether an item or service is covered and under what clinical circumstances it is considered to be reasonable, necessary, and appropriate. In the absence of a national coverage determination, local Medicare fiscal intermediaries and carriers may specify more restrictive criteria than otherwise would apply nationally. For instance, Cahaba Government Benefit Administrators, the fiscal intermediary for Alabama, has issued a local coverage determination setting forth very detailed criteria it proposes to use in determining the medical appropriateness of services provided by IRFs. We cannot predict whether other Medicare contractors will adopt additional local coverage determinations or other policies or how these will affect us.

 

41


Table of Contents
Index to Financial Statements

Our facilities face national, regional, and local competition for patients from other health care providers.

 

We operate in a highly competitive industry. Although we are the largest provider of ambulatory surgery and rehabilitative health care services, and one of the largest providers of outpatient diagnostic services, in the United States, in any particular market we may encounter competition from local or national entities with longer operating histories or other competitive advantages. There can be no assurance that this competition, or other competition which we may encounter in the future, will not adversely affect our business, financial condition, results of operations, or cash flows.

 

Competition for staffing may increase our labor costs and reduce profitability.

 

Our operations are dependent on the efforts, abilities, and experience of our management and medical support personnel, such as physical therapists, nurses, and other health care professionals. We compete with other health care providers in recruiting and retaining qualified management and support personnel responsible for the daily operations of each of our facilities. In some markets, the availability of physical therapists, nurses, and other medical support personnel has become a significant operating issue to health care providers. This shortage may require us to continue to enhance wages and benefits to recruit and retain qualified personnel or to hire more expensive temporary personnel. We also depend on the available labor pool of semi-skilled and unskilled employees in each of the markets in which we operate. If our labor costs increase, we may not be able to raise rates to offset these increased costs. Because a significant percentage of our revenues consist of fixed, prospective payments, our ability to pass along increased labor costs is limited. Our failure to recruit and retain qualified management, physical therapists, nurses, and other medical support personnel, or to control our labor costs, could have a material adverse effect on our business, financial condition, results of operations, and cash flows.

 

We depend on our relationships with the physicians who use our facilities.

 

Our business depends upon the efforts of the physicians who provide health care services at our facilities and/or refer their patients to our facilities and the strength of our relationships with these physicians. Each physician referring or treating patients at one of our facilities may also practice at other facilities not owned by us.

 

At each of our facilities, our business could be adversely affected if a significant number of key physicians or a group of physicians:

 

    terminated their relationship with, or reduced their use of, our facilities,

 

    failed to maintain the quality of care provided or otherwise adhere to professional standards at our facilities, or

 

    exited the market entirely.

 

Our stock trades on the over-the-counter “Pink Sheets” market and our stock price may be volatile.

 

In March 2003, the NYSE delisted our common stock. Shortly thereafter, our stock began trading in the over-the-counter “Pink Sheets” market under the symbol HLSH. Although we plan to apply for listing of our stock on either the NYSE or the NASDAQ in 2006, we may not be successful in that effort. Our stock price has been volatile during the past two years and may continue to be volatile for the foreseeable future.

 

Item 2. Properties

 

Our principal executive offices are located in Birmingham, Alabama, where we own and maintain a headquarters building of approximately 200,000 square feet located on an 85-acre corporate campus. In addition to our headquarters building, we lease or own nearly 1,300 facilities through various consolidated entities to

 

42


Table of Contents
Index to Financial Statements

support our operations. Our leases generally have initial terms of 5 years, but range from 1 to 99 years. Most of our leases contain options to extend the lease period for up to 5 additional years. Our consolidated entities are sometimes responsible for property taxes, property and casualty insurance, and routine maintenance expenses. Other than our headquarters campus, our acute care hospital located in Birmingham, Alabama, and our “Digital Hospital” described below, none of our other properties is material to our business. Each of our material properties is used by our corporate and other segment, except our Digital Hospital, which is not in use but is held by our corporate and other segment. We have pledged all the property of HealthSouth Corporation as collateral to secure the performance of our obligations under our amended and restated credit agreement. For additional information about our amended and restated credit agreement, see Note 10, Long-term Debt, to our accompanying consolidated financial statements.

 

We also currently own, and from time to time may acquire, certain other improved and unimproved real properties in connection with our business. See Note 7, Property and Equipment, to our accompanying consolidated financial statements for more information about the properties we own and certain related indebtedness.

 

Over the past 18 months we have sold approximately $40 million in land and buildings, not including properties sold in connection with the sale of operating facilities. We sold one acute care hospital in June 2001 and another in October 2003. We are currently exploring a sale of our only remaining acute care hospital, which has 219 licensed beds and is located in Birmingham, Alabama, as well as our “Digital Hospital,” which is currently under construction in Birmingham, Alabama. As of December 31, 2004, we had invested $190 million in the Digital Hospital project and estimate it will require an additional $200 million to complete. We have not signed a definitive agreement with respect to the sale of either hospital and there can be no assurance any sale will take place. See Note 7, Property and Equipment, to our accompanying consolidated financial statements, for a discussion of the significant impairment charge we recognized in 2003 relating to the Digital Hospital, as well as the additional impairment charge we plan to recognize in 2004.

 

Our headquarters, facilities, and other properties are suitable for their respective uses and are, in general, adequate for our present needs. Our properties are subject to various federal, state, and local statutes and ordinances regulating their operation. Management does not believe that compliance with such statutes and ordinances will materially affect our business, financial condition, or results from operations.

 

Item 3. Legal Proceedings

 

Investigations and Proceedings Commenced by the SEC, the Department of Justice, and Other Governmental Authorities

 

In September 2002, the Securities and Exchange Commission (the “SEC”) notified us that it was conducting an investigation of trading in our securities that occurred prior to an August 27, 2002 press release concerning the impact of new Medicare billing guidance on our expected earnings. On February 5, 2003, the United States District Court for the Northern District of Alabama issued a subpoena requiring us to provide various documents in connection with a criminal investigation of us and certain of our directors, officers, and employees being conducted by the United States Attorney for the Northern District of Alabama. On March 18, 2003, agents from the Federal Bureau of Investigation (the “FBI”) executed a search warrant at our headquarters in connection with the United States Attorney’s investigation and were provided access to a number of financial records and other materials. The agents simultaneously served a grand jury subpoena on us on behalf of the criminal division of the Department of Justice (“DOJ”). Some of our employees also received subpoenas.

 

On March 19, 2003, the SEC filed a lawsuit captioned Securities and Exchange Commission v. HealthSouth Corp., et al., CV-03-J-0615-S, in the United States District Court for the Northern District of Alabama. The complaint alleges that we overstated earnings by at least $1.4 billion since 1999, and that this overstatement

 

43


Table of Contents
Index to Financial Statements

occurred because our then-Chairman and Chief Executive Officer, Richard M. Scrushy, insisted that we meet or exceed earnings expectations established by Wall Street analysts.

 

The SEC states in its complaint that our actions and those of Mr. Scrushy violated and/or aided and abetted violations of the antifraud, reporting, books-and-records, and internal controls provisions of the federal securities laws. Specifically, the SEC charged us with violations of Section 17(a) of the Securities Act of 1933 (the “Securities Act”) and Sections 10(b), 13(a), 13(b)(2)(A) and 13(b)(2)(B) of the Securities Exchange Act of 1934 (the “Exchange Act”), and Exchange Act Rules 10b-5, 12b-20, 13a-1, and 13a-13. The SEC sought a permanent injunction against us, civil money penalties, disgorgement of ill-gotten gains and losses avoided, as well as prejudgment interest. On March 19, 2003, we consented to the entry of an order by the court that (1) required us to place in escrow all extraordinary payments (whether compensation or otherwise) to our directors, officers, partners, controlling persons, agents, and employees, (2) prohibited us and our employees from destroying documents relating to our financial activities and/or the allegations in the SEC’s lawsuit against us and Mr. Scrushy, and (3) provided for expedited discovery in the lawsuit brought by the SEC. In an order entered May 7, 2003, the court stayed the SEC’s lawsuit pending the resolution of any criminal charges against Mr. Scrushy.

 

On June 6, 2005, the SEC approved a settlement (the “SEC Settlement”) with us relating to this lawsuit. Under the terms of the SEC Settlement, we have agreed, without admitting or denying the SEC’s allegations, to be enjoined from future violations of certain provisions of the securities laws. We have also agreed to pay a $100 million civil penalty and disgorgement of $100 to the SEC in installments over two years, beginning in the fourth quarter of 2005. We consented to the entry of a final judgment (which judgment was entered by the United States District Court for the Northern District of Alabama, Southern Division) to implement the terms of the SEC Settlement. See Item 1, Business, “SEC Settlement,” for additional information about the SEC Settlement. Mr. Scrushy remains a defendant in the lawsuit.

 

On November 4, 2003, Mr. Scrushy was charged in federal court on 85 counts of wrongdoing in connection with his actions while employed by us. A superseding indictment of 58 counts, released on September 29, 2004, added charges of obstruction of justice and perjury while consolidating and eliminating some of the 85 counts of conspiracy, mail fraud, wire fraud, securities fraud, false statements, false certifications, and money laundering that were previously charged. The superseding indictment also seeks the forfeiture of $278 million in property from Mr. Scrushy allegedly derived from his offenses. The trial of Mr. Scrushy on the charges set forth in the superseding indictment began on January 25, 2005 and is ongoing. Some of the charges have been dismissed by the court.

 

On April 10, 2003, the DOJ’s civil division notified us that it was expanding its investigation (which began with the lawsuit United States ex rel. Devage v. HealthSouth Corp., et al., C.A. No. SA-98-EA-0372-FV, filed in the United States District Court for the Western District of Texas, as discussed in Item 1) into allegations of fraud associated with Medicare cost reports submitted by us for fiscal years 1995 through 2002. We subsequently received subpoenas from the Office of Inspector General (the “OIG”) of the United States Department of Health and Human Services and requests from the DOJ’s civil division for documents and other information regarding this investigation. As described in Item 1, “Medicare Program Settlement,” on December 30, 2004, we announced that we had entered into a global settlement agreement with the DOJ’s civil division and other parties to resolve the primary claims made in the Devage litigation, although the DOJ’s civil division continues to review certain self-disclosures made by us to the OIG.

 

In the summer of 2003, we discovered certain irregular payments made to a foreign official under a consulting agreement entered into in connection with an October 2000 agreement between us and the Sultan Bin Abdul Aziz Foundation to manage an inpatient rehabilitation hospital in Riyadh, Saudi Arabia. We notified the DOJ immediately, and we have cooperated fully with the investigation. One former executive pled guilty to charges of wire fraud in connection with the irregular payments, and another former executive pled guilty to charges of making a false statement to government investigators in connection with the investigation. Two additional former executives have been acquitted of charges that they participated in the fraud. We terminated the

 

44


Table of Contents
Index to Financial Statements

October 2000 agreement and entered into a new agreement, effective January 1, 2004, to manage the Riyadh facility. Effective October 2004, we terminated our relationship with the Sultan Bin Abdul Aziz Foundation and the Riyadh facility entirely.

 

At least 17 of our former officers, including all five of our former chief financial officers, have agreed to plead guilty to federal criminal charges filed in connection with the investigations described above. These individuals pled guilty to a variety of charges, including securities fraud, accounting fraud, filing false tax returns, making a false statement to governmental authorities, falsifying books and accounts, wire fraud, conspiracy, and falsely certifying financial information with the SEC.

 

Securities Litigation

 

On June 24, 2003, the United States District Court for the Northern District of Alabama consolidated a number of separate securities lawsuits filed against us under the caption In re HealthSouth Corp. Securities Litigation, Master Consolidation File No. CV-03-BE-1500-S (the “Consolidated Securities Action”). The Consolidated Securities Action included two prior consolidated cases (In re HealthSouth Corp. Securities Litigation, CV-98-J-2634-S and In re HealthSouth Corp. 2002 Securities Litigation, Consolidated File No. CV-02-BE-2105-S) as well as six lawsuits filed in 2003. Including the cases previously consolidated, the Consolidated Securities Action comprised over 40 separate lawsuits. The court divided the Consolidated Securities Action into two subclasses:

 

    Complaints based on purchases of our common stock were grouped under the caption In re HealthSouth Corp. Stockholder Litigation, Consolidated Case No. CV-03-BE-1501-S (the “Stockholder Securities Action”), which was further divided into complaints based on purchases of our common stock in the open market (grouped under the caption In re HealthSouth Corp. Stockholder Litigation, Consolidated Case No. CV-03-BE-1501-S) and claims based on the receipt of our common stock in mergers (grouped under the caption HealthSouth Merger Cases, Consolidated Case No. CV-98-2777-S). Although the plaintiffs in the HealthSouth Merger Cases have separate counsel and have filed separate claims, the HealthSouth Merger Cases are otherwise consolidated with the Stockholder Securities Action for all purposes.

 

    Complaints based on purchases of our debt securities were grouped under the caption In re HealthSouth Corp. Bondholder Litigation, Consolidated Case No. CV-03-BE-1502-S (the “Bondholder Securities Action”).

 

On January 8, 2004, the plaintiffs in the Consolidated Securities Action filed a consolidated class action complaint. The complaint names us as a defendant, as well as more than 30 of our current and former employees, officers and directors, the underwriters of our debt securities, and our former auditor. The complaint alleges, among other things, (1) that we misrepresented or failed to disclose certain material facts concerning our business and financial condition and the impact of the Balanced Budget Act of 1997 on our operations in order to artificially inflate the price of our common stock, (2) that from January 14, 2002 through August 27, 2002, we misrepresented or failed to disclose certain material facts concerning our business and financial condition and the impact of the changes in Medicare reimbursement for outpatient therapy services on our operations in order to artificially inflate the price of our common stock, and that some of the individual defendants sold shares of such stock during the purported class period, and (3) that Richard M. Scrushy instructed certain former senior officers and accounting personnel to materially inflate our earnings to match Wall Street analysts’ expectations, and that senior officers of HealthSouth and other members of a self-described “family” held meetings to discuss the means by which our earnings could be inflated and that some of the individual defendants sold shares of our common stock during the purported class period. The consolidated class action complaint asserts claims under Sections 11, 12(a)(2) and 15 of the Securities Act, and claims under Sections 10(b), 14(a), 20(a) and 20A of the Exchange Act.

 

45


Table of Contents
Index to Financial Statements

We have moved to dismiss in part the claims against us. We continue discussions with the parties to this litigation and await a ruling on the identity of the lead plaintiff and lead counsel in the Stockholder Securities Action.

 

On March 17, 2004, an individual securities fraud action captioned Amalgamated Gadget, L.P. v. HealthSouth Corp., 4-04CV-198-A, was filed in the United States District Court for the Northern District of Texas. The complaint made allegations similar to those in the Consolidated Securities Action and asserted claims under the federal securities laws and Texas state law based on the plaintiff’s purchase of $24 million in face amount of 3.25% convertible debentures. The court denied our motion to transfer the action to the United States District Court for the Northern District of Alabama, and also denied our motion to dismiss. This action has been settled by the agreement of the parties and dismissed with prejudice.

 

On November 24, 2004, an individual securities fraud action captioned Burke v. HealthSouth Corp., et al., 04-B-2451 (OES), was filed in the United States District Court of Colorado against us, some of our former directors and officers, and our former auditors. The complaint makes allegations similar to those in the Consolidated Securities Action and asserts claims under the federal securities laws and Colorado state law based on plaintiff’s alleged receipt of unexercised options and his open-market purchases of our stock. By order dated May 3, 2005, the action was transferred to the United States District Court for the Northern District of Alabama, where it remains pending.

 

Derivative Litigation

 

Between 1998 and 2004, a number of lawsuits purporting to be derivative actions (i.e., lawsuits filed by shareholder plaintiffs on our behalf) were filed in several jurisdictions, including the Circuit Court for Jefferson County, Alabama, the Delaware Court of Chancery, and the United States District Court for the Northern District of Alabama. Most of these lawsuits have been consolidated as described below:

 

    All derivative complaints filed in the Circuit Court of Jefferson County, Alabama since 2002 have been consolidated and stayed in favor of the first-filed action captioned Tucker v. Scrushy, No. CV-02-5212, filed August 28, 2002. Although Tucker is ongoing, the Circuit Court has stayed discovery pending the criminal trial of Richard M. Scrushy. The Tucker complaint names as defendants a number of former HealthSouth officers and directors. Tucker also asserts claims on our behalf against Ernst & Young LLP, UBS Group, and UBS Investment Services, as well as against MedCenterDirect.com, Source Medical Solutions, Inc., Capstone Capital Corp., Healthcare Realty Trust, and G.G. Enterprises.

 

    Two derivative lawsuits filed in the United States District Court for the Northern District of Alabama were consolidated under the caption In re HealthSouth Corp. Derivative Litigation, CV-02-BE-2565. The court has stayed further action in In re HealthSouth Corp. Derivative Litigation in deference to the litigation pending in state courts in Alabama and Delaware.

 

    Two derivative lawsuits filed in the Delaware Court of Chancery were consolidated under the caption In re HealthSouth Corp. Shareholders Litigation, Consolidated Case No. 19896. Plaintiffs’ counsel in this litigation and in Tucker have agreed to litigate all claims asserted in those lawsuits in the Tucker litigation, except for claims relating to an agreement to retire a HealthSouth loan to Richard M. Scrushy with shares of our stock (the “Buyback Claim”). On November 24, 2003, the court granted the plaintiffs’ motion for summary judgment on the Buyback Claim and rescinded the retirement of Scrushy’s loan. The court’s judgment was affirmed on appeal. Although a final judgment has been awarded to us on the Buyback Claim, neither we nor the plaintiffs have been able to recover on the judgment because Mr. Scrushy’s assets have been frozen pending the resolution of criminal charges against him. The plaintiffs’ remaining claims are being litigated in Tucker.

 

When originally filed, the primary allegations in the Tucker case involved self-dealing by Richard M. Scrushy and other insiders through transactions with various entities allegedly controlled by Mr. Scrushy. The complaint was amended four times to add additional defendants and include claims of accounting fraud,

 

46


Table of Contents
Index to Financial Statements

improper Medicare billing practices, and additional self-dealing transactions. The Second Amended Complaint, filed on March 21, 2003, added Ernst & Young LLP as a defendant and alleged it was liable for negligently, wantonly, and/or recklessly failing to perform its professional obligations as an independent auditor. The Third Amended Complaint, filed on August 8, 2003, added UBS as a defendant and alleged that it was liable for breaching its fiduciary duties to us and for aiding and abetting the accounting fraud by “falsely promoting” our stock despite knowledge of inflated financial information. The other consolidated cases contain similar claims.

 

On September 8, 2003, a derivative lawsuit captioned Teachers Retirement Sys. of Louisiana v. Scrushy, C.A. No. 20529-NC, was filed in the Delaware Court of Chancery. The complaint contains allegations similar to those made in the Tucker case, class claims, as well as a request for relief seeking an order compelling us to hold an annual meeting of stockholders. On December 2, 2003, we announced a settlement of the plaintiff’s claims seeking an annual meeting of stockholders. The Court of Chancery has stayed the remaining claims in favor of earlier-filed litigation in Alabama. This case was not consolidated with In re HealthSouth Corp. Shareholders Litigation.

 

On November 19, 2004, a derivative lawsuit captioned Campbell v. HealthSouth Corp., Scrushy, et al., CV-04-6985, was filed in Circuit Court of Jefferson County, Alabama, alleging that we wrongfully refused to file with the Internal Revenue Service refund requests for overpayment of taxes and seeking an order allowing the plaintiff to file claims for refund of excess tax paid by us. This suit was filed just prior to the voluntary dismissal of a similar suit brought by the same plaintiff in the United States District Court for the Northern District of Alabama. We have informed the plaintiff that we intend to file any appropriate applications for tax refunds within the applicable time periods, consistent with the advice of our tax counsel. This lawsuit was not consolidated with the Tucker case because it involves different claims. It is still pending.

 

Litigation by and Against Former Independent Auditors

 

On March 18, 2005, Ernst & Young LLP filed a lawsuit captioned Ernst & Young LLP v. HealthSouth Corp., CV-05-1618, in the Circuit Court of Jefferson County, Alabama. The complaint asserts that the filing of the claims against us was for the purpose of suspending any statute of limitations applicable to those claims. The complaint alleges that we provided Ernst & Young LLP with fraudulent management representation letters, financial statements, invoices, bank reconciliations, and journal entries in an effort to conceal accounting fraud. Ernst & Young LLP claims that as a result of our actions, Ernst & Young LLP’s reputation has been injured and it has and will incur damages, expense, and legal fees. Ernst & Young LLP seeks recoupment and setoff of any recovery against Ernst & Young LLP in the Tucker case, as well as litigation fees and expenses, damages for loss of business and injury to reputation, and such other relief to which it may be entitled. On April 1, 2005, we answered Ernst & Young LLP’s claims and asserted counterclaims alleging, among other things, that from 1996 through 2002, when Ernst & Young LLP served as our independent auditors, Ernst & Young LLP acted recklessly and with gross negligence in performing its duties, and specifically that Ernst & Young LLP failed to perform reviews and audits of our financial statements with due professional care as required by law and by its contractual agreements with us. Our counterclaims further allege that Ernst & Young LLP either knew of or, in the exercise of due care, should have discovered and investigated the fraudulent and improper accounting practices being directed by Richard M. Scrushy and certain other officers and employees, and should have reported them to our board of directors and the Audit Committee. The counterclaims seek compensatory and punitive damages, disgorgement of fees received from us by Ernst & Young LLP, and attorneys’ fees and costs.

 

ERISA Litigation

 

In 2003, six lawsuits were filed in the United States District Court for the Northern District of Alabama against us and some of our current and former officers and directors alleging breaches of fiduciary duties in connection with the administration of our Employee Stock Benefit Plan (the “ESOP”). These lawsuits have been consolidated under the caption In re HealthSouth Corp. ERISA Litigation, Consolidated Case No. CV-03-BE-1700-S. The plaintiffs filed a consolidated complaint on December 19, 2003 that alleges, generally, the

 

47


Table of Contents
Index to Financial Statements

fiduciaries to the ESOP breached their duties to loyally and prudently manage and administer the ESOP and its assets in violation of sections 404 and 405 of the Employee Retirement Income Security Act of 1974, 29 U.S.C. § 1001 et seq. (“ERISA”), by failing to monitor the administration of the ESOP, failing to diversify the portfolio held by the ESOP, and failing to provide other fiduciaries with material information about the ESOP. The plaintiffs seek actual damages including losses suffered by the plan, imposition of a constructive trust, equitable and injunctive relief against further alleged violations of ERISA, costs pursuant to 29 U.S.C. § 1132(g), and attorneys’ fees. The plaintiffs also seek damages related to losses under the plan as a result of alleged imprudent investment of plan assets, restoration of any profits made by the defendants through use of plan assets, and restoration of profits that the plan would have made if the defendants had fulfilled their fiduciary obligations. The parties to this litigation are actively involved in settlement negotiations.

 

Insurance Coverage Litigation

 

In 2003, approximately 14 insurance companies filed complaints in state and federal courts in Alabama, Delaware, and Georgia alleging that the insurance policies issued by those companies to us and/or some of our directors and officers should be rescinded on grounds of fraudulent inducement. The complaints also seek a declaration that we and/or some of our current and former directors and officers are not covered under various insurance policies. These lawsuits challenge the majority of our director and officer liability policies, including our primary director and officer liability policy in effect for the claims at issue. Actions filed by insurance companies in the United States District Court for the Northern District of Alabama were consolidated for pretrial and discovery purposes under the caption In re HealthSouth Corp. Insurance Litigation, Consolidated Case No. CV-03-BE-1139-S. Three lawsuits filed by insurance companies in the Circuit Court of Jefferson County, Alabama have been consolidated with the Tucker case for discovery and other pretrial purposes. Cases related to insurance coverage that were filed in Georgia and Delaware have been dismissed. We have filed counterclaims against a number of the plaintiffs in these cases alleging, among other things, bad faith for wrongful failure to provide coverage.

 

Litigation by Former Officers

 

Richard M. Scrushy filed two lawsuits against us in the Delaware Court of Chancery. One lawsuit, captioned Scrushy v. HealthSouth Corp., C.A. No. 20357-NC, filed on June 10, 2003, sought indemnification and advancement of Mr. Scrushy’s legal fees. The other lawsuit, captioned Scrushy v. Gordon, et al., C.A. No. 20375, filed June 16, 2003, named us and our then-current directors as defendants and petitioned the court to enjoin the defendants from excluding Mr. Scrushy from board meetings and from conducting the business of HealthSouth exclusively through the meetings of the Special Committee. The second lawsuit also sought access to certain information, including meetings of the Special Committee. Both lawsuits were voluntarily dismissed without prejudice.

 

On August 22, 2003, Anthony Tanner, our former Secretary and Executive Vice President—Administration and Secretary, filed a petition in the Circuit Court of Jefferson County, Alabama, captioned In re Tanner, CV-03-5378, seeking permission to obtain certain information through the discovery process prior to filing a lawsuit. That petition was voluntarily dismissed with prejudice on August 11, 2004. On December 29, 2004, Mr. Tanner filed a lawsuit in the Circuit Court of Jefferson County, Alabama, captioned Tanner v. HealthSouth Corp., CV-04-7715, alleging that we breached his employment contract by failing to pay certain retirement benefits. The complaint requests damages, a declaratory judgment, and a preliminary injunction to require payment of past due amounts under the contract and reinstatement of the claimed retirement benefits.

 

On December 23, 2003, Jason Hervey, one of our former officers, filed a lawsuit captioned Hervey v. HealthSouth Corp., et al., CV-03-8031, in the Circuit Court of Jefferson County, Alabama. The complaint sought compensatory and punitive damages in connection with our alleged breach of his employment contract. We settled this lawsuit in 2005.

 

48


Table of Contents
Index to Financial Statements

Litigation Against Former Officers

 

On June 10, 2004, we filed a collection action in the Circuit Court of Jefferson County, Alabama, captioned HealthSouth Corp. v. James Goodreau, CV-04-3619, to collect unpaid loans in the original principal amount of $55,500 that we made to James A. Goodreau, our former Director of Corporate Security, while he was a HealthSouth employee. Mr. Goodreau has asserted counterclaims against us seeking monetary damages in an unspecified amount and equitable relief based upon his contention that he was promised lifetime employment with us by Mr. Scrushy. This case is still pending.

 

On August 30, 2004, we filed a collection action in the United States District Court for the Northern District of Alabama, captioned HealthSouth Corp. v. Daniel J. Riviere, CV-04-CO-2592-S, to collect unpaid loans in the original principal amount of $3,163,421 that we made to Daniel J. Riviere, our former President – Ambulatory Services Division, while he was a HealthSouth employee. Mr. Riviere filed a six-count counterclaim against us on April 5, 2005 seeking (1) severance benefits exceeding $2 million under a written employment agreement dated March 18, 2003, (2) a declaratory judgment that the non-compete clause in his employment agreement is void, (3) damages in an unspecified amount based on stock allegedly purchased and held by him in reliance on misrepresentations made by Richard M. Scrushy, (4) $500,000 in lost profits based allegedly on us forcing him to sell shares of our common stock after he was terminated, (5) damages in an unspecified amount based on our alleged conversion of the cash value of certain insurance policies after his termination, and (6) set-off of any award from his counterclaim against unpaid loans we made to him. On April 5, 2005, Mr. Riviere commenced a Chapter 7 bankruptcy case in the U.S. Bankruptcy Court for the Northern District of Florida, Case No. 05-30718-LMK, and this lawsuit is stayed pending resolution of the bankruptcy proceedings.

 

Litigation by Former Medical Director

 

On April 5, 2001, Helen M. Schilling, one of our former medical directors, filed a lawsuit captioned Helen M. Schilling, M.D. v. North Houston Rehabilitation Associates d/b/a HealthSouth Houston Rehabilitation Institute, Romano Rehabilitation Hospital, Inc. and Anne Leon, Cause No. 01-04-02243-CV, in the 410th Judicial District Court of Montgomery County, Texas. The plaintiff claimed, among other things, that we wrongfully terminated her medical director agreement. On November 5, 2003, after a jury trial, the court entered a final judgment awarding the plaintiff $465,000 in compensatory damages and $865,000 in exemplary damages. We appealed the judgment and settled the case while on appeal in 2005.

 

Certain Regulatory Actions

 

The False Claims Act, 18 U.S.C. § 287, allows private citizens, called “relators,” to institute civil proceedings alleging violations of the False Claims Act. These so-called qui tam, or “whistleblower,” cases are sealed by the court at the time of filing. The only parties privy to the information contained in the complaint are the relator, the federal government, and the presiding court. We recently settled one qui tam lawsuit, Devage, which is discussed in Item 1. We are aware of two other qui tam lawsuits, Mathews and Colbert, which are discussed below. It is possible that additional qui tam lawsuits have been filed against us and that we are unaware of such filings or have been ordered by the presiding court not to discuss or disclose the filing of such lawsuits. Thus, we may be subject to liability exposure under one or more undisclosed qui tam cases brought pursuant to the False Claims Act.

 

On April 1, 1999, a plaintiff relator filed a lawsuit captioned United States ex rel. Mathews v. Alexandria Rehabilitation Hospital, CV-99-0604, in the United States District Court for the Western District of Louisiana. On February 29, 2000, the United States elected not to intervene in the lawsuit. The complaint alleged, among other things, that we filed fraudulent reimbursement claims under the Medicare program on a nationwide basis. The district court dismissed the False Claims Act allegations of two successive amended complaints. However, the district court’s dismissal of the third amended complaint with prejudice was partially reversed by the United States Court of Appeals for the Fifth Circuit on October 22, 2002. The case was remanded to the district court,

 

49


Table of Contents
Index to Financial Statements

and our subsequent motion to dismiss was denied on February 21, 2004. The case will proceed into discovery on False Claims Act allegations concerning one HealthSouth facility during a specific timeframe.

 

On January 30, 2001, a plaintiff relator filed a lawsuit captioned United States ex rel. Colbert v. Blue Cross and Blue Shield of Alabama and HealthSouth Corp., CV-01-C-0292-S, in the United States District Court for the Northern District of Alabama. The lawsuit, in which the United States did not intervene, alleged, among other things, that we conspired with Blue Cross and Blue Shield of Alabama (“Blue Cross”) to hinder Blue Cross’ investigative functions in administering the Medicare program by having Blue Cross terminate, on a pretextual basis, the relator’s employment with Blue Cross. The complaint also claimed that we conspired with Blue Cross to (1) violate the whistleblower retaliation provision of the False Claims Act by having Blue Cross terminate the relator’s employment and (2) have certain unidentified false claims allowed or paid by Blue Cross under the Medicare program. The parties filed a joint stipulation of dismissal with prejudice and the case has been dismissed.

 

Americans with Disabilities Act Litigation

 

On April 19, 2001 a nationwide class action now captioned Michael Yelapi, et al. v. St. Petersburg Surgery Center, et al., Case No:8:01-CV-787-T-17EAJ, was filed in the United States District Court for the Middle District of Florida alleging violations of the Americans with Disabilities Act, 42 U.S.C. § 12181, et seq. (the “ADA”) and the Rehabilitation Act of 1973, 92 U.S.C. § 792 et seq. (the “Rehabilitation Act”) at our facilities. The complaint alleges violations of the ADA and Rehabilitation Act for the purported failure to remove barriers and provide accessibility to our facilities, including reception and admitting areas, signage, restrooms, phones, paths of access, elevators, treatment and changing rooms, parking, and door hardware. As a result of these alleged violations, the plaintiffs are seeking an injunction ordering that we make necessary modifications to achieve compliance with the ADA and the Rehabilitation Act, as well as attorneys’ fees. We have entered into a settlement agreement with the plaintiffs that would require us to correct any deficiencies under the ADA and the Rehabilitation Act at all of our facilities. We are awaiting an order approving the settlement agreement from the court.

 

General Medicine, P.C. and Meadowbrook Actions

 

Pursuant to a Plan and Agreement of Merger dated February 17, 1997, Horizon/CMS Healthcare Corporation (“Horizon/CMS”) became a wholly-owned subsidiary of HealthSouth Corporation. At the time of the merger, there was pending against Horizon/CMS in the United States District Court for the Eastern District of Michigan a lawsuit captioned General Medicine, P.C. v. Horizon/CMS Healthcare Corporation, CV-96-72624. The complaint alleged that Horizon/CMS wrongfully terminated a contract with General Medicine, P.C. (“General Medicine”) for the provision of medical directorship services to long-term care facilities owned and/or operated by Horizon/CMS. Effective December 31, 2001, while this litigation was pending, we sold all of our stock in Horizon/CMS to Meadowbrook Healthcare Corporation (“Meadowbrook”) pursuant to a Stock Purchase Agreement dated November 2, 2001. On May 3, 2004, Horizon/CMS consented to the entry of a $376 million final judgment in favor of General Medicine (the “Consent Judgment”). At the time of the Consent Judgment, we had no ownership or other interest in Horizon/CMS.

 

On August 16, 2004, General Medicine filed a lawsuit captioned General Medicine, P.C. v. HealthSouth Corp., CV-04-958, in the Circuit Court of Shelby County, Alabama, seeking to recover the amount of the Consent Judgment from us. The complaint alleges that while Horizon/CMS was a wholly-owned subsidiary of HealthSouth Corporation and General Medicine was an existing creditor of Horizon/CMS, we caused Horizon/CMS to transfer assets to us thereby rendering Horizon/CMS insolvent and unable to pay its creditors. The complaint asserts that these transfers were made for less than a reasonably equivalent value and/or with the actual intent to defraud creditors of Horizon/CMS, including General Medicine, in violation of the Alabama Uniform Fraudulent Transfer Act. General Medicine’s complaint requests relief including the avoidance of the subject

 

50


Table of Contents
Index to Financial Statements

transfers of assets, attachment of the assets transferred to us, appointment of a receiver over the transferred properties, and a monetary judgment for the value of properties transferred.

 

On February 28, 2005, the Circuit Court of Shelby County, Alabama entered an order transferring the General Medicine case to the Circuit Court of Jefferson County, Alabama, where it was assigned case number CV-05-1483. On April 28, 2005, we filed an “Answer and Third-Party Complaint” denying liability and joining Meadowbrook as a third-party defendant in the lawsuit. In our Third-Party Complaint, we seek a judgment declaring that Meadowbrook is contractually obligated under the Stock Purchase Agreement dated November 2, 2001, to indemnify us and hold us harmless against the claims asserted by General Medicine in its complaint. Meadowbrook has filed a declaratory judgment action against us in the Circuit Court of Shelby County, Alabama, captioned Meadowbrook Healthcare Corporation v. HealthSouth Corp., CV-04-1131, seeking a declaration that it is not contractually obligated to indemnify us against General Medicine’s complaint. On May 9, 2005, the Circuit Court of Shelby County, Alabama entered an order transferring the Meadowbrook case to the Circuit Court of Jefferson County, Alabama, where it was assigned case number CV-05-3042. We have filed a Motion to Consolidate the General Medicine and Meadowbrook cases.

 

For additional information about Meadowbrook, see Note 7, Property and Equipment, to the accompanying consolidated financial statements.

 

Massachusetts Real Estate Actions

 

On February 3, 2003, HRPT Properties Trust (“HRPT”) filed a lawsuit against Senior Residential Care/North Andover, Limited Partnership (“SRC”) in the Land Court for the Commonwealth of Massachusetts captioned HRPT Properties Trust v. Senior Residential Care/North Andover, Limited Partnership, Misc. Case No. 287313, in which it claimed an ownership interest in certain parcels of real estate in North Andover, Massachusetts and alleged that SRC unlawfully occupied and made use of those properties. On March 17, 2003, we (and our subsidiary, Greenery Securities Corp.) moved to intervene in this case claiming ownership of the disputed property pursuant to an agreement that involved the conveyance of five nursing homes. We seek to effect a transfer of title to the disputed property by HRPT to us or our nominee.

 

On April 16, 2003, Senior Housing Properties Trust (“SNH”) and its wholly owned subsidiary, HRES1 Properties Trust (“HRES1”), filed a lawsuit against us in Land Court for the Commonwealth of Massachusetts captioned Senior Housing Properties Trust and HRES1 Properties Trust v. HealthSouth Corporation, Misc. Case No 289182, seeking reformation of a lease pursuant to which we, through subsidiaries, operate the Braintree Rehabilitation Hospital in Braintree, Massachusetts and the New England Rehabilitation Hospital in Woburn, Massachusetts. HRES1 and SNH allege that certain of our representatives made false statements regarding our financial condition, thereby inducing HRES1 to enter into lease terms and other arrangements to which it would not have otherwise agreed. HRES1 and SNH have since amended their complaint to add claims for rescission and damages for fraud. HRES1 and SNH seek to reform the lease to increase the annual rent from $8.7 million to $10.3 million, to increase the repurchase option price at the end of the lease term to $80.3 million from $40 million, and to change the lease term to expire on January 1, 2006 instead of December 31, 2011. We filed an answer to the complaint and amended complaint denying the allegations, and we asserted claims against HRPT and counterclaims against SNH and HRES1 for breach of contract, reformation, and fraud based on the failure to convey title to the property in North Andover. We also seek damages incurred as a result of that failure to convey.

 

The two actions in the Land Court have been consolidated for all purposes, and the parties are still in the discovery phase of the proceedings. A trial will be scheduled after December 1, 2005.

 

In a related action, on November 2, 2004, we filed a lawsuit in the Commonwealth of Massachusetts, Middlesex County Superior Court, captioned HealthSouth Corporation v. HRES1 Properties Trust, Case No 04-4345, in response to our receipt of a notice from HRES1 Properties Trust (“HRES1”) purporting to

 

51


Table of Contents
Index to Financial Statements

terminate our lease governing the Braintree Rehabilitation Hospital in Braintree, Massachusetts and the New England Rehabilitation Hospital in Woburn, Massachusetts due to our alleged failure to furnish quarterly and annual financial information pursuant to the terms of the lease. In the lawsuit, we seek a declaration that we are not in default of our obligations under the lease, as well as an injunction preventing HRES1 from terminating the lease, taking possession of the property on which the hospitals and facilities are located, and assuming or acquiring the hospital businesses and any licenses related thereto. We filed an amended complaint asserting violations of the Massachusetts unfair and deceptive business practices statute. On November 8, 2004, HRES1 and SNH, its parent, filed a counterclaim seeking a declaration that it lawfully terminated the lease and an order requiring us to use our best efforts to transfer the licenses for the hospitals and to continue to manage the hospitals during the time necessary to effect such transfer. The case is currently pending.

 

Other Litigation

 

On September 17, 1998, John Darling, who was one of the federal False Claims Act relators in the now-settled Devage case (see discussion in Item 1), filed a lawsuit captioned Darling v. HealthSouth Sports Medicine & Rehabilitation, et al., 98-6110-CI-20, in the Circuit Court for Pinellas County, Florida. The complaint alleges that Mr. Darling was injured while receiving physical therapy during a 1996 visit to a HealthSouth outpatient rehabilitation facility in Clearwater, Florida. The complaint was amended in December 2004 to add a punitive damage claim. This amended complaint alleges that fraudulent misrepresentations and omissions by us resulted in the injury to Mr. Darling. We recently participated in an unsuccessful court-ordered mediation. The case is scheduled for trial in July 2005.

 

We have been named as a defendant in two lawsuits brought by individuals in the Circuit Court of Jefferson County, Alabama, Nichols v. HealthSouth Corp., CV-03-2023, filed March 28, 2003, and Hilsman v. Ernst & Young, HealthSouth Corp., et al., CV-03-7790, filed December 12, 2003. The plaintiffs allege that we, some of our former officers, and our former auditor engaged in a scheme to overstate and misrepresent our earnings and financial condition. The plaintiffs seek compensatory and punitive damages. On March 24, 2003, a lawsuit captioned Warren v. HealthSouth Corp., et al., CV-03-5967, was filed in the Circuit Court of Montgomery County, Alabama. The lawsuit, which claims damages for the defendants’ alleged negligence, wantonness, fraud and breach of fiduciary duty, was transferred to the Circuit Court of Jefferson County, Alabama. Each of the lawsuits described in this paragraph has been consolidated with the Tucker case for discovery and other pretrial purposes.

 

On June 30, 2004, two physical therapy providers in New Jersey filed a class action lawsuit captioned William Weiss Physical Therapy, et al., v. HealthSouth Corporation, et al., Docket No. BER-L-10218-04 (N.J. Super.) in the Superior Court of New Jersey. The nine count complaint alleges certain unfair trade practices in offering physical therapy services in violation of the New Jersey Physical Therapy Licensing Act of 1983. This case has been dismissed with prejudice.

 

On May 13, 2003, Plano Hospital Investors, Inc. (“Plano”) filed a complaint captioned Plano Hospital Investors, Inc., et al., v. HealthSouth Corp., et al., Cause No. 219-1416-03, in the 219th Judicial District Court of Collin County, Texas. Plano is a limited partner in Collin County Rehab Associates Limited Partnership, a partnership in which we, through wholly owned subsidiaries, are the general partner and hold limited partner interests. Plano alleges that we conducted unauthorized and improper sweeps of partnership funds into a HealthSouth centralized cash management account instead of a partnership account, that we improperly received late partnership distributions, and that the predecessor general partner took a negative capital contribution improperly increasing its interest, and upon the sale of that interest to us, our interest, in the partnership. The plaintiff seeks injunctive relief and unspecified damages. The parties to this lawsuit are currently engaged in settlement negotiations.

 

On December 28, 2004, we commenced a collection action in the Circuit Court of Jefferson County, Alabama, captioned HealthSouth Medical Center, Inc. v. Neurological Surgery Associates, P.C., CV-04-7700, to

 

52


Table of Contents
Index to Financial Statements

collect unpaid loans in the original principal amount of $275,000 made to Neurological Surgery Associates, P.C. (“NSA”), pursuant to a written Practice Guaranty Agreement. The purpose of the loans was to enable NSA to employ a physician who would bring necessary specialty skills to patients served by both NSA and our acute-care hospital in Birmingham, Alabama. NSA has asserted counterclaims that we breached verbal promises to lease space and employees from NSA, to pay NSA for billing and coding services performed by NSA on behalf of the subject physician-employee, and to pay NSA to manage the subject physician-employee.

 

On April 15, 2004, Klemett L. Belt, Jr. filed a complaint captioned Belt v. HealthSouth Corp., CV-2004-02517, in the Second Judicial District Court of Bernalillo County, New Mexico. Mr. Belt, a former executive officer and director of Horizon/CMS Healthcare Corporation, entered into a Non-Competition and Retirement Agreement with Horizon/CMS that we subsequently assumed in our acquisition of Horizon/CMS pursuant. Mr. Belt alleged in his complaint that he was entitled to retirement benefits, life insurance and, in the event of certain events of default, liquidated damages pursuant to a contractual provision requiring that the life insurance policies be fully paid and permitting Mr. Belt to receive a lump sum cash payment in lieu of certain unpaid retirement benefits. Mr. Belt alleges that we defaulted under the terms of the agreement due to our nonpayment of insurance policy premium payments beginning on December 31, 2003. As a result of our alleged default under the agreement, Mr. Belt sought liquidated damages in lieu of retirement benefits, payment of insurance policy premiums, amounts sufficient to compensate Mr. Belt for excess income taxes, interest, expenses, attorneys’ fees, and such other relief as may be determined by the court. We entered into a settlement agreement with Mr. Belt pursuant to which we must pay certain damages and relinquish our right to receive returned insurance premiums, if any, under a split dollar arrangement.

 

Item 4. Submission of Matters to a Vote of Security Holders

 

On March 16, 2004, we commenced a solicitation of consents seeking approval of proposed amendments to, and waivers under, the indentures governing our 6.875% Senior Notes due 2005, 7.375% Senior Notes due 2006, 7.000% Senior Notes due 2008, 8.500% Senior Notes due 2008, 8.375% Senior Notes due 2011, 7.625% Senior Notes due 2012, and 10.750% Senior Subordinated Notes due 2008 on issues relating to our inability to provide current financial statements and our ability to incur indebtedness under certain circumstances. On May 7, 2004, we announced that we were amending the solicitation of consents from holders of our 10.750% Senior Subordinated Notes due 2008 to further conform the definition of “Refinancing Indebtedness” in the indenture governing our 10.750% Senior Subordinated Notes to the definition in the indentures governing our senior notes. On June 24, 2004, we announced that we had closed all of our consent solicitations for our outstanding public debt. The vote totals for the consents are set forth on the following table:

 

Notes


   Principal Amount
Outstanding ($)


   Principal Amount
Voted For ($)


   Principal Amount
Voted Against ($)


   Principal Amount
Abstained ($)


6.875% Senior Notes due 2005

   245,000,000    243,212,000    0    1,788,000

7.375% Senior Notes due 2006

   180,300,000    179,442,000    0    858,000

7.000% Senior Notes due 2008

   250,000,000    247,320,000    0    2,680,000

8.500% Senior Notes due 2008

   343,000,000    312,051,000    11,580,000    19,369,000

8.375% Senior Notes due 2011

   347,700,000    347,659,976    0    40,024

7.625% Senior Notes due 2012

   908,700,000    908,146,000    250,000    304,000

10.750% Senior Sub. Notes due 2008

   319,260,000    284,807,000    50,000    34,403,000

 

In connection with the consummation of the consent solicitations, we executed the following supplemental indentures as of May 14, 2004:

 

    Second Supplemental Indenture to the Indenture, dated as of February 1, 2001, between us and The Bank of New York, as trustee, governing our 8.500% Senior Notes due 2008

 

53


Table of Contents
Index to Financial Statements
    Second Supplemental Indenture to the Indenture, dated as of September 25, 2000, between us and HSBC Bank USA, as successor trustee to The Bank of New York, governing our 10.750% Senior Subordinated Notes due 2008

 

We also executed the following supplemental indentures as of June 24, 2004:

 

    First Supplemental Indenture to the Indenture, dated as of June 22, 1998, between us and Wilmington Trust Company, as successor trustee to PNC Bank, National Association, governing our 6.875% Senior Notes due 2005

 

    Second Supplemental Indenture to the Indenture, dated as of September 28, 2001, between us and Wilmington Trust Company, as successor trustee to National City Bank, governing our 7.375% Senior Notes due 2006

 

    First Supplemental Indenture to the Indenture, dated as of June 22, 1998, between us and Wilmington Trust Company, as successor trustee to PNC Bank, National Association, governing our 7.000% Senior Notes due 2008

 

    Second Supplemental Indenture to the Indenture, dated as of September 28, 2001, between us and Wilmington Trust Company, as successor trustee to National City Bank, governing our 8.375% Senior Notes due 2011

 

    First Supplemental Indenture to the Indenture, dated as of May 22, 2002, between us and The Bank of Nova Scotia Trust Company of New York, as trustee, governing our 7.625% Senior Notes due 2012

 

PART II

 

Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

 

Market Information

 

On March 19, 2003, after the Securities and Exchange Commission issued an Order of Suspension of Trading, the New York Stock Exchange suspended trading in our common stock, which was then listed under the symbol HRC. That same day, Standard & Poor’s announced that it removed our common stock from the S&P 500 Index. The NYSE continued the trading halt and eventually delisted our common stock. On March 25, 2003, immediately following the delisting from the NYSE, our stock began trading in the over-the-counter “Pink Sheets” market under the symbol HLSH.

 

54


Table of Contents
Index to Financial Statements

The following table sets forth the high and low bid quotations per share of HealthSouth common stock as reported on the over-the-counter market from March 25, 2003 through December 31, 2004 and the high and low reported sale prices for HealthSouth common stock as reported on the NYSE Composite Transactions Tape for prior periods. The stock price information is based on published financial sources. Over-the-counter market quotations reflect inter-dealer prices, without retail mark-up, mark-down or commissions, and may not necessarily represent actual transactions.

 

     Market

   High

   Low

2000

                  

First Quarter

   NYSE    $ 7.31    $ 4.75

Second Quarter

   NYSE      8.56      5.38

Third Quarter

   NYSE      8.13      5.19

Fourth Quarter

   NYSE      17.50      8.13

2001

                  

First Quarter

   NYSE    $ 16.50    $ 12.12

Second Quarter

   NYSE      16.26      11.25

Third Quarter

   NYSE      18.49      14.06

Fourth Quarter

   NYSE      16.84      11.88

2002

                  

First Quarter

   NYSE    $ 15.02    $ 10.84

Second Quarter

   NYSE      15.90      11.87

Third Quarter

   NYSE      13.00      2.79

Fourth Quarter

   NYSE      5.12      3.31

2003

                  

First Quarter (Jan. 1—Mar. 24)

   NYSE    $ 4.90    $ 3.10

First Quarter (Mar. 25—Mar. 31)

   OTC      0.11      0.08

Second Quarter

   OTC      0.84      0.10

Third Quarter

   OTC      3.43      0.67

Fourth Quarter

   OTC      4.80      2.73

2004

                  

First Quarter

   OTC    $ 6.18    $ 3.76

Second Quarter

   OTC      6.06      4.10

Third Quarter

   OTC      6.41      5.01

Fourth Quarter

   OTC      6.46      4.88

 

Holders

 

As of May 31, 2005, there were 397,063,445 shares of HealthSouth common stock issued and outstanding, net of treasury shares, held by approximately 8,597 holders of record.

 

Dividends

 

We have never paid cash dividends on our common stock, and we do not anticipate paying cash dividends in the foreseeable future. In addition, the terms of our principal bank credit agreement and the indentures covering some of our publicly traded debt securities restrict our ability to pay cash dividends on our common stock if we do not meet specified financial requirements. We currently anticipate that any future earnings will be retained to finance our operations and reduce debt.

 

Recent Sales of Unregistered Securities

 

Between December 5, 2003 and January 20, 2004 we sold 230,750 unregistered shares of common stock to various employees pursuant to the exercise of outstanding stock options. The aggregate consideration for these sales was $869,460. In 2004 we issued 468,057 shares of restricted stock to various directors and executive

 

55


Table of Contents
Index to Financial Statements

officers in reliance on Section 4(2) of the Securities Act of 1933, as amended. There was no monetary consideration for these issuances.

 

Securities Authorized for Issuance Under Equity Compensation Plans

 

The information required by Item 201(d) of Regulation S-K is provided under Item 12, Security Ownership of Certain Beneficial Owners and Management, “Securities Authorized for Issuance Under Equity Compensation Plans,” which is incorporated herein by reference.

 

Purchases of Equity Securities

 

The following table provides information regarding the repurchase of our common stock made during the period covered by this report. None of the repurchases identified below were made as part of a publicly announced plan or program, and there are no current repurchase plans or programs in place.

 

Period


   Total Number
of Shares
Purchased


   Average Price
Paid Per Share


March 1, 2002 through March 31, 2002(1)

   150,700    $ 12.97

May 1, 2002 through May 31, 2002(1)

   3,500    $ 14.24

July 1, 2002 through July 31, 2002(1)

   135,000    $ 8.01

August 1, 2002 through August 31, 2002(2)

   2,506,770    $ 4.58

September 1, 2002 through September 30, 2002(1)

   1,142,000    $ 4.28

(1) These shares were purchased in open market transactions on an ad hoc basis.
(2) These shares were acquired from Richard M. Scrushy in order to satisfy the pledge of stock under a loan made to Mr. Scrushy under our 1999 Executive Equity Loan Plan. For additional information about this loan, see Note 12, Shareholders’ Equity, to our accompanying consolidated financial statements. See also Item 3, Legal Proceedings, “Derivative Litigation,” for a description of litigation related to this loan.

 

Item 6. Selected Financial Data

 

We derived the selected historical consolidated financial data presented below from our audited consolidated financial statements and related notes included elsewhere in this annual report. You should refer to Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations, and the notes to our accompanying consolidated financial statements for additional information regarding the financial data presented below, including matters that might cause this data not to be indicative of our future financial condition or results of operations. In addition, you should note the following information regarding the selected historical consolidated financial data presented below.

 

    We have restated our previously reported consolidated financial statements for the fiscal years ended December 31, 2001 and 2000. The restatement adjustments resulted in a cumulative net reduction to shareholders’ equity of $3.9 billion and $3.5 billion as of December 31, 2001 and 2000, respectively, and a reduction in previously reported net income of $393.6 million and $642.7 million for the years ended December 31, 2001 and 2000, respectively. Adjustments to our January 1, 2000 previously reported retained earnings balance approximated $3.0 billion.

 

   

We have not restated our previously reported consolidated financial statements for the fiscal year ended December 31, 1999, and we have not presented any financial data from that period below. In light of the substantial time, effort, and expense incurred since March 2003 to complete the restatement of our consolidated financial statements for 2001 and 2000, we have determined that extensive additional efforts would be required to restate our 1999 financial data, and incurring the costs associated with restating 1999 would not provide any additional benefit to our shareholders. In particular, after December 31, 1999, we have experienced significant turnover in relevant personnel, greatly decreasing

 

56


Table of Contents
Index to Financial Statements
 

our ability to reconstruct detailed financial data for 1999 and prior periods. Previously published financial information for 1999 and earlier periods should not be relied upon.

 

    Included in our net loss for 2003, 2002, 2001 and 2000 are property and equipment and goodwill and other intangible asset impairment charges of $468.3 million, $117.6 million, $0.4 million, and $10.4 million, respectively. These charges were recorded as a result of experiencing continued significant decreases in projected revenue and operating profit at numerous facilities and significant changes in the business climate over this four-year period. We performed impairment analyses and calculated the fair value of our long-lived assets with the assistance of a third party valuation specialist using a combination of discounted cash flows and market valuation models based on competitors’ multiples of revenue, gross profit, and other financial ratios. These impairment charges are shown separately as a component of operating loss within the consolidated statements of operations, excluding $4.1 million and $1.4 million of impairment charges in 2002 and 2001, respectively, related to certain closed facilities which are included in discontinued operations.

 

    In 2003, our net loss includes the cost related to our settlement with the SEC and certain additional settlements, as well as legal fees related to this litigation and certain other actions brought against us. Also, as a result of the Medicare Program Settlement, our 2002 net loss includes a $347.7 million charge as Government and class action settlements expense. For additional information, see Note 21, Medicare Program Settlement, Note 22, SEC Settlement, and Note 23, Contingencies and Other Commitments, to our accompanying consolidated financial statements.

 

    As noted throughout this annual report, significant changes have occurred at HealthSouth since the events of March 19, 2003. The steps taken to stabilize our business and operations, provide vital management assistance, and coordinate our legal strategy came at significant financial cost. During 2003, our net loss includes professional fees associated with the reconstruction and restatement of our previously issued consolidated financial statements of approximately $70.6 million.

 

    We recorded the cumulative effect of an accounting change in both 2003 and 2002. Effective January, 1, 2003, we adopted the provisions of FASB Statement No. 143, Accounting for Asset Retirement Obligations, and recorded a related charge of approximately $2.5 million. On January 1, 2002, we recorded a charge of approximately $48.2 million as a result of the adoption of FASB Statement No. 142, Goodwill and Other Intangible Assets, related to an impairment of goodwill of our diagnostic segment.

 

57


Table of Contents
Index to Financial Statements
     Year ended December 31,

 
     2003

    2002

    2001

    2000

 
                 (Restated)     (Restated)  
     ($ in thousands)  

Income Statement Data:

                                

Net operating revenues

   $ 3,957,604     $ 3,960,142     $ 3,553,057     $ 3,498,836  

Salaries and benefits

     1,716,995       1,745,322       1,618,546       1,627,583  

Professional and medical director fees

     87,375       103,980       85,384       89,423  

Supplies

     399,560       361,825       333,835       342,855  

Other operating expenses

     863,444       916,617       862,620       842,916  

Provision for doubtful accounts

     133,836       137,060       100,620       189,811  

Depreciation and amortization

     200,195       237,775       353,657       359,003  

(Gain) loss on disposal of assets

     (13,225 )     87,043       35,193       104,798  

Impairment of goodwill

     335,623       —         —         —    

Impairment of intangible assets

     —         22,163       —         —    

Impairment of long-lived assets

     132,722       95,480       438       10,387  

Government and class action settlements expense

     170,949       347,716       —         8,248  

Professional fees—reconstruction and restatement

     70,558       —         —         —    

(Gain) loss on early extinguishment of debt

     (2,259 )     (9,644 )     5,136       1,615  

Interest expense and amortization of debt discount

     268,443       255,035       311,386       290,838  

Interest income

     (7,323 )     (6,881 )     (7,497 )     (8,717 )

Loss (gain) on sale of investments

     15,811       (12,491 )     651       34,572  

Equity in net income of nonconsolidated affiliates

     (15,769 )     (15,320 )     (16,909 )     (27,351 )

Minority interests in earnings of consolidated affiliates

     99,456       90,359       60,679       71,062  
    


 


 


 


       4,456,391       4,356,039       3,743,739       3,937,043  
    


 


 


 


Loss from continuing operations

     (498,787 )     (395,897 )     (190,682 )     (438,207 )

Provision for income tax (benefit) expense

     (42,419 )     21,221       (28,244 )     (76,584 )
    


 


 


 


Discontinued operations, net of income tax expense

     24,267       (1,517 )     (28,787 )     (2,620 )
    


 


 


 


Cumulative effect of accounting change, net of income tax expense

     (2,456 )     (48,189 )     —         —    
    


 


 


 


Net loss

   $ (434,557 )   $ (466,824 )   $ (191,225 )   $ (364,243 )
    


 


 


 


Weighted average common shares outstanding:

                                

Basic

     396,132       395,520       390,485       386,626  
    


 


 


 


Diluted*

     405,831       408,321       415,163       407,061  
    


 


 


 


Basic and diluted loss per share:

                                

Loss from continuing operations, net of tax

   $ (1.15 )   $ (1.06 )   $ (0.42 )   $ (0.93 )

Discontinued operations, net of tax

     0.06       Nil       (0.07 )     (0.01 )

Cumulative effect of accounting change, net of tax

     (0.01 )     (0.12 )     —         —    
    


 


 


 


Net loss per common share

   $ (1.10 )   $ (1.18 )   $ (0.49 )   $ (0.94 )
    


 


 


 


 

* Per share diluted amounts are treated the same as basic per share amounts, because the effect is antidilutive.

 

58


Table of Contents
Index to Financial Statements
     December 31,

 
     2003

    2002

    2001

    2000

 
                 (Restated)     (Restated)  
     (in thousands)  

Balance Sheet Data:

                                

Cash and marketable securities

   $ 472,781     $ 94,057     $ 67,240     $ 90,777  

Restricted cash

     174,857       24,031       31,693       2,130  

Working capital (deficit)

     165,636       (492,877 )     (94,911 )     (20,464 )

Total assets

      4,196,258        4,533,016        4,578,266        4,735,376  

Long-term debt, including current portion

     3,522,067       3,508,220       3,559,224       3,650,878  

Shareholders’ equity (deficit)

     (963,837 )     (528,759 )     (111,509 )     35,685  

 

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

The following Management’s Discussion and Analysis of Financial Condition and Results of Operations (“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. The discussion also provides information about the financial results of the various segments of our business to provide a better understanding of how those segments and their results affect the financial condition and results of operations of HealthSouth as a whole.

 

Forward Looking Information

 

This MD&A should be read in conjunction with our accompanying consolidated financial statements and related notes. 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 1, Business, “Risk Factors.”

 

Executive Overview

 

As described in detail in Item 1, Business, the more than two years since our last filing have been marked by profound turmoil and change. During this period, a significant portion of our time and attention has been devoted to matters primarily outside the ordinary course of business such as replacing our executive management team, cooperating with federal investigators, restructuring our finances, and reconstructing our accounting records. We have also devoted substantial resources to improving fundamental business systems including our corporate governance functions, financial controls, and operational infrastructure. At the same time, our accounting staff and outside professionals have spent more than one million hours completing the reconstruction of our books and the restatement of our previously issued financial statements.

 

While we have been primarily focused on responding to these pressing challenges, our business, and the health care market in general, have continued to evolve. On the positive side, health care sector growth continues to outpace the economy in response to an aging U.S. population and other factors. In addition, the delivery of health care services is migrating to outpatient and post-acute care environments, which suits our business model. On the other hand, we anticipate pricing pressure in the markets we serve, as well as increased competition. Most importantly, the revised 75% Rule, which is described in greater detail later in this Item, presents our most significant operating challenge as it limits our ability to treat Medicare patients in our largest division. These trends in our markets, which appear to be indicative of trends in the broader health care industry, present challenges and opportunities for us.

 

On the whole, our core business remains sound. We continue to be the largest provider of ambulatory surgery and rehabilitative health care services in the United States, with approximately 1,300 facilities and 40,000 full- and part-time employees. In addition, despite the serious financial, operational, and legal difficulties

 

59


Table of Contents
Index to Financial Statements

we have faced and continue to face, our business is generating significant cash. Under ordinary circumstances, we think our size and our ability to generate cash from operations could be important competitive advantages. Unfortunately, we have significant issues to overcome before we can capitalize on those potential advantages or other competencies. Our first priorities are to improve operations and our capital structure, which we are pursuing diligently.

 

Our Business

 

Our business is currently divided into four primary operating divisions—inpatient, surgery centers, outpatient, and diagnostic—and a fifth division that manages certain other revenue producing activities and corporate functions. These five divisions correspond to our five reporting segments discussed later in this Item and throughout this annual report.

 

Inpatient. Our inpatient division, which comprises the majority of our net operating revenues and is our most profitable division, provides treatment at approximately 94 inpatient rehabilitation facilities (“IRFs”), 9 long-term acute care hospitals (“LTCHs”), and 152 satellites of inpatient facilities providing primarily outpatient care. This division continues to be the market leader in inpatient rehabilitation services in terms of revenues, number of IRFs, and patients served. Between 2000 and 2003, our inpatient division performed well due primarily to Medicare reimbursement changes, discussed later in this Item, which rewarded efficient providers. In 2004, operating earnings of this division remained stable due largely to treating higher acuity patients and stricter expense controls. We expect this division to continue to show positive results. However, as discussed below, the revised 75% Rule is likely to have a materially negative impact on future results of operations.

 

Surgery Centers. Our surgery centers division, which is our second largest division in terms of net operating revenues, operates approximately 177 freestanding ambulatory surgery centers (“ASCs”) and 3 surgical hospitals. Our surgery centers segment’s net operating revenues grew from 2000 to 2002, and remained relatively flat from 2002 to 2003. We believe the segment’s revenue performance is due in large part to overall growth in the industry rather than solid execution. Since March 2003, the division has struggled due in large part to an inability to efficiently resyndicate (i.e., sell ownership interests in) its partnership portfolio and its inability to control costs. Since January 2005, resyndication activity has improved, and we are working on new processes to improve operating room efficiency, decrease supply costs, and optimize staffing. We expect this division to benefit as outpatient procedures continue to migrate to the more efficient ASC environment. However, potential benefits from industry growth may be offset by physician partners who are demanding a higher ownership interest in our partnerships, thereby lowering our share of partnership earnings.

 

Outpatient. Our outpatient division currently provides outpatient therapy services at approximately 765 HealthSouth facilities and 39 facilities managed under contract by us. This division’s performance was disappointing between 2000 and 2003, due primarily to poor operational systems and increased competition from physician-owned physical therapy sites. In 2004, we have seen continued declines in this business. We continue to try to improve margins by closing underperforming facilities and by making operational improvements within the division, although we do not expect marked improvement in this division for the foreseeable future.

 

Diagnostic. Our diagnostic division operates approximately 96 diagnostic imaging centers. This division’s performance has declined since 2001, due to poor margins for the diagnostic market in general and strong competition from physician-owned diagnostic service centers. In 2004, however, we have seen stabilization of both net operating revenues and operating earnings, which we believe is due in part to payor pressures to decrease perceived over-utilization of diagnostic services by physician-owned diagnostic service centers. We continue to focus on operational improvements to increase our margins.

 

As shown by the following charts, our inpatient and surgery centers divisions made up more than 75% of 2003 net operating revenues and approximately 85% of 2003 Consolidated Adjusted EBITDA (as defined in this Item, “Consolidated Results of Operations,”) from our four primary operating divisions. For a reconciliation of

 

60


Table of Contents
Index to Financial Statements

loss from continuing operations to Consolidated Adjusted EBITDA, see this Item, “Consolidated Adjusted EBITDA.”

 

LOGO         LOGO

 

We believe that the aging of the U.S. population, changes in technology, and the continuing growth in health care spending will increase demand for the types of services we provide. First, many of the health conditions associated with aging—like stroke and heart attacks, neurological disorders, and diseases and injuries to the muscles, bones, and joints—will increase the demand for ambulatory surgery and rehabilitative services. Second, pressure from payors to provide efficient, high-quality health care services is forcing many procedures traditionally performed in acute care hospitals out of the acute care environment. We believe these market factors align with our strengths. Given our limited resources, we plan to prioritize investment of time and capital based on where realistic growth prospects are strongest, which is currently our inpatient and surgery centers divisions.

 

Key Challenges

 

Although our business is continuing to generate substantial revenues, and market factors appear to favor our outpatient and post-acute care business model, we still have several immediate internal and external challenges to overcome before we can realize significant improvements in our business, including:

 

    Operational Improvements. We need to improve our operational efficiency, particularly in our surgery centers, outpatient, and diagnostic divisions. This includes streamlining our division management structure, continuing to consolidate or divest underperforming facilities, implementing standardized performance metrics and practices, and ensuring high quality care. We also will strive to reduce operational variation within each division.

 

    Price Pressure. We are seeing downward pressure on prices in our markets, from both commercial and government payors. For commercial payors, the pressure seems to be primarily in response to their clients’ (employers) desire to control escalating costs. For government payors, the pressure is stemming primarily from a growing federal deficit. We anticipate continuing price pressure in all our divisions. For example, Medicare has frozen ASC pricing through 2009, and there are additional efforts underway to modify ASC pricing that could have a material impact on our operations.

 

   

Single-Payor Exposure. Medicare comprises more than 42% of our consolidated net operating revenues and more than 70% of our largest division’s revenues. Consequently, single-payor exposure presents a serious risk. In particular, the revised 75% Rule, which is discussed later in this Item 7, is the single biggest operating risk we face. Our inpatient division has begun to deny admissions of certain types of patients at several locations in an attempt to ensure compliance with the revised 75% Rule. We project this reduction in patient census, unless mitigated, will have a materially adverse impact on the inpatient segment’s revenues. We previously estimated that the revised 75% Rule could negatively impact our net operating revenues by $95 million to $100 million in 2005. Our inpatient division is taking steps to mitigate the impact of the revised 75% Rule, and we previously estimated the impact to our net operating revenues to be approximately $50 million to $55 million when our mitigation strategies are

 

61


Table of Contents
Index to Financial Statements
 

taken into consideration. In the second quarter of 2005, as many of our facilities approach the end of their cost reporting years, we have seen a greater than anticipated decline in inpatient volumes, a significant portion of which is attributable to the revised 75% Rule. Accordingly, the financial impact estimated could be greater than previously disclosed.

 

    Competition. Competition is increasing as physicians look for new revenue sources to offset declining incomes. In our outpatient and diagnostic divisions, physician practices are the natural owners of most patient volume. Any physician group that generates a substantial portion of facility volume for us may have reached sufficient critical mass to insource their referrals, and is therefore a potential competitor. In addition, the low barriers to entry in the outpatient physical therapy sector, and decreasing barriers to entry in the diagnostic sector, make competition from physician practices a particular problem in those markets.

 

    Declining Ownership Share of Surgery Centers. Like most other ASCs, the majority of our centers are owned in partnership with surgeons and other physicians who perform procedures at the centers. As a result of increased competition in the ASC market and other factors, physicians are demanding increased equity participation in ASCs. Consequently, we expect to see our percentage ownership of centers within our ASC portfolio decline over time, thereby reducing our share of partnership earnings from our ASCs.

 

    Leverage. We are highly leveraged and must reduce our debt to decrease our annual debt service cost. We had $3.5 billion in long-term debt as of December 31, 2004, and we incurred $282 million of interest expense in 2004. We estimate we will incur $280 million in interest expense in 2005. Our high leverage increases our cost of capital, decreases our net income, and prevents us from taking advantage of potential growth opportunities.

 

    Settlement Costs. In addition to being highly leveraged, we have significant cash obligations we must meet in the near future as a result of recent settlements with various federal agencies. Specifically, we will be paying the remaining balance of our $325 million settlement in quarterly installments over the next three years to satisfy our obligations under a settlement described in Item 1, Business, “Medicare Program Settlement.” Furthermore, we will pay $100 million to the SEC in five installments over a two year period beginning in the fourth quarter of 2005, as described in Item 1, Business, “SEC Settlement.”

 

    Continuing Investigations and Litigation. We face continuing government investigations, as well as numerous class action and individual lawsuits, all of which will consume considerable management attention and company resources and could result in substantial additional payments and fines.

 

    Reconstruction and Restatement Costs. We paid approximately $257 million in 2004 and approximately $54 million in the first quarter of 2005 in connection with the restructuring of our financial reporting processes, internal accounting controls, and managerial operations, and the restatement of our consolidated financial statements. We anticipate incurring additional related costs in the future, although we expect these costs to decline over time.

 

    Access to Public Markets. This filing is our first annual or quarterly periodic filing since 2002. It will likely be 2006 before we can become a “current filer” in compliance with SEC regulations, and we will not be able to apply for relisting on a major securities exchange until that time. Consequently, we will not have access to public capital markets until 2006, at the earliest, which will make it more difficult to grow our business.

 

Strategic Plan

 

Although management’s attention recently has been focused on a range of tactical issues critical to HealthSouth’s survival, our executive management team has spent considerable time developing a comprehensive strategic plan for the next three to five years that is focused on HealthSouth’s future, not its past.

 

62


Table of Contents
Index to Financial Statements

The plan, which has been approved by the Special Committee of our board of directors, is divided into the following three phases:

 

    Phase 1—Operational Focus. Because our limited borrowing capacity precludes our ability, in the near term, to grow through developing new facilities, we must generate additional cash flow from operating activities by improving operational performance in all our operating divisions. In the first phase, we plan to focus on key operational initiatives such as mitigating the impact of the revised 75% Rule, realizing significant operating performance improvements in each division through standardization of labor and supply chain practices and reduction of fixed costs, completing additional surgery center resyndications, and developing a robust quality agenda. In addition, we plan to establish an appropriate internal control environment, pilot new post-acute care services, and establish our business development capabilities. Phase I has already begun and is anticipated to extend through the second quarter of 2007.

 

    Phase 2—Operational/Growth Focus. In this phase, we will continue establishing an appropriate internal control environment. We will also continue making operational improvements by developing ways to use our size to create supply chain efficiencies and to identify and disseminate operational best practices in patient care, sales, and payor contracting. Assuming we are successful in achieving our targeted operational improvements in Phase I and mitigating the impact of the revised 75% Rule, we anticipate we will generate sufficient additional cash flow from operating activities to enable us to take advantage of selected development opportunities in the post-acute and surgery markets. Specifically, we plan to build new IRFs, LTCHs, and surgery centers in target markets. During this phase, we also plan to grow promising new post-acute services that are complementary to our existing services.

 

    Phase 3—Growth Focus. The third phase will be more outward looking. We plan to continue to acquire or build IRFs and LTCHs in target markets, develop new ASCs, grow new post-acute care businesses, and evaluate potential acquisitions.

 

We are into the first phase of our strategic plan, and we are already making significant strides. For example, we have cured long-term debt defaults and increased our liquidity. We are continuing to cooperate with government investigations and have entered into key settlements with the government and various private parties. Operationally, we have replaced the presidents of each of our primary operating divisions, reorganized these divisions by eliminating unnecessary management layers, increased productivity, divested underperforming facilities, and worked to improve operational systems. We are also beginning to implement mitigation strategies for the revised 75% Rule in our inpatient facilities, enhance the resyndication process for our ASCs, and implement new information systems to improve cash collections in our diagnostic division. Finally, this annual report represents a substantial step toward achieving compliance with SEC reporting requirements, and we hope to become a current filer with the SEC with the filing of our 2005 Form 10-K in 2006, which will enable us to apply for relisting on a major securities exchange and gain access to public capital markets.

 

We believe our strategic plan capitalizes on our strengths, market direction, and legitimate growth opportunities. We are implementing a realistic operational plan and creating the appropriate infrastructure— organization, policies, protocols, systems, and reports—to support it. Finally, we are setting priorities based on resources and with our long-range goals of quality, profitability, and shareholder value at the forefront of our minds.

 

Restatement and Reclassification of Previously Issued Consolidated Financial Information

 

As a result of the events of March 19, 2003, we have undertaken a comprehensive review of our previously filed consolidated financial statements. Due to the lack of systematic and reliable internal controls and the lack of access to HealthSouth’s prior management and senior personnel, the restatement process required an extensive effort by hundreds of financial and accounting professionals, including external consultants, to assist management in locating, verifying, and/or reconstructing supporting records for financial statement accounts.

 

63


Table of Contents
Index to Financial Statements

As a result of the comprehensive review, we have restated our previously reported consolidated financial statements for the years ended December 31, 2001 and 2000. The restatement adjustments resulted in a cumulative net reduction to shareholders’ equity of $3.9 billion and $3.5 billion as of December 31, 2001 and 2000, respectively, and a reduction in previously reported net income of approximately $393.6 million and $642.7 million for the years ended December 31, 2001 and 2000, respectively. We have also restated the January 1, 2000 opening retained earnings balance to recognize corrected items that relate to prior periods. Adjustments to our January 1, 2000 previously reported retained earnings balance approximated $3.0 billion.

 

Except as otherwise specified, all information presented in this Item, our accompanying consolidated financial statements, and the related notes include all such restatements. For additional information and a detailed discussion of the accounts restated, see Note 2, Restatement and Reclassification of Previously Issued Consolidated Financial Statements, to our accompanying consolidated financial statements.

 

Consolidated Results of Operations

 

HealthSouth is the largest provider of ambulatory surgery and rehabilitative health care services in the United States, with approximately 1,300 facilities and 40,000 full- and part-time employees. We provide these services through a national network of inpatient and outpatient rehabilitation facilities, outpatient surgery centers, diagnostic centers, medical centers, and other health care facilities.

 

During 2003, 2002, 2001, and 2000, we derived consolidated net operating revenues from the following payor sources:

 

     For the year ended December 31,

 
     2003

    2002

    2001

    2000

 
                 (Restated)     (Restated)  

Medicare

   42.7 %   37.8 %   31.4 %   29.1 %

Medicaid

   2.1 %   2.4 %   2.6 %   2.6 %

Workers’ compensation

   9.4 %   10.7 %   12.1 %   12.5 %

Managed care and other discount plans

   31.3 %   33.0 %   32.9 %   31.8 %

Other third party payors

   9.4 %   10.8 %   14.6 %   17.0 %

Other income

   5.1 %   5.3 %   6.4 %   7.0 %
    

 

 

 

Total

   100.0 %   100.0 %   100.0 %   100.0 %
    

 

 

 

 

We provide our patient care services through four primary operating segments and certain other services through a fifth operating segment. These segments are discussed in more detail in this Item, “Segment Results of Operations.”

 

When reading our consolidated statements of operations, it is important to recognize the following items included within our results of operations:

 

    Impairments—During 2003, we recorded a charge of approximately $335.6 million for the impairment of goodwill and an additional charge of approximately $132.7 million for the impairment of certain long-lived assets. During 2002, we recorded an impairment charge of approximately $95.5 million to reduce the carrying value of property and equipment and an impairment charge of $22.2 million to reduce the carrying value of amortizable intangibles of certain operating facilities to their estimated fair market value. During 2001 and 2000, triggering events related to facility closings and facilities experiencing negative cash flow from operations resulted in the recognition of impairment charges of $0.4 million and $10.4 million, respectively, for certain long-lived assets. These charges are discussed in more detail in this Item, “Segment Results of Operations,” and Note 7, Property and Equipment, and Note 8, Goodwill and Other Intangible Assets, to our accompanying consolidated financial statements.

 

64


Table of Contents
Index to Financial Statements
    Government and class action settlements expense—In 2003, our net loss includes the cost related to our settlement with the SEC and certain additional settlements, as well as legal fees related to this litigation and certain other actions brought against us. For additional information, see Note 22, SEC Settlement, and Note 23, Contingencies and Other Commitments, to our accompanying consolidated financial statements.

 

As a result of the Medicare Program Settlement, as discussed in more detail in Note 21, Medicare Program Settlement, to our accompanying consolidated financial statements, we recorded a total charge of $347.7 million during 2002 as Government and class action settlements expense. Of this charge, approximately $194.0 million, $96.5 million, and $57.2 million have been allocated to our inpatient, outpatient, and corporate and other segments, respectively. Although the Medicare Program Settlement was made on a global basis rather than a claim-by-claim basis, our allocation was based upon our evaluation of the damages asserted by the DOJ civil division on a claim-by-claim basis and our analysis of the value of those claims.

 

In 2000, we recorded a charge of $8.2 million due to a settlement with the DOJ related to improperly filed Medicare cost reports.

 

    Professional fees—reconstruction and restatement—As noted throughout this annual report, significant changes have occurred at HealthSouth since the events of March 19, 2003. The steps taken to stabilize our business and operations, provide vital management assistance, and coordinate our legal strategy came at significant financial cost. During 2003, professional fees associated with the reconstruction and restatement of our previously issued reports approximated $70.6 million. For similar amounts spent during 2004 and the first quarter of 2005, please see this Item, “Liquidity and Capital Resources—Funding Commitments.”

 

    (Gain) loss on early extinguishment of debt—In each year, we recorded either a gain or loss on early extinguishment of debt due to our termination of certain capital leases or various credit agreements, or the repurchase of various bonds. The most significant amount was recorded in 2002, when we recognized a $9.6 million gain on early extinguishment of debt. During 2002, we repurchased portions of various bonds for $457.1 million prior to their scheduled maturity dates. The repurchase amounts were less than the carrying amounts of these bonds and resulted in an approximate $25.8 million gain on the extinguishment of debt.

 

This gain was offset by a $13.9 million loss from a real estate transaction with First Cambridge, as discussed in more detail in Note 20, Related Party Transactions, to our accompanying consolidated financial statements. The remaining $2.3 million of loss on early extinguishment of debt in 2002 is due to the refinancing of our 1998 Credit Agreement and the write-off of $2.3 million of unamortized loan costs in association with this transaction. For more information regarding these transactions, please see Note 10, Long-term Debt, to our accompanying consolidated financial statements.

 

    Cumulative effect of an accounting change, net of tax—We recorded the cumulative effect of an accounting change in both 2003 and 2002. Effective January, 1, 2003, we adopted the provisions of FASB Statement No. 143, Accounting for Asset Retirement Obligations, and recorded a related charge of approximately $2.5 million. On January 1, 2002, we recorded a charge of approximately $48.2 million as a result of the adoption of FASB Statement No. 142, Goodwill and Other Intangible Assets, related to an impairment of goodwill of our diagnostic segment.

 

65


Table of Contents
Index to Financial Statements

From 2000 through 2003, our consolidated results of operations were as follows:

 

     For the year ended December 31,

    Percentage Change

 
       2003 vs.
2002


    2002 vs.
2001


    2001 vs.
2000


 
     2003

    2002

    2001

    2000

       
                 (Restated)     (Restated)                 (Restated)  
     ($ in thousands)                    

Net operating revenues

   $ 3,957,604     $ 3,960,142     $ 3,553,057     $ 3,498,836     (0.1 )%   11.5 %   1.5 %
    


 


 


 


 

 

 

Operating expenses:

                                                  

Salaries and benefits

     1,716,995       1,745,322       1,618,546       1,627,583     (1.6 )%   7.8 %   (0.6 )%

Professional and medical director fees

     87,375       103,980       85,384       89,423     (16.0 )%   21.8 %   (4.5 )%

Supplies

     399,560       361,825       333,835       342,855     10.4 %   8.4 %   (2.6 )%

Other operating expenses

     863,444       916,617       862,620       842,916     (5.8 )%   6.3 %   2.3 %

Provision for doubtful accounts

     133,836       137,060       100,620       189,811     (2.4 )%   36.2 %   (47.0 )%

Depreciation and amortization

     200,195       237,775       353,657       359,003     (15.8 )%   (32.8 )%   (1.5 )%

(Gain) loss on disposal of assets

     (13,225 )     87,043       35,193       104,798     (115.2 )%   147.3 %   (66.4 )%

Impairment of goodwill, intangible assets, and long-lived assets

     468,345       117,643       438       10,387     298.1 %   26,759.1 %   (95.8 )%

Government and class action settlements expense

     170,949       347,716       —         8,248     (50.8 )%   N/A     (100.0 )%

Professional fees—reconstruction and restatement

     70,558       —         —         —       N/A     N/A     N/A  
    


 


 


 


 

 

 

Total operating expenses

     4,098,032       4,054,981       3,390,293       3,575,024     1.1 %   19.6 %   (5.2 )%

(Gain) loss on early extinguishment of debt

     (2,259 )     (9,644 )     5,136       1,615     (76.6 )%   (287.8 )%   218.0 %

Interest expense and amortization of debt discount

     268,443       255,035       311,386       290,838     5.3 %   (18.1 )%   7.1 %

Interest income

     (7,323 )     (6,881 )     (7,497 )     (8,717 )   6.4 %   (8.2 )%   (14.0 )%

Loss (gain) on sale of investments

     15,811       (12,491 )     651       34,572     (226.6 )%   (2018.7 )%   (98.1 )%

Equity in net income of nonconsolidated affiliates

     (15,769 )     (15,320 )     (16,909 )     (27,351 )   2.9 %   (9.4 )%   (38.2 )%

Minority interests in earnings of consolidated affiliates

     99,456       90,359       60,679       71,062     10.1 %   48.9 %   (14.6 )%
    


 


 


 


 

 

 

Loss from continuing operations before income tax expense and cumulative effect of accounting change

     (498,787 )     (395,897 )     (190,682 )     (438,207 )   26.0 %   107.6 %   (56.5 )%

Provision for income tax (benefit) expense

     (42,419 )     21,221       (28,244 )     (76,584 )   (299.9 )%   (175.1 )%   (63.1 )%
    


 


 


 


 

 

 

Loss from continuing operations before cumulative effect of accounting change

     (456,368 )     (417,118 )     (162,438 )     (361,623 )   9.4 %   156.8 %   (55.1 )%

Income (loss) from discontinued operations, net of income tax expense

     24,267       (1,517 )     (28,787 )     (2,620 )   (1699.7 )%   (94.7 )%   998.7 %
    


 


 


 


 

 

 

Loss before cumulative effect of accounting change

     (432,101 )     (418,635 )     (191,225 )     (364,243 )   3.2 %   118.9 %   (47.5 )%

Cumulative effect of accounting change, net of income tax expense

     (2,456 )     (48,189 )     —         —       (94.9 )%   N/A     N/A  
    


 


 


 


 

 

 

Net loss

   $ (434,557 )   $ (466,824 )   $ (191,225 )   $ (364,243 )   (6.9 )%   144.1 %   (47.5 )%
    


 


 


 


 

 

 

 

66


Table of Contents
Index to Financial Statements

Operating Expenses as a % of Net Operating Revenues

 

     For the year ended December 31,

 
     2003

    2002

    2001

    2000

 
                 (Restated)     (Restated)  

Salaries and benefits

   43.4 %   44.1 %   45.6 %   46.5 %

Professional and medical director fees

   2.2 %   2.6 %   2.4 %   2.6 %

Supplies

   10.1 %   9.1 %   9.4 %   9.8 %

Other operating expenses

   21.8 %   23.1 %   24.3 %   24.1 %

Provision for doubtful accounts

   3.4 %   3.5 %   2.8 %   5.4 %

Depreciation and amortization

   5.1 %   6.0 %   10.0 %   10.3 %

(Gain) loss on disposal of assets

   (0.3 )%   2.2 %   1.0 %   3.0 %

Impairment of goodwill, intangible assets, and long-lived assets

   11.8 %   3.0 %   0.0 %   0.3 %

Government and class action settlement expense

   4.3 %   8.8 %   0.0 %   0.2 %

Professional fees—reconstruction and restatement

   1.8 %   0.0 %   0.0 %   0.0 %
    

 

 

 

Total operating expenses as a % of net operating revenues

   103.5 %   102.4 %   95.4 %   102.2 %
    

 

 

 

 

The response of our lenders and other creditors to the governmental investigations into our financial reporting and related activities forced us to take immediate steps in 2003 to increase our liquidity. With our revolving credit facility frozen by our lenders, we needed to liquidate certain assets and slow discretionary spending in order to supplement cash from operating activities and provide us with the cash we needed for the restructuring period. During 2003, we increased our cash and cash equivalents by $382.1 million due to the closing or sale of certain facilities, liquidation of our fleet of aircraft, discontinuation of certain non-core businesses, reduction in workforce at our corporate office, tax refunds received, and reduced spending on the Digital Hospital and Source Medical.

 

Due to the discovery of fraudulent activities and reporting, many co-owners in our partnerships requested that cash belonging to those partnerships not be commingled with our corporate cash accounts. As a result of these requests, the amount of our restricted cash increased by $96.7 million from 2002 to 2003. Due to changes in the actuarial assumptions used in our self-insurance calculations related to professional liability, workers’ compensation, and other insurance claims, restricted cash held by our self-insured captive funds increased by $37.7 million from 2002 to 2003. These amounts are discussed more in Note 1, Summary of Significant Accounting Policies, to our accompanying consolidated financial statements. We were also required to post over $15 million in refundable deposits with vendors who were concerned about our ability to pay on credit. These refundable deposits are included in prepaid expenses on our accompanying consolidated balance sheets. Many vendors also decreased their payment terms when the fraud was uncovered. At the end of 2002, most payment terms with vendors equaled or exceeded 30 days. By the end of 2003, most vendor terms had decreased to less than 30 days.

 

As a result of the asset sales and long-lived asset impairment charges mentioned above, as well as our need to reduce discretionary spending, net property and equipment decreased by approximately $249.1 million, or 14.5%, during 2003. More specifically, this decrease is primarily the result of facility closures, the sale of our fleet of aircraft, and impairment charges related to the Digital Hospital.

 

Net Operating Revenues

 

Our consolidated net operating revenues primarily include revenues derived from patient care services provided by one of our four primary operating segments. It also includes other revenues generated from management and administrative fees, trainer income, operation of the conference center located on our corporate campus, and other non-patient care services.

 

For the years ended December 31, 2000 through 2003, we show strong net operating revenues ranging from $3.5 billion to $4.0 billion in each year. In spite of the negative publicity and turmoil surrounding the company in

 

67


Table of Contents
Index to Financial Statements

2003, consolidated net operating revenues declined by less than 1.0% year over year. Although our segments experienced significant declines in volume related to the negative publicity and other competitive factors, our segments achieved improved payor mix and price increases to offset the decline in volume.

 

The most notable event of 2002 was the conversion of our inpatient segment from the Medicare cost reimbursement system to the Medicare Inpatient Rehabilitation Facility—Prospective Payment System reimbursement system (“IRF-PPS”), as discussed in greater detail within the “Segment Results of Operations—Inpatient” section below. Conversion to this new reimbursement system was the primary driver of our increased net operating revenues from 2001 to 2002, as our inpatient segment was rewarded for being an efficient provider.

 

From 2000 to 2001, net operating revenues increased by 1.5%. Although our inpatient and surgery centers segments achieved significant increases in net operating revenues year over year, the sale of our occupational medicine facilities in March 2001 offset the revenue increases on a consolidated basis. Net operating revenues of our inpatient segment increased by $90.4 million, while net operating revenues of our surgery centers segment increased by $49.8 million. The sale of our occupational medicine facilities decreased net operating revenues by approximately $77.4 million, year over year.

 

Salaries and Benefits

 

Salaries and benefits represents the most significant cost to us and includes all amounts paid to full- and part-time employees, including all related costs of benefits provided to employees. It also includes amounts paid for contract labor.

 

During 2003, our full time equivalents decreased by over 1,200 employees, as we adjusted our staffing levels for the volume declines experienced by our operating segments and reduced our workforce at our corporate headquarters. However, the average cost per full time equivalent increased due to the rising costs of medical and other benefits and workers’ compensation expenses. These rising costs offset the cost savings anticipated from the reduction in full time equivalents and resulted in only a 1.6% decrease in salaries and benefits from 2002 to 2003.

 

During 2002, company-wide full time equivalents decreased by approximately 30 employees, while increased costs associated with employee benefits and workers’ compensation increased the average cost per full time equivalent. However, revenue growth outpaced the rising costs of benefits, and we were able to decrease salaries and benefits as a percent of net operating revenues.

 

Company-wide full time equivalents decreased by approximately 20 in 2001, and the average cost per full time equivalent also decreased slightly. As a result, salaries and benefits decreased to 45.6% of net operating revenues in 2001.

 

Professional and Medical Director Fees

 

Professional and medical director fees include fees paid under contracts with radiologists, medical directors, and other clinical professionals at our centers for services provided.

 

Professional and medical director fees decreased from 2002 to 2003 due primarily to the termination of contracts associated with Alabama Sports Medicine and Orthopedic Center due to relationships and conflicts of interests, as well as high costs associated with these contracts.

 

As discussed in more detail within this Item, “Segment Results of Operations—Diagnostic,” the majority of our diagnostic segment’s contracts with radiologists and other clinical personnel are tied to the number of scans performed, associated revenues with each scan, or cash collections. These fees increased in 2002 due to more scans performed by our diagnostic centers.

 

68


Table of Contents
Index to Financial Statements

Supplies

 

Supplies include costs associated with supplies used while providing patient care at our facilities. Examples include pharmaceuticals, implants, bandages, food, and other similar items. In each year, our inpatient and surgery centers segments comprise over 75% of our supplies expense.

 

Over 85% of the increase in supplies from 2002 to 2003 is due to the acquisition of Metro West hospital in November 2002. During 2003, we incurred a full year of Metro West’s operating expenses, including approximately $32.9 million related to supplies expense. From 2001 to 2002, supplies expense increased primarily due to the increased volumes experienced by our surgery centers in 2002. The decrease in supplies expense from 2000 to 2001 is a result of the sale of our occupational medicine facilities and Richmond Medical Center in 2001, offset by increased supplies expense at our surgery centers due to increased volume and a shift in case mix, as discussed later in this Item, and rising drug costs.

 

Other Operating Expenses

 

Other operating expenses include costs associated with managing and maintaining our operating facilities as well as the general and administrative costs related to the operation of our corporate office. These expenses include such items as repairs and maintenance, utilities, contract services, rent, and insurance.

 

Other operating expenses also include software development costs in 2001 through 2003. During 2001, we began funding Source Medical for the HCAP software development, as discussed in more detail in Note 9, Investment in and Advances to Nonconsolidated Affiliates, to our accompanying consolidated financial statements. During 2003, 2002, and 2001, $11.8 million, $25.3 million, and $81.3 million, respectively, were provided to Source Medical.

 

The decrease in other operating expenses from 2002 to 2003 is due to increased expenses at our inpatient segment offset by reduced expenses at our corporate and other segment. Operating expenses increased at our inpatient segment due to an increase in the acuity of patients serviced in 2003, as discussed in more detail within the “Segment Results of Operations” section below, and the net increase of two inpatient facilities during the year. These increased costs were offset by a reduction in discretionary spending as a result of the events of March 19, 2003. We decreased our discretionary spending on items such as office supplies, telephone, travel and entertainment, meetings, contract services, media production, contributions, airplane and hangar rent, software development costs, and event sponsorships. However, we incurred $70.6 million in Professional fees—reconstruction and restatement, during 2003, as discussed above.

 

Other operating expenses increased in 2002 as a result of increased insurance expense during the year. During 2002, the insurance market hardened in general and premiums on property and casualty insurance generally increased due to the impact of the events of September 11, 2001. Accounting and legal fees also increased due to fees paid to KPMG LLP and Ernst & Young LLP during 2002 for due diligence and tax services provided in preparation for the potential spin off of our surgery centers segment. The remainder of the increase is due primarily to increased legal and professional fees incurred during 2002 in contemplation of a variety of transactions during the year as well as the SEC’s investigation of stock sales made by our then-Chairman and Chief Executive Officer, Richard M. Scrushy.

 

From 2000 to 2001, our other operating expenses grew due primarily to the funding of Source Medical, as discussed above, and $42.0 million in lease termination costs associated with the Greenery facilities in 2001, as discussed in more detail in Note 2, Restatement and Reclassification of Previously Issued Consolidated Financial Statements, to our accompanying consolidated financial statements. These increased costs were offset by decreased costs associated with the sale of our occupational medicine facilities and Richmond Medical Center in 2001. Given the above combined with operational efficiencies achieved in 2001 in other areas and the increase in

 

69


Table of Contents
Index to Financial Statements

net operating revenues in 2001, our other operating expenses remained relatively consistent as a percent of net operating revenues year over year.

 

Provision for Doubtful Accounts

 

From 2002 to 2003, the provision for doubtful accounts remained relatively consistent as a percent of net operating revenues. During 2003, our inpatient segment was able to decrease its provision for doubtful accounts through continued significant improvements in collections precipitated by consistent application of policies around the identification, pursuit, and recording of bad debts which began in 2001. Our provision for doubtful accounts also decreased due to the increase in the percent of our net operating revenues from Medicare, as bad debts have not historically been associated with Medicare as a payor. However, these improvements in the provision for doubtful accounts were offset by continued cash collections difficulties within our diagnostic segment. Please see “Segment Results of Operations” within this Item for more information regarding the provision for doubtful accounts at our diagnostic segment.

 

The increase in the provision for doubtful accounts in 2002 is the result of a decline in operational efficiency within our diagnostic segment, as discussed in more detail within the “Segment Results of Operations” section of this Item.

 

From 2000 to 2001, our provision for doubtful accounts decreased from 5.4% of net operating revenues to 2.8% of net operating revenues, respectively. This decrease is due to reductions in the provision for doubtful accounts at our inpatient and outpatient segments. Our inpatient segment was able to decrease its provision for doubtful accounts through significant improvements in collections precipitated by consistent application of policies around the identification, pursuit, and recording of bad debts during the year. Outpatient management attributes its improvement to better collection efforts by outpatient’s operations department on collecting past due accounts in 2001, as well as the closure of underperforming facilities during the year.

 

Depreciation and Amortization

 

The decrease in depreciation expense from 2002 to 2003 is primarily due to the sale of assets and closure of facilities during 2003, primarily in our outpatient and diagnostic segments. Depreciation and amortization decreased from 2001 to 2002 primarily due to our adoption of FASB Statement No. 142, which requires the cessation of amortization of goodwill, on January 1, 2002.

 

(Gain) Loss on Disposal of Assets

 

The net gain on disposal of assets in 2003 primarily resulted from the sale of our inpatient facility in Reno, Nevada.

 

As part of our restatement process, we performed a complete physical inventory of our facilities. We removed all items we could not locate from the fixed assets system and adjusted the general ledger accordingly. For facilities that were closed, we removed any asset not physically located from the fixed asset system and the general ledger as of the facility’s closure date. As a result of this procedure, we incurred a charge of approximately $35.6 million in 2002, which is included in (Gain) loss on disposal of assets in our consolidated statements of operations. The remainder of the 2002 loss on disposal of assets is primarily attributable to the sale of the Wentworth Nursing Home by our inpatient segment.

 

In 2001, we sold four inpatient rehabilitation facilities to Meadowbrook Healthcare, Inc., an entity formed by one of our former chief financial officers, Michael D. Martin. As a result of this transaction, which is discussed in more detail in Note 7, Property and Equipment, to our accompanying consolidated financial statements, we recorded a $37.4 million loss on disposal of assets. Our diagnostic segment also recorded a net loss on disposal of assets in 2001 due to the closure or sale of 23 facilities, including those located in the United

 

70


Table of Contents
Index to Financial Statements

Kingdom. The above losses were offset by gains recorded on the sale of our occupational medicine facilities and Richmond Medical Center in 2001.

 

In 2000, the net loss on disposal of assets was the result of numerous individually insignificant asset disposals at our surgery centers, outpatient, diagnostic, and corporate and other segments.

 

Interest Expense and Amortization of Debt Discount

 

As noted above, we are a highly leveraged company with over $3.5 billion of debt as of December 31, 2003. This high debt level obviously results in high debt service costs, with cash paid for interest expense approximating $269.4 million in 2003.

 

Interest expense increased during 2003 primarily due to increased average interest rates on our borrowings. As a result of the events of March 19, 2003, our interest rate increased to “default rates” on our then-existing credit agreement. Our average borrowing rate on all debt in 2003 was 7.6% compared to 7.2% in 2002. These increased rates resulted in an increase in interest expense of approximately $14.7 million in 2003. Increased interest expense related to higher rates was offset by lower average borrowings during 2003. Average borrowings declined by approximately $18.6 million in 2003 over 2002, providing an offset of approximately $1.3 million to interest expense.

 

From 2001 to 2002, interest expense and amortization of debt discount decreased primarily as a result of lower average borrowing rates in 2002. Our average borrowing rate in 2002 approximated 7.2% compared to an average borrowing rate of 8.6% in 2001. This decrease in average rates had a positive impact to interest expense of approximately $50.2 million, year over year. Additionally, average borrowings declined by $71.3 million during 2002 resulting in an approximate $6.2 million decrease in interest expense, year over year.

 

Interest expense and amortization of debt discount increased from 2000 to 2001 primarily due to a shift in borrowing away from our short-term revolver to long-term debt, resulting in a higher weighted average borrowing rate. Our average borrowing rates in 2001 approximated 8.6% compared to average rates of 8.1% during 2000. These increased rates resulted in an increase in interest expense of approximately $19.9 million during 2001. In addition, average borrowings increased by $7.7 million, year over year, resulting in an approximate $0.6 million increase in interest expense.

 

Loss (Gain) on Sale of Investments

 

In each year presented in our consolidated statements of operations, the net gain or loss on sale of investments is primarily comprised of numerous individually insignificant transactions related to less than 100% owned entities, including investments in nonconsolidated affiliates. Loss (gain) on sale of investments also includes the realized gains and losses recorded on the sale of marketable securities, and, in 2002, a gain on the termination of an interest rate swap. For more information regarding this interest rate swap, please see Note 10, Long-term Debt, to our accompanying consolidated financial statements.

 

During 2003, we sold our investment in HealthTronics for approximately $3.7 million and recognized a gain on the sale of approximately $0.7 million. With the sale of this investment, we eliminated all of our investments in marketable securities. During 2002, we sold our investment in BEI Medical’s common stock for approximately $1.2 million, realizing a gain on this sale of approximately $0.7 million. During 2001, we sold our investments in Almost Family and Caremark Rx for $5.0 million and $27.0 million, respectively, realizing a total gain of approximately $22.7 million on these sales. Both investments were related party transactions that are discussed in more detail in Note 6, Marketable Securities, in our accompanying consolidated financial statements.

 

71


Table of Contents
Index to Financial Statements

Equity in Net Income of Nonconsolidated Affiliates

 

During 2000, our equity in net income of nonconsolidated affiliates includes the effect of gains from asset disposals at certain outpatient affiliates. Thus, our share of these affiliates’ net income was higher in 2000. Also, in 2001, several of our diagnostic and surgery affiliates experienced increased operating costs over the prior year.

 

Minority Interests in Earnings of Consolidated Entities

 

Minority interests in earnings of consolidated affiliates represents the share of net income or loss allocated to members or partners in our consolidated entities. For 2000 through 2003, the number and average external ownership interest in these consolidated entities were as follows:

 

     As of and for the year ended December 31,

 
     2003

    2002

    2001

    2000

 
                 (Restated)     (Restated)  

Active consolidated affiliates

   322     324     327     335  

Average external ownership interest

   32.5 %   32.6 %   31.8 %   31.5 %

 

Of our active consolidated affiliates, approximately 70% of them are in our inpatient and surgery centers segments. This relationship can be seen in the significant increase in minority interests in earnings of consolidated affiliates from 2001 to 2002, when our inpatient segment experienced a significant increase in revenues due to their conversion to a prospective payment system and our surgery centers’ revenues increased due to increased volumes at our ASCs and better pricing on most services.

 

Loss from Continuing Operations Before Income Tax Expense and Cumulative Effect of Accounting Change

 

The increase in our loss from continuing operations before income tax expense and cumulative effect of accounting change (“loss from continuing operations”) from 2002 to 2003 is due to the 1.1% increase in total operating expenses while our net operating revenues remained relatively flat. In addition to the increase in our operating expenses, we incurred increased interest expense (as a result of higher average borrowing rates) and an increased loss on sale of investments (due to the interest rate swap gain recorded in 2002).

 

From 2001 to 2002, our net operating revenues grew primarily as a result of our inpatient segment’s conversion to IRF-PPS, as we were rewarded for being an efficient provider. However, the increase in our net operating revenues was consumed by the Medicare Program Settlement and impairment charges recorded during the year. In addition, we incurred significant increases in our insurance costs and several other operating expenses, as discussed above, which resulted in an operating loss during 2002. Our operating loss was offset slightly by the gain on early extinguishment of debt and the gain on sale of investments recorded in 2002, as well as decreased interest expense (due to lower average borrowing rates) year over year. It should also be noted that our minority interest expense increased in 2002 due primarily to the positive trend shown by our inpatient segment in 2002. As a result of the above, our loss from continuing operations increased in 2002.

 

From 2000 to 2001, our net operating revenues increased by 1.5% while our operating expenses decreased by 5.2%. The decrease in operating expenses was primarily the result of a decrease in the provision for doubtful accounts, a decrease in the net loss on asset disposals, a decrease in impairment charges, and a decrease in Government and class action settlements expense during 2001. As a result of the above, our loss from continuing operations decreased in 2001.

 

Provision for Income Tax (Benefit) Expense

 

We realized a $42.4 million tax benefit from continuing operations in 2003 as compared to a $21.2 million tax expense in 2002. Substantially all of this difference relates to the fact that we realized a $25.6 million deferred tax benefit due to the reduction of the deferred tax liability associated with certain indefinite life assets.

 

72


Table of Contents
Index to Financial Statements

This reduction was the result of an impairment of goodwill in 2003. In 2002, a deferred tax expense of $30.6 million was initially provided to reflect the increase in the deferred tax liability associated with these assets. Additionally, HealthSouth Corporation and its subsidiaries file separate income tax returns in a number of states, some of which result in current state liabilities. The current state income tax liability in 2003 is approximately $11.0 million less than in 2002 as a function of decreased pre-tax state income. A valuation allowance is provided against remaining net deferred tax assets as it is not more likely than not that the company will realize these deferred tax assets.

 

Although we realized a pre-tax loss from continuing operations in 2002, a net tax expense is provided. The current portion is comprised of a tax benefit which results from our estimate that we will be able to carry back a portion of our current federal net operating loss pursuant to the provisions of the Job Creation and Worker Assistance Act of 2002 (the “Worker Assistance Act”), enacted by Congress on March 9, 2002. The Worker Assistance Act extended the carryback period to 5 years for net operating losses incurred in 2001 and 2002 only. Additionally, HealthSouth Corporation and its subsidiaries file separate income tax returns in a number of states, some of which result in current state income tax liabilities. The current state income tax liability in 2002 increased approximately $13.4 million from 2001 as a function of increased pre-tax state income. A deferred tax expense of $30.6 million was provided in 2002 to reflect the increase in a deferred tax liability associated with certain indefinite life assets, as compared to a deferred tax expense of $9.4 million provided on these assets in 2001. This liability is recorded as it is not able to be relieved through the realization of deferred tax assets. A valuation allowance is provided against remaining net deferred tax assets as it is not more likely than not that the company will realize these deferred tax assets.

 

In 2001, we realized a $28.2 million tax benefit from continuing operations, as compared to an $76.6 million tax benefit in 2000. Substantially all of the reduction in the tax benefit from 2000 to 2001 is a function of the amount of the federal tax net operating loss for each year. Additionally, HealthSouth Corporation and its subsidiaries file separate income tax returns in a number of states, some of which result in current state tax liabilities. The current state income tax liability in 2001 decreased approximately $6.3 million as compared to 2000 as a function of decreased pre-tax state income. A deferred tax expense of $9.4 million was provided in 2001 to reflect the increase in a deferred tax liability associated with certain indefinite life assets, as compared to a deferred tax expense of $15.0 million provided on these assets in 2000. This liability is recorded as it is not able to be relieved through the realization of deferred tax assets. A valuation allowance is provided against remaining net deferred tax assets as it is not more likely than not that the company will realize these deferred tax assets.

 

Consolidated Adjusted EBITDA

 

Management believes Consolidated Adjusted EBITDA is an important measure of operating performance, leverage capacity and debt service ability. We have included this measure because we believe it provides investors with additional information about our ability to incur and service debt and make capital expenditures. Consolidated Adjusted EBITDA is also a component of certain covenants contained within and defined by our Amended and Restated Credit Agreement, as discussed in more detail in Note 10, Long-term Debt, to our accompanying consolidated financial statements.

 

However, Consolidated Adjusted EBITDA is not a measure of financial performance under generally accepted accounting principles in the United States of America, and the items excluded from Consolidated Adjusted EBITDA are significant components in understanding and assessing financial performance. Therefore, Consolidated Adjusted EBITDA should not be considered a substitute for net loss from continuing operations or cash flows from operating, investing, or financing activities. Because Consolidated Adjusted EBITDA is not a measurement determined in accordance with generally accepted accounting principles in the United States of America and is thus susceptible to varying calculations, Consolidated Adjusted EBITDA, as presented, may not be comparable to other similarly titled measures of other companies. Revenue and expenses are measured in accordance with the policies and procedures described in Note 1, Summary of Significant Accounting Policies, to our accompanying consolidated financial statements.

 

73


Table of Contents
Index to Financial Statements

From 2000 through 2003, our Consolidated Adjusted EBITDA was as follows:

 

Reconciliation of Loss from Continuing Operations to Consolidated Adjusted EBITDA

     For the year ended December 31,

 
     2003

    2002

    2001

    2000

 
                 (Restated)     (Restated)  

Loss from continuing operations before income tax expense and cumulative effect of accounting change

   $ (498,787 )   $ (395,897 )   $ (190,682 )   $ (438,207 )

Depreciation and amortization

     200,195       237,775       353,657       359,003  

(Gain) loss on disposal of assets

     (13,225 )     87,043       35,193       104,798  

Impairment charges

     468,345       117,643       438       10,387  

Government and class action settlements expense

     170,949       347,716       —         8,248  

Professional fees—reconstruction and restatement

     70,558       —         —         —    

(Gain) loss on early extinguishment of debt

     (2,259 )     (9,644 )     5,136       1,615  

Interest expense and amortization of debt discount

     268,443       255,035       311,386       290,838  

Interest income

     (7,323 )     (6,881 )     (7,497 )     (8,717 )

Loss (gain) on sale of investments

     15,811       (12,491 )     651       34,572  
    


 


 


 


Consolidated Adjusted EBITDA

     672,707       620,299       508,282       362,537  
    


 


 


 


 

Consolidated Adjusted EBITDA in 2003 increased primarily as a result of our efforts to reduce discretionary spending during the year and headcount reductions at our corporate headquarters.

 

Consolidated Adjusted EBITDA increased from 2001 to 2002 due to our inpatient division’s conversion to the Medicare IRF Prospective Payment System reimbursement system which rewards efficient providers.

 

The increase in Consolidated Adjusted EBITDA from 2000 to 2001 is due primarily to increased volumes at our inpatient, surgery centers, and diagnostic segments offset by higher general and administrative expenses, primarily due to the funding of Source Medical and software development costs. Our outpatient segment also made certain operational improvements that lowered their expenses and improved their Consolidated Adjusted EBITDA in 2001.

 

Impact of Inflation

 

Overall, inflation has not had a material impact on our operations during recent years. Unless inflation increases significantly, it is not expected to materially adversely affect our results of operations in the near term.

 

Relationships and Transactions with Related Parties

 

HealthSouth and its prior management team and board of directors engaged in numerous relationships and transactions with related parties. These transactions involved certain venture capital firms, investments, real property, and indebtedness of management. For more information on our historic relationships and transactions with related parties, please see Item 13, Certain Relationships and Related Transactions, of this report, and Note 6, Marketable Securities, Note 9, Investment in and Advances to Nonconsolidated Affiliates, Note 12, Shareholders’ Equity, and Note 20, Related Party Transactions, to our accompanying consolidated financial statements.

 

As part of our restructuring process, we have eliminated our interests in and relationships with related parties. These types of transactions are not material to our ongoing operations, and therefore, will not be presented as a separate discussion within this Item. When these relationships or transactions were significant to

 

74


Table of Contents
Index to Financial Statements

our results of operations during the years ended December 31, 2003, 2002, 2001, or 2000, information regarding the relationship or transaction(s) have been included within this Item.

 

Segment Results of Operations

 

Our new executive management team, under the direction of the Special Committee of the board of directors, has restructured our business activities and financial, operational, and management structure. As a result of this restructuring process, our internal financial reporting and management structure is focused on the major types of services provided by HealthSouth. We currently provide various patient care services through four operating divisions and certain other services through a fifth division, which correspond to our five reporting business segments: (1) inpatient, (2) surgery centers, (3) outpatient, (4) diagnostic, and (5) corporate and other. For additional information regarding our business segments and related information, please see Item 1, Business, and Note 24, Segment Reporting, to our accompanying consolidated financial statements.

 

Segment financial data for the years ended December 31, 2001 and 2000 has been restated to recognize the above changes in our organizational structure. A detailed description of the services, as well as financial data, for each segment can be found in Item 1, Business, and in Note 24, Segment Reporting, to our accompanying consolidated financial statements. Future changes to this organizational structure may result in changes to the reportable segments disclosed.

 

Inpatient

 

We are the nation’s largest provider of inpatient rehabilitation services. Our inpatient rehabilitation facilities provide comprehensive services to patients who require intensive institutional rehabilitation care. Patient care is provided by nursing and therapy staff as directed by a physician order. Internal case managers monitor each patient’s progress and provide documentation of patient status, achievement of goals, functional outcomes and efficiency.

 

Our inpatient segment operates inpatient rehabilitation facilities (“IRFs”), long-term acute care hospitals (“LTCHs”), and skilled nursing units and provides treatment on both an inpatient and outpatient basis. As of December 31, 2004, our inpatient segment operated 94 freestanding IRFs, 9 LTCHs, and 152 outpatient facilities near our IRFs or LTCHs. In addition to HealthSouth facilities, our inpatient segment manages 13 inpatient rehabilitation units and 2 gamma knives. Our inpatient segment also has 11 therapy staffing contracts with acute care providers. Our inpatient facilities are located in 28 states, with a concentration of facilities in Texas, Pennsylvania, Florida, Tennessee, and Alabama. We also have facilities in Puerto Rico and Australia.

 

75


Table of Contents
Index to Financial Statements

For the years ended December 31, 2003, 2002, 2001, and 2000, our inpatient segment comprised approximately 50.9%, 48.2%, 42.9%, and 40.9% of consolidated net operating revenues. For 2000 through 2003, this segment’s operating results were as follows:

 

     For the year ended December 31,

     2003

   2002

   2001

   2000

               (Restated)    (Restated)
     (in thousands)

Inpatient

      

Net operating revenues

   $ 2,016,168    $ 1,907,342    $ 1,522,872    $ 1,432,481

Operating expenses*

     1,573,159      1,558,619      1,396,232      1,427,082
    

  

  

  

Operating earnings

   $ 443,009    $ 348,723    $ 126,640    $ 5,399
    

  

  

  

Discharges

     120      118      115      119

Outpatient visits

     2,342      2,538      2,678      2,592
     (not in thousands)

Full time equivalents

     19,636      19,291      18,661      17,904

Average length of stay

     16.2 days      16.6 days      17.5 days      17.4 days

* Excludes corporate overhead allocation. See Note 24, Segment Reporting, to our accompanying consolidated financial statements. Includes the effect of minority interests in earnings of consolidated affiliates and equity in net income of nonconsolidated affiliates.

 

During 2003, 2002, 2001, and 2000, inpatient’s net operating revenues were derived from the following payor sources:

 

     For the year ended December 31,

 
     2003

    2002

    2001

    2000

 
                 (Restated)     (Restated)  

Medicare

   70.6 %   64.0 %   56.4 %   53.4 %

Medicaid

   2.3 %   3.0 %   3.3 %   3.6 %

Workers’ compensation

   3.8 %   4.4 %   5.7 %   5.7 %

Managed care and other discount plans

   14.4 %   17.1 %   20.1 %   20.9 %

Other third party payors

   6.3 %   8.6 %   10.4 %   11.3 %

Other income

   2.6 %   2.9 %   4.1 %   5.1 %
    

 

 

 

Total

   100.0 %   100.0 %   100.0 %   100.0 %
    

 

 

 

 

Our inpatient segment’s payor mix is weighted heavily towards Medicare. Prior to 2002, our freestanding and hospital-based IRFs received cost-based reimbursement from Medicare. Under the cost reimbursement system, each IRF determined its costs related to Medicare patients, based on Medicare’s definition of allowable costs and the percentage of Medicare business, and filed for reimbursement of those costs from Medicare. Effective January 1, 2002, this cost-based methodology was replaced with a Prospective Payment System (“PPS”) for our IRFs. Under IRF-PPS, our IRFs receive fixed payment amounts per discharge based on certain rehabilitation impairment categories established by the Department of Health and Human Services. With PPS, our facilities retain the difference, if any, between its fixed payment from Medicare and its operating costs. Thus, our facilities are rewarded for being high quality, low cost providers. During 2003, the segment operated seven LTCHs that converted to LTCH-PPS and began receiving fixed payment amounts per discharge based on diagnosis-related groups determined by the Department of Health and Human Services. For additional information regarding Medicare reimbursement, please see the “Sources of Revenue” section of Item 1, Business, of this annual report.

 

From 2000 to 2003, the portion of our inpatient segment’s net operating revenues attributable to Medicare has grown. This was due in part to the change from cost-based reimbursement to IRF-PPS, which increased our

 

76


Table of Contents
Index to Financial Statements

Medicare reimbursement. In addition, many of the health conditions treated at our inpatient facilities are associated with aging, and increased marketing efforts have focused on these areas, such as the stroke campaign which began in 2002. As a result, new business has come from Medicare patients. Furthermore, we now have 9 LTCHs in operation. These LTCHs provide specialized acute care for medically complex patients who are critically ill with multi-system complications and/or failures and require long hospitalizations. The majority of these patients are covered by the Medicare program since Medicare utilization in an LTCH can exceed 90%.

 

Due to the significance of Medicare payments to our inpatient facilities, the number of patient discharges is a key metric utilized by the segment to monitor and evaluate its performance. The number of outpatient visits is also tracked in order to measure the volume of outpatient activity within the segment. The segment’s primary operating expenses include salaries and benefits and supplies. Salaries and benefits represents the most significant cost to the segment and includes all amounts paid to full- and part-time employees, including all related costs of benefits provided to employees. It also includes amounts paid for contract labor. Supply costs include all expenses associated with supplies used while providing patient care. These costs include pharmaceuticals, needles, bandages, food, and other similar items.

 

75% Rule

 

On May 7, 2004, CMS issued a final rule that stipulates revised Medicare classification criteria that a facility is required to meet to be considered an IRF by Medicare. The revised 75% Rule, which became effective July 1, 2004, is discussed in more detail in Item 1, Business, “Sources of Revenue.” The revised 75% Rule generally provides that to be considered an IRF, and to receive reimbursement for services under the IRF-PPS methodology, 75% of a facility’s total patient population must require intensive rehabilitation services associated with treatment of at least one of 13 designated medical conditions. The revised 75% Rule will be phased in over a period that began on July 1, 2004, at a 50% level, and will end (i.e., full compliance will be required) for cost reporting periods beginning on or after July 1, 2007.

 

Our inpatient division has begun to deny admissions of certain types of patients at several locations in an attempt to ensure compliance with the revised 75% Rule. We project this reduction in census, unless mitigated, will have a materially adverse impact on the inpatient segment’s revenues. We previously estimated that the revised 75% Rule could negatively impact our net operating revenues by $95 million to $100 million in 2005. Our inpatient division is taking steps to mitigate the impact of the revised 75% Rule, and we previously estimated the impact to our net operating revenues to be approximately $50 million to $55 million when our mitigation strategies are taken into consideration. In the second quarter of 2005, as many of our facilities approach the end of their cost reporting years, we have seen a greater than anticipated decline in inpatient volumes, a significant portion of which is attributable to the revised 75% Rule. Accordingly, the financial impact estimated could be greater than previously disclosed. Our mitigation strategy is discussed in Item 1, Business, “Operating Divisions—Inpatient”. We are also participating with the rest of the industry to help educate various governmental agencies and policy makers about the efficacy of inpatient rehabilitative care.

 

Net Operating Revenues

 

In 2003, our inpatient segment yielded an approximate 5.7% increase in net operating revenues due to higher net revenue per discharge, or improvement in our reimbursement per case, as well as a 1.7% increase in discharges. The increase in net operating revenues per discharge is due primarily to the increase in the segment’s Case Mix Index (“CMI”). An increase in CMI indicates that our patients have a higher acuity. For Medicare, which approximated 70.6% of inpatient’s 2003 net operating revenues, the result of an increase in CMI is an increased payment to the segment. In addition, a market basket adjustment of 3.0% was received from Medicare in October 2003. A market basket adjustment is made to Medicare rates by the Department of Health and Human Services to provide an economic adjustment that is often passed on to providers. The increased reimbursements were offset by a 7.7% decrease in outpatient visits. The decrease in outpatient net operating revenue occurred as a result of a clarification in Medicare outpatient billing regulations that resulted in more therapy being provided

 

77


Table of Contents
Index to Financial Statements

in group settings verses individual sessions. Competition from physicians offering physical therapy within their own offices also contributed to the decrease in outpatient visits in 2003.

 

The most significant increase in net operating revenues came in 2002 when inpatient converted to IRF-PPS. Approximately 90% of the increase in net operating revenues from 2001 to 2002 is due to higher average net revenue per discharge in 2002. The improvement per discharge is primarily due to the conversion from the Medicare cost reimbursement system to the Medicare IRF-PPS reimbursement system, as discussed above. The remaining 10% of the increase in net operating revenues is due to a 2.6% increase in the number of discharges year over year combined with a 5.2% decrease in outpatient visits.

 

In 2001, net operating revenues increased by 6.3%. Year over year, the net revenue per discharge increased due to an increase in the average length of stay from 17.4 days in 2000 to 17.5 days in 2001 as well as an increase in outpatient visits of 3.3%. This increase in net revenue was offset by a 3.4% decrease in the number of discharges from 2000 to 2001.

 

Operating Expenses

 

LOGO

 

Salaries and Benefits

 

Salaries and benefits comprised over 51% of inpatient’s operating expenses in each year.

 

Salaries and benefits increased by $57.1 million, or 6.7%, from 2002 to 2003. Approximately $41.7 million of the increased costs associated with salaries and benefits are due to annual merit increases and significant increases in group medical expenses and workers’ compensation costs. From 2002 to 2003, the segment experienced an approximate 4.8% increase in benefit costs. The remainder of the increase in salaries and benefits is due to an increase in full-time equivalents of 345. This increase in full time equivalents is primarily the result of increased patient acuity and the net increase of 2 facilities during 2003.

 

From 2001 to 2002, salaries and benefits increased by $57.7 million, or 7.2%. Approximately 47% of this increase is due to a 630 person, or 3.4%, increase in full time equivalents, year-over-year. This increase is the result of increased volumes and the opening of three new facilities in 2002. Annual merit increases, rising group medical costs, and increased workers’ compensation costs contributed to the remaining 53% of the increase.

 

78


Table of Contents
Index to Financial Statements

Salaries and benefits increased by $57.0 million, or 7.7%, from 2000 to 2001. The increase in salaries and benefits is attributable to a 757, or 4.2%, increase in full time equivalents and annual merit increases of approximately 3.3% coupled with significant increases in group medical expenses and workers’ compensation costs. Year over year, the increase in full time equivalents, due primarily to the opening of four new facilities in 2001, accounted for approximately 55% of the increased expenses, while increased costs for salaries and benefits accounted for the remaining 45%.

 

Supplies

 

From 2002 to 2003, supplies expense increased by $5.8 million, or 5.6%. This increase is due to the increased CMI, as discussed above, as a higher acuity correlates to a higher cost patient, especially in drug expenses. Supplies expense increased by $4.3 million, or 4.3%, from 2001 to 2002. This increase is primarily due to the opening of three new facilities during 2002 and the initial purchase of supplies required to open these facilities. Supplies expense increased by $8.4 million, or 9.3%, from 2000 to 2001. This increase is due primarily to rising drug and medical supply costs.

 

Provision for Doubtful Accounts

 

Our inpatient segment’s provision for doubtful accounts has decreased from 3.4% of net operating revenues in 2000 to 1.6% of net operating revenues in 2003. In years subsequent to 2000, our inpatient segment was able to decrease its provision for doubtful accounts as a percent of net operating revenues through significant improvements in collections precipitated by consistent application of policies around the identification, pursuit, and recording of bad debts during the year. This decrease in the provision for doubtful accounts is also attributable to the increase in the percent of our net operating revenues from Medicare, as bad debts have not historically been associated with Medicare as a payor.

 

All Other Operating Expenses

 

From 2002 to 2003, all other operating expenses decreased by 6.2%. These expenses decreased as a result of no Medicare Program Settlement recorded in 2003 and a $21.8 million net gain on asset disposals recorded during the year. The net gain on asset disposals was primarily the result of the sale of our inpatient facility in Reno, Nevada. These decreases were offset by increased operating expenses associated with the higher acuity patients serviced in 2003, the net increase of two facilities during the year, and increased insurance costs. Higher acuity patients utilize more therapeutic and diagnostic services, such as dialysis and MRIs, which increases our costs.

 

From 2001 to 2002, all other operating expenses increased by 17.8%. This increase is primarily the result of the Medicare Program Settlement. As a result of the Medicare Program Settlement, as discussed in more detail in Note 21, Medicare Program Settlement, to our accompanying consolidated financial statements, and in this Item, “Consolidated Results of Operations,” our inpatient segment recorded a charge of $194.0 million during 2002 as Government and class action settlements expense.

 

During 2002, we also incurred certain impairment charges. We examined all of our facilities for impairment as of December 31, 2002, as a result of both continuing losses at certain facilities and the substantial decline in our stock price during the last six months of 2002. Based on this review, we recorded an impairment charge of approximately $5.5 million in 2002 to reduce the carrying value of amortizable intangibles of certain facilities to their estimated fair market value. We also recorded an impairment charge of $2.5 million to reduce the carrying value of long-lived assets of certain facilities to their estimated fair market value. We determined the fair value of these impaired assets based on the discounted future cash flows of these facilities using an average weighted average discount rate of 10.5%.

 

These increases in operating expenses in 2002 were offset by an approximate 30% decrease in depreciation and amortization due to our adoption of FASB Statement No. 142 on January 1, 2002. Under FASB Statement

 

79


Table of Contents
Index to Financial Statements

No. 142, we no longer amortize goodwill. It should also be noted that our inpatient segment recorded a net loss on disposal of assets of approximately $40.5 million in 2002, relating primarily to the sale of Wentworth Nursing Home.

 

From 2000 to 2001, all other operating expenses decreased by 14.0%. During 2001, our minority interests in earnings of consolidated affiliates decreased due to the start up of three new partnership facilities and a decline in business due to competitive pressures at two other partnership locations. Operating expenses also decreased as a result of the reduction in discharges in 2001.

 

Inpatient’s operating expenses in 2001 also includes a net loss of $41.2 million related primarily to the sale of the four Meadowbrook facilities, as discussed in more detail in Note 7, Property and Equipment, to our accompanying consolidated financial statements. The sale of the Meadowbrook facilities resulted in a loss on asset disposals of approximately $37.4 million. In 2000, inpatient recorded a net loss on asset disposals of approximately $0.5 million.

 

Operating Earnings

 

Operating earnings increased from 2002 to 2003, as inpatient volumes remained strong as the segment focused on expense management and billing and collection practices. The increase in operating earnings from 2001 to 2002 is due to the favorable impact of IRF-PPS, as our facilities were rewarded for being efficient service providers, offset by the allocation of the Medicare Program Settlement to our inpatient segment. The increase in operating earnings from 2000 to 2001 is due to the impact of more outpatient volume combined with a Medicare cost reimbursement methodology that ensures payments increase with an increasing cost base.

 

Surgery Centers

 

We operate the largest network of ambulatory surgery centers (“ASCs”) in the United States. As of December 31, 2004, we provided these services through the operation of our network of approximately 177 freestanding ASCs and 3 surgical hospitals in 36 states, with a concentration of centers in California, Texas, Florida, North Carolina, and Pennsylvania.

 

Our surgery centers provide the facilities and medical support staff necessary for physicians to perform non-emergency surgical procedures in more than a dozen specialties, such as orthopedic, GI, ophthalmology, plastic, and general surgery. For 2000 through 2003, this segment’s operating results were as follows:

 

     For the year ended December 31,

     2003

    2002

   2001

   2000

                (Restated)    (Restated)
     (in thousands)

Surgery Centers

      

Net operating revenues

   $ 920,079     $ 926,407    $ 866,854    $ 817,072

Operating expenses*

     983,283       825,971      785,686      813,666
    


 

  

  

Operating (loss) earnings

   $ (63,204 )   $ 100,436    $ 81,168    $ 3,406
    


 

  

  

Cases

     783       806      784      760
     (not in thousands)

Full time equivalents

     5,242       5,230      5,026      4,866

* Excludes corporate overhead allocation. See Note 24, Segment Reporting, to our accompanying consolidated financial statements. Includes the effect of minority interests in earnings of consolidated affiliates and equity in net income of nonconsolidated affiliates.

 

 

80


Table of Contents
Index to Financial Statements

During the years ended December 31, 2003, 2002, 2001, and 2000, our surgery centers segment derived its net operating revenues from the following payor sources:

 

     For the year ended December 31,

 
     2003

    2002

    2001

    2000

 
                 (Restated)     (Restated)  

Medicare

   16.3 %   16.4 %   16.1 %   16.7 %

Medicaid

   2.4 %   2.4 %   2.2 %   2.2 %

Workers’ compensation

   12.3 %   13.0 %   12.7 %   12.3 %

Managed care and other discount plans

   51.6 %   52.7 %   47.5 %   45.9 %

Other third party payors

   15.4 %   13.6 %   18.6 %   20.9 %

Other income

   2.0 %   1.9 %   2.9 %   2.0 %
    

 

 

 

Total

   100.0 %   100.0 %   100.0 %   100.0 %
    

 

 

 

 

The increase in the percent of our net operating revenues from managed care and other discount plans is the result of a macro trend towards greater penetration of managed care in most large urban markets, which is where most of our ASCs are located. This trend is shifting payors from the other third party payors category into managed care and other discount plans.

 

The number of cases handled by our centers is a key metric utilized by the segment to regularly evaluate its performance. The segment’s primary operating expenses include salaries and benefits and supplies. Salaries and benefits represents the most significant cost to the segment and includes all amounts paid to full- and part-time employees at our centers, as well as all related costs of benefits provided to employees. Supply costs include all expenses associated with medical supplies used while providing patient care at our centers. Such costs include sterile disposables, pharmaceuticals, implants, and other similar items.

 

Like most other ASCs, the majority of our centers are owned in partnership with surgeons and other physicians who perform procedures at the centers. As existing physician partners retire or change geographic location, it is important that the surgery segment periodically provide other physicians with opportunities to purchase ownership interests in our ASCs in order to maintain or increase case volumes and net operating revenues. Our ability to resyndicate our partnerships is a key success factor for our surgery centers’ segment.

 

Our surgery centers segment’s net operating revenues grew from 2000 to 2002, and remained relatively flat from 2002 to 2003. However, as noted earlier in this Item, we believe the segment’s revenue performance is due in large part to overall growth in the industry rather than solid execution. Since March 2003, the division has struggled due in large part to an inability to efficiently resyndicate its partnership portfolio and its inability to control costs.

 

Net Operating Revenues

 

From 2002 to 2003, the number of cases handled by our surgery centers declined by 2.9%. This decrease in cases contributed to an approximate $26.2 million decrease in net operating revenues. However, the segment was able to achieve increased pricing on its services to almost offset the negative impact on net operating revenues year over year. The majority of the case decline occurred during the last six months of 2003. Management attributes the decline to its inability to resyndicate its partnership interest in each center and the negative publicity HealthSouth received as a result of the events of March 19, 2003. Because of our inability to report financial information during 2003, there was no resyndication activity during 2003.

 

Our surgery centers performed approximately 22,000 more cases in 2002 than 2001. This increase in cases yielded an approximate $23.5 million in additional net operating revenues during 2002. Volumes increased in 2002 due to more specialty services provided by our centers during the year, including ENT (ears, nose, and

 

81


Table of Contents
Index to Financial Statements

throat), gastro, pain management, orthopedic, and podiatry. The volume increase is in spite of the closure of 12 facilities that negatively impacted net operating revenues by approximately $24.1 million in 2002. The segment was also able to achieve increased pricing on most services during 2002, which generated approximately $38.9 million in additional net operating revenues during the year.

 

The number of cases handled by our surgery centers increased by approximately 3.2% from 2000 to 2001. This increase in cases contributed approximately $26.3 million in additional revenues during 2001. This volume increase and the related revenues are in spite of the closure of 11 facilities during 2001 that negatively impacted revenues by approximately $13.4 million. Our surgery centers also experienced a change in mix during 2001 to slightly more orthopedic cases, which carry a higher net operating revenue per case than other services. This shift in case mix combined with pricing increases across all services generated approximately $19.7 million in additional net operating revenues during 2001.

 

Operating Expenses

 

LOGO

 

Salaries and Benefits

 

In each year, salaries and benefits represents over 28% of our surgery centers segment’s operating expenses. From 2000 through 2003, the rising cost of benefits provided to employees caused the segment to experience increased salaries and benefits expense.

 

During 2003, salaries and benefits increased by $10.9 million, or 3.9%. Approximately 94% of this increase is due to annual merit increases coupled with increased costs associated with employee medical benefits. The remainder is due to the addition of 12 full time equivalents in 2003.

 

Salaries and benefits increased by $29.8 million, or 11.9% from 2001 to 2002. The number of full time equivalents increased by 204 as the number of cases handled by our centers increased. This increase in full time equivalents contributed approximately $10.1 million to the increased salaries and benefits. Annual merit increases, increased use of contract labor, and rising costs associated with benefits provided to employees contributed to the remainder of the increase.

 

From 2000 to 2001, salaries and benefits increased by $20.1 million, or 8.8%. Approximately $7.6 million of this increase is due to an increase of 160 full-time equivalents due to the increased volumes experienced by

 

82


Table of Contents
Index to Financial Statements

our ASCs during 2001. Annual merit increases and rising costs associated with benefits provided to employees contributed approximately $12.5 million to the increased expenses.

 

Supplies

 

Supplies represents over 20% of our surgery centers segment’s operating expenses in each year, making it important for our ASCs to appropriately manage and monitor these costs. However, these costs were not appropriately managed after the events of March 19, 2003. Many of our facilities purchased excess levels of supplies in fear of a cash shortage by HealthSouth or in an effort to maintain relationships with certain vendors. As a result of these actions and other unfavorable vendor terms, supplies expense increased by $8.3 million, or 4.2%, in 2003.

 

Supply costs increased by $16.1 million, or 8.9%, from 2001 to 2002. Approximately 31% of this increase is due to the increased volumes experienced during 2002. The remainder of the increase is due to price increases on certain supplies, such as implants and prosthetics.

 

From 2000 to 2001, supply costs increased by $11.8 million, or 7.0%. Almost half of this increase is the result of over 24,000 more cases performed during 2001. The remainder of the increase in supplies expense primarily relates to the mix of cases during 2001 compared to 2000. During 2001, we had an increase in the number of orthopedic cases, which normally carry a higher supply cost due to the implants and prosthetics used in these cases.

 

Provision for Doubtful Accounts

 

From 2000 through 2003, the provision for doubtful accounts of our surgery centers segment consistently remained between 3.0% and 4.0% of net operating revenues.

 

All Other Operating Expenses

 

All other operating expenses increased by 44.7% from 2002 to 2003. This increase is due to the $176.2 million goodwill impairment charge recorded by the surgery centers segment in 2003. We performed an impairment review as required by FASB Statement No. 142 as of October 1, 2003 and concluded that a potential goodwill impairment existed in our surgery centers operating segment. The amount of the impairment, which was determined by calculating the implied fair value of goodwill, primarily recognizes the decline in the expected future operating performance of our surgery centers.

 

The impairment charge was offset by decreased discretionary spending during 2003, as a result of the events of March 19, 2003, for items such as travel, meetings, entertainment, charitable donations, and event sponsorships. The segment also cancelled a contract for e-procurement at the end of 2002 that reduced 2003’s operating expenses by $4.9 million.

 

From 2001 to 2002, all other operating expenses decreased by 3.0%. This decrease is due primarily to our adoption of FASB Statement No. 142 on January 1, 2002, which requires the cessation of goodwill amortization. Our adoption of FASB Statement No. 142 decreased amortization expense by $43.5 million.

 

The decrease in amortization expense was offset by impairment charges in 2002. As of December 31, 2002, we examined all of our facilities for impairment, as both continuing losses at certain facilities and the substantial decline in our stock price during the last six months of 2002 indicated that numerous triggering events had occurred. Based on this review, we recorded an impairment charge of approximately $6.2 million to reduce the carrying value of amortizable intangibles to their estimated fair market value and an impairment charge of approximately $31.8 million to reduce the carrying value of certain long-lived assets to their estimated fair market value. We determined fair market value using discounted future cash flows and a weighted average discount rate of 10.5%.

 

83


Table of Contents
Index to Financial Statements

From 2000 to 2001, all other operating expenses decreased by 16.7%. This decrease is primarily the result of a decrease in the net loss on asset disposals recorded in each year. During 2001, our surgery centers segment recorded an approximate $8.9 million net loss on the disposal of various assets, with the largest component of the net loss related to assets of our Greensboro, North Carolina facility. During 2000, a $34.5 million net loss on asset disposals was recorded by the surgery centers segment primarily due to the sale of assets associated with ASCs located in Illinois, Nevada, and Texas.

 

All other operating expenses also decreased in 2001 due to no impairment charges recorded during the year. During 2000, triggering events related to facility closings and facilities experiencing negative cash flow from operations resulted in our surgery centers segment recognizing impairment charges of $2.7 million on long-lived assets.

 

Operating Earnings

 

As noted earlier in this Item, our surgery centers were able to maintain their net operating revenues in 2003, but struggled due in large part to an inability to resyndicate its partnership portfolio and control costs. During 2003, the segment also recorded an impairment charge of $176.2 million related to goodwill. These issues can be seen in the decline in operating earnings from 2002 to 2003.

 

Increased volumes and pricing drove the increase in operating earnings from 2001 to 2002. Likewise, from 2000 to 2001, our surgery centers also experienced increased volumes and pricing, as well as an improved case mix, which resulted in an increase in operating earnings in 2001.

 

Outpatient

 

We are the largest operator of outpatient rehabilitation facilities in the United States. As of December 31, 2004, we provided outpatient rehabilitative health care services through approximately 765 HealthSouth facilities and 39 facilities managed under contract by us. We have locations in 44 states, with a concentration of centers in Florida, Texas, New Jersey, New York, and Missouri.

 

Our outpatient rehabilitation facilities are staffed by physical therapists, occupational therapists, and other clinicians and support personnel, depending on the services provided at a particular location, and we are open at hours designed to accommodate the needs of the patient population being served and the local demand for services. Our outpatient centers offer a range of rehabilitative health care services, including physical therapy and occupational therapy, with a particular focus on orthopedic, sports-related, work-related, hand and spine injuries, and various neurological/neuromuscular conditions.

 

For 2000 through 2003, this segment’s operating results were as follows:

 

     For the year ended December 31,

     2003

    2002

   2001

   2000

                (Restated)    (Restated)
     (in thousands)

Outpatient

      

Net operating revenues

   $ 586,988     $ 663,589    $ 691,800    $ 689,757

Operating expenses*

     637,522       644,427      607,504      652,895
    


 

  

  

Operating (loss) earnings

   $ (50,534 )   $ 19,162    $ 84,296    $ 36,862
    


 

  

  

Visits

     5,861       7,109      7,565      7,584
     (not in thousands)

Full time equivalents

     6,286       7,392      7,513      7,667

* Excludes corporate overhead allocation. See Note 24, Segment Reporting, to our accompanying consolidated financial statements. Includes the effect of minority interests in earnings of consolidated affiliates and equity in net income of nonconsolidated affiliates.

 

84


Table of Contents
Index to Financial Statements

For the years ended December 31, 2003, 2002, 2001, and 2000, outpatient’s net operating revenues were derived from the following payor sources:

 

     For the year ended December 31,

 
     2003

    2002

    2001

    2000

 
                 (Restated)     (Restated)  

Medicare

   9.5 %   8.2 %   7.6 %   6.7 %

Medicaid

   1.0 %   1.0 %   1.1 %   1.2 %

Workers’ compensation

   26.7 %   27.5 %   27.4 %   28.6 %

Managed care and other discount plans

   45.3 %   43.5 %   42.3 %   40.6 %

Other third party payors

   9.6 %   11.3 %   12.1 %   13.0 %

Other income

   7.9 %   8.5 %   9.5 %   9.9 %
    

 

 

 

Total

   100.0 %   100.0 %   100.0 %   100.0 %
    

 

 

 

 

The number of visits patients make to our centers is a key metric utilized by the segment to regularly evaluate its performance. Outpatient’s net operating revenues include revenues from patient visits, as well as revenues generated from trainers and management contracts. Outpatient has contracts with schools, municipalities, and other parties around the country to provide physical therapists and/or athletic trainers for various events. Outpatient also receives management and administrative fees for facilities it manages, but does not own. Trainer income, management fees, and administrative fees comprise the majority of the segment’s other income.

 

The segment’s most significant operating expense is salaries and benefits, which includes all amounts paid to full- and part-time employees at our centers, as well as all related costs of benefits provided to employees. Due to the nature of the services provided by our outpatient centers, supplies expense does not represent a significant portion of the segment’s operating expenses, unlike our other business segments.

 

Our outpatient segment participates in a slower growing, lower margin business. Due to regulatory changes, physicians that once referred business to us are now treating patients at their own facilities. Due to the relatively low barriers to entry associated with an outpatient facility, our outpatient segment continues to face increased competition from physician-owned physical therapy sites.

 

Net Operating Revenues

 

Net operating revenues have declined since 2001.

 

From 2002 to 2003, the number of patient visits to our facilities declined by 17.6%. This decreased volume negatively impacted net operating revenues in 2003 by $107.4 million. Management attributes the volume decline to increased competition from physician- owned physical therapy sites, expiration of non-compete agreements from prior acquisitions, and the negative publicity HealthSouth received after the events of March 19, 2003. The volume impact of these factors resulted in the net closure of 135 facilities during 2003, which accounted for approximately $18.8 million of the total volume decrease of $107.4 million. The remaining $88.6 million of the volume decrease represents the impact of the above factors on our facilities that remained open. During 2003, non-patient revenues, including trainer income and management fee income, also decreased by $7.5 million due to facility closures and contract terminations during the year.

 

Although volumes decreased in 2003, the outpatient segment was able to achieve a higher net patient revenue per visit, increasing this metric by $7 per visit and yielding approximately $38.4 million in additional net operating revenues during 2003. The increase per visit is due to the segment’s examination and elimination of managed care contracts with low reimbursement rates, a price increase on most services, and the segment’s clinical focus on more manual therapy services that result in higher net revenues per visit.

 

 

85


Table of Contents
Index to Financial Statements

From 2001 to 2002, patient visits to our facilities decreased by 6.0% and was the primary factor in the 4.1% decrease in net operating revenues year over year. As competition from physician-owned physical therapy sites increased, we experienced declining volumes that resulted in the net closure of 100 facilities in 2002. During 2002, non-patient revenues, including trainer income and management fee income, decreased by $6.1 million due to facility closures and contract terminations during the year.

 

From 2000 to 2001, net operating revenues increased by less than 1%, with the number of patient visits to our facilities decreasing by 19,000 visits. The decreased volumes negatively impacted net operating revenues by approximately $1.6 million in 2001. However, the decrease in volume was offset by the positive impact of price increases during 2002, which resulted in a $6.7 million increase in net operating revenues. During 2001, non-patient revenues, including trainer income and management fee income, decreased by $3.1 million due to facility closures and contract terminations during the year.

 

Operating Expenses

 

LOGO

 

Salaries and Benefits

 

Salaries and benefits represent over 47% of outpatient’s operating expenses in each year.

 

From 2000 through 2003, the most significant change in salaries and benefits occurred from 2002 to 2003, when these expenses decreased by $48.1 million, or 13.6%. The majority of this decrease is due to the closure of facilities in 2003, as described above, that resulted in a 1,106 decrease in full time equivalents year-over-year. This decrease in full time equivalents decreased salaries and benefits by approximately $52.9 million. Decreased costs associated with fewer full time equivalents was offset by increasing costs associated with employee benefits.

 

Salaries and benefits increased by $3.0 million, or 0.9%, from 2001 to 2002. During 2002, full time equivalents decreased by 121 due to facility closures during the year. This decrease in full time equivalents resulted in an approximate $5.7 million decrease in salaries and benefits. However, this decrease was offset by an overall increase in the average salary per full time equivalent. During 2002, the segment experienced a change in employee mix, as our outpatient facilities changed the personnel skill mix to one more heavily weighted towards higher-paid personnel, which are typically clinically oriented.

 

 

86


Table of Contents
Index to Financial Statements

From 2000 to 2001, salaries and benefits decreased by $10.0 million, or 2.8%, primarily as a result of a reduction of 154 full time equivalents during 2001 as a result of the net closure of 70 facilities.

 

Provision for Doubtful Accounts

 

The provision for doubtful accounts decreased from 8.2% of net operating revenues in 2000 to 2.8% of net operating revenues in 2003. From 2000 to 2001, the provision for doubtful accounts decreased by $22.7 million from 8.2% of net operating revenues to 4.9% of net operating revenues, respectively. Management attributes this improvement to better collection efforts by outpatient’s operations department on collecting past due accounts in 2001, as well as the closure of underperforming facilities during the year. During 2002, the provision for doubtful accounts decreased by $19.6 million as the segment increased resources to focus on collections greater than 120 days old. In 2003, the provision for doubtful accounts increased by $2.3 million due primarily to bad debts associated with nonconsolidated affiliates with whom we have management contracts.

 

All Other Operating Expenses

 

From 2002 to 2003, all other operating expenses increased by 14.1% due primarily to impairment charges recorded during 2003. As a result of the events of March 19, 2003, we performed an impairment review, as required by FASB Statement No. 142, and concluded that a potential goodwill impairment existed in the outpatient operating segment. We calculated the implied fair value of the outpatient segment’s goodwill and determined that the outpatient segment’s goodwill was impaired by $135.9 million. Our outpatient segment also recorded a $4.1 million impairment charge related to long-lived assets in 2003. Increased operating expenses due to impairment charges were offset slightly by a decrease in depreciation and amortization expense due to the net closure of 135 facilities and the expiration of numerous noncompete agreements in 2003.

 

From 2001 to 2002, all other operating expenses increased by 24.0%. This increase is primarily the result of the Medicare Program Settlement recorded in 2002. As a result of the Medicare Program Settlement, as discussed in more detail in Note 21, Medicare Program Settlement, to our accompanying consolidated financial statements, and in this Item, “Consolidated Results of Operations,” our outpatient segment recorded a charge of $96.5 million during 2002 as Government and class action settlements expense.

 

During 2002, our outpatient segment also recorded $16.7 million in impairment charges. As of December 31, 2002, we examined all of our facilities for impairment, as both continuing losses at certain facilities and the substantial decline in our stock price during the last six months of 2002 indicated that numerous triggering events had occurred. Based on this review, our outpatient segment recorded an impairment charge of $4.7 million during 2002 to reduce the carrying value of amortizable intangibles of certain facilities to their estimated fair market value. This segment also recorded a 2002 impairment charge of $12.0 million to reduce the carrying value of certain long-lived assets of certain facilities to their estimated fair market value.

 

The above increases in operating expenses in 2002 were offset by a 49.9% decrease in depreciation and amortization expense. Depreciation and amortization expense decreased from 2001 to 2002, as effective January 1, 2002, we adopted FASB Statement No. 142 and ceased amortizing goodwill at that time. The adoption of FASB Statement No. 142 accounts for approximately 77% of the decrease in depreciation and amortization expense year over year. The remaining 23% of the decrease is due to the disposal of assets during 2002 related to facility closures.

 

From 2000 to 2001, all other operating expenses decreased by 5.4%. This decrease is primarily the result of the net loss on asset disposals recorded in each year. In 2001, outpatient recorded a net loss of $6.0 million on the disposal of assets, while in 2000, outpatient recorded a net loss from asset disposals of $30.4 million. In both years, the net loss recorded is the result of the disposal of numerous individually insignificant assets from facilities that were closed during the year. It should also be noted that impairment charges approximating $0.1 million and $0.7 million were recorded against certain long-lived assets in 2001 and 2000, respectively.

 

 

87


Table of Contents
Index to Financial Statements

Operating Earnings

 

Our outpatient segment experienced negative operating earnings in 2003 due primarily to the $135.9 million goodwill impairment charge recorded by the segment. Operating earnings were also negatively impacted due to the declining net operating revenues as a result of increased competition from physician-owned physical therapy sites, as well as the expiration of noncompete agreements from prior acquisitions and the negative publicity we received as a result of the events of March 19, 2003. This increased competition decreased our net operating revenues and forced us to close numerous underperforming facilities during the year.

 

During 2002, the segment was able to adjust its costs and close underperforming facilities when it began experiencing declining volumes during the year. However, the recording of the Medicare Program Settlement in 2002 negatively impacted the segment’s operating earnings by $96.5 million and resulted in the year over year decrease in operating earnings.

 

From 2000 to 2001, operating earnings increased due primarily to the operational improvements made by the segment in 2001 that reduced the provision for doubtful accounts, as discussed above, and the change in the net loss on disposal of assets year over year.

 

Diagnostic

 

We are the second largest operator of freestanding diagnostic imaging centers in the United States. As of December 31, 2004, we performed diagnostic services through the operation of our network of approximately 96 diagnostic centers in 26 states and the District of Columbia, with a concentration of centers in Texas, Washington, D.C., Alabama, Georgia, and Florida.

 

Our diagnostic centers provide outpatient diagnostic imaging services, including MRI services, CT services, X-ray services, ultrasound services, mammography services, nuclear medicine services and fluoroscopy. We do not provide all services at all sites, although approximately 75% of our diagnostic centers are multi-modality centers offering multiple types of service. Our outpatient diagnostic procedures are performed by experienced radiological technologists. After the diagnostic procedure is completed, the images are reviewed by radiologists who have contracted with us. These radiologists prepare an interpretation which is then delivered to the referring physician.

 

Due to the equipment utilized when performing diagnostic services for our patients, our diagnostic segment generally has high capital costs, including costs for maintaining its equipment.

 

For 2000 to 2003, our diagnostic segment’s operating results were as follows:

 

Diagnostic    For the year ended December 31,

 
   2003

    2002

    2001

   2000

 
               (Restated)    (Restated)  
   (in thousands)  

Net operating revenues

   $ 279,581     $ 305,914     $ 273,968    $ 250,298  

Operating expenses*

     319,761       346,204       219,938      253,333  
    


 


 

  


Operating (loss) earnings

   $ (40,180 )   $ (40,290 )   $ 54,030    $ (3,035 )
    


 


 

  


Scans

     892       1,053       1,049      903  
     (not in thousands)  

Full time equivalents

     1,414       1,579       1,569      1,402  

* Excludes corporate overhead allocation. See Note 24, Segment Reporting, to our accompanying consolidated financial statements. Includes the effect of minority interests in earnings of consolidated affiliates and equity in net income of nonconsolidated affiliates.

 

88


Table of Contents
Index to Financial Statements

For the years ended December 31, 2003, 2002, 2001, and 2000, diagnostic derived its net operating revenues from the following payor sources:

 

     For the year ended December 31,

 
     2003

    2002

    2001

    2000

 
                 (Restated)     (Restated)  

Medicare

   16.5 %   16.8 %   14.9 %   12.4 %

Medicaid

   2.7 %   2.2 %   1.8 %   2.1 %

Workers’ compensation

   7.6 %   10.1 %   11.9 %   12.5 %

Managed care and other discount plans

   63.4 %   56.9 %   42.9 %   39.2 %

Other third party payors

   8.6 %   12.5 %   26.1 %   31.2 %

Other income

   1.2 %   1.5 %   2.4 %   2.6 %
    

 

 

 

Total

   100.0 %   100.0 %   100.0 %   100.0 %
    

 

 

 

 

The increase in the percent of our net operating revenues from managed care and other discount plans is the result of a macro trend towards greater penetration of managed care in most large urban markets, which is where most of our diagnostic centers are located. This trend is shifting payors from the other third party payors category into managed care and other discount plans.

 

The number of scans performed is a key metric utilized by the segment to regularly evaluate its performance. The segment’s primary operating expenses include salaries and benefits, professional and medical director fees, and supplies. Salaries and benefits represents the most significant cost to the segment and includes all amounts paid to full- and part-time employees at our centers, as well as all related costs of benefits provided to employees. Professional and medical director fees primarily include fees paid under contracts with radiologists and other clinical professionals to read and interpret the scans performed at our centers. Payments under these contracts are normally tied to the number of scans read by each independent contractor, associated revenues with each scan, or cash collections. Supply costs include all expenses associated with supplies used while performing diagnostic services for our patients. These costs primarily consist of the film costs associated with each scan.

 

As noted earlier in this Item, our Diagnostic segment’s performance has been on a downward trend since 2001, due to poor margins for the diagnostic market in general and strong competition from physician-owned diagnostic service centers. We see competition only increasing as diagnostic equipment manufacturers lower costs and offer special financing to attract physician purchasers, resulting in a decline in the number of physician referrals sent to our diagnostic centers. However, over-utilization of diagnostic services may create a payor environment that is less attractive to physician-owned facilities.

 

Net Operating Revenues

 

Net operating revenues showed positive trends from 2000 through 2002, but declined by over 8% in 2003 due primarily to increased competition from physician-owned facilities coupled with the negative publicity surrounding HealthSouth after the events of March 19, 2003. From 2002 to 2003, the number of scans performed at our facilities decreased by 161,000 scans and resulted in an approximate $46.9 million negative impact to net operating revenues during 2003. The decrease in volume was offset by an improved payor mix and a relatively smaller decrease in volume in the higher paying modalities that together yielded an approximate $20.5 million increase in net operating revenues during 2003.

 

Approximately 4% of the increase in net operating revenues in 2002 was the result of increased volume, with 96% of the increase attributable to improved payor mix and a relatively greater increase in volume of the higher paying modalities.

 

In 2001, our diagnostic centers performed an additional 146,000 scans, resulting in an increase to net operating revenues of approximately $40.2 million. However, our average net operating revenue per scan

 

89


Table of Contents
Index to Financial Statements

decreased by 5.7% during the year, offsetting the volume increase by $16.6 million. The decline in net operating revenue per scan was the result of faster growth within the lower priced scan volumes, such as x-rays, that served to dilute the average net operating revenue per scan. While growth was achieved in all types of scans, the higher priced MRI and CT scans grew at a slower rate than all other volumes.

 

Operating Expenses

 

LOGO

 

Although not included in operating expenses of the segment, we recorded a charge of approximately $48.2 million to reduce the carrying value of goodwill as a result of our adoption of FASB Statement No. 142 on January 1, 2002. This charge is reported as a cumulative effect of an accounting change in our accompanying consolidated financial statements. This impairment recognizes the decline in the expected operating performance of the diagnostic segment between the dates the goodwill was recorded and our adoption of FASB Statement No. 142.

 

Salaries and Benefits

 

The declining volumes in 2003 forced management to reduce its full time equivalents by 165, including the net closure of 16 facilities, which resulted in a $6.7 million decrease in salaries and benefits. During 2002, the segment experienced an 8.9% increase in salaries and benefits due to a change in employee mix, as our diagnostic centers changed the personnel skill mix to one more heavily weighted towards higher-paid personnel, which are typically clinically oriented. Salaries and benefits increased by $5.9 million, or 9.7%, in 2001 due to an increase of 167 full time equivalents necessary to service the increased scan volume experienced during the year.

 

Supplies

 

The only significant change in supplies from 2000 through 2003 came in 2003 when supplies expense decreased by 16.8% in correlation with the decrease in volumes during the year. Although the segment’s volume increased significantly from 2000 to 2001, supplies expense remained relatively flat as the segment’s increased volume was relatively greater in the low-intensity scans that have a lower overall supply cost per scan.

 

Professional and Medical Director Fees

 

From 2000 through 2003, professional and medical director fees generally followed the same trend as our net operating revenues and cash collections. The most significant change in these fees came in 2002 when

 

90


Table of Contents
Index to Financial Statements

professional and medical director fees increased by $9.8 million, due primarily to the increase in net operating revenues, year over year.

 

Provision for Doubtful Accounts

 

Our diagnostic segment’s provision for doubtful accounts has grown from 4.9% of net operating revenues in 2001 to 16.8% of net operating revenues in 2003. The most significant dollar increase in the provision for doubtful accounts occurred from 2001 to 2002 when the provision increased by $20.4 million, or 151.5%. In 2003, the provision for doubtful accounts increased by $13.1 million, or 38.6%. These increases are primarily the result of a decline in operational efficiency within the segment as a result of a) outsourcing the diagnostic segment’s collection activities to a third party vendor (beginning March 2002), and b) the conversion of 44 of the segment’s clinics to a new patient accounting system which failed to meet expectations. The contract with the third-party vendor was terminated in April 2003, with ensuing litigation which was settled in November 2004. However, a dispute has arisen regarding the terms of the settlement agreement, making the matter the subject of ongoing litigation. The 44 clinics were taken off the new patient accounting system during the summer of 2003.

 

We are in the process of implementing new information systems to improve cash collections in our diagnostic segment.

 

All Other Operating Expenses

 

From 2002 to 2003, all other operating expenses decreased by 15.7%. This decrease is primarily the result of a decrease in impairment charges year over year. As a result of the events of March 19, 2003, we performed an impairment review as required by FASB Statement No. 142 and concluded a potential goodwill impairment existed in our diagnostic segment. We calculated the implied fair value of the diagnostic segment’s goodwill and determined that an impairment charge of $23.5 million was appropriate. After this impairment charge, there is no goodwill remaining on our diagnostic segment. In 2003, our diagnostic segment also recorded a $0.5 million impairment charge related to long-lived assets.

 

During 2002, we examined all of our facilities for impairment, as both continuing losses at certain facilities and the substantial decline in our stock price during the last six months of 2002 indicated that numerous triggering events had occurred. Based on this review, we recorded an impairment charge of approximately $5.7 million to reduce the carrying value of amortizable intangibles and an impairment charge of $49.0 million to reduce the carrying value of property and equipment of our diagnostic segment to their estimated fair market value. The fair market value for these impairments was based on the discounted future cash flows of this segment using an average weighted average discount rate of 10.5%.

 

From 2001 to 2002, all other operating expenses increased by 108%. This increase is primarily the result of the 2002 impairment charges discussed above. Our diagnostic segment also had increased operating expenses in 2002 due to fees associated with the outsourcing of accounts receivable collections activities in 2002, as discussed above. The segment also experienced increased occupancy costs, equipment rental and maintenance expense, and insurance expense during 2002.

 

All other operating expenses decreased by 27.4% from 2000 to 2001. This decrease is primarily attributable to the net loss on asset disposals recorded in each year. During 2001, our diagnostic segment recorded a net loss on asset disposals of approximately $12.3 million related to the disposal or closure of 23 facilities, including the regional business office in Nashville, Tennessee and the facilities in Indian River and Vero Beach, Florida, Chattanooga, Tennessee, and the United Kingdom. During 2000, the segment recorded a net loss on disposal of assets of approximately $20.2 million related to the closure of the regional business offices in Houston, Texas and Memphis, Tennessee. The remainder of the decrease is due to decreased costs associated with the net closure of 16 underperforming facilities in 2001, as well as a decrease in impairment charges recorded in 2001. In 2001 and 2000, triggering events related to facility closings and facilities experiencing negative cash flow from

 

91


Table of Contents
Index to Financial Statements

operations resulted in the recognition of impairment charges of $0.4 million and $6.2 million, respectively, for long-lived assets. We determined the fair value of the impaired assets at a facility primarily based on the discounted future cash flows of these facilities using an average weighted average discount rate of 10.5%.

 

Operating Earnings

 

Our diagnostic segment’s operating earnings have been negative in each year from 2000 to 2003, except in 2001. The improvement from 2000 to 2001 was directly related to the increased volume of lower intensity scans that allowed for increased net operating revenues with only minor increases in normal operational expenses. From 2001 to 2002, operating earnings decreased as the segment was unable to realize the increase in its net operating revenues due to increased operating expenses incurred during the year, as described above, especially as it relates to $54.7 million of asset impairment charges in 2002. In 2003, operating earnings continued its negative trend primarily as a result of decreased volumes and resulting decreased net operating revenues experienced during the year. Operating earnings in 2003 also includes $24.0 million of asset impairment charges.

 

We continue to focus on operational improvements to increase our margins and combat the effects of increased competition in this industry.

 

Corporate and Other

 

Corporate and other includes revenue-producing functions that are managed directly from our corporate office and that do not fall within one of the four operating segments discussed above, including our medical centers, other patient care services, and certain non-patient care services.

 

    Medical Centers. In 2001, we operated five acute care hospitals, four of which we owned and one of which we operated under a management contract. Between 2001 and December 31, 2004, we sold two hospitals, shut down the hospital we previously operated under a management contract (we took ownership of that hospital in 2002), and ceased providing acute care services at one hospital in favor of inpatient rehabilitation services. We are exploring a sale of our only remaining acute care hospital, which has 219 licensed beds and is located in Birmingham, Alabama, as well as our “Digital Hospital,” which is currently under construction in Birmingham, Alabama. As of December 31, 2004, we had invested $190 million in the Digital Hospital project and estimate it will require an additional $200 million to complete. We have not signed a definitive agreement with respect to either hospital and there can be no assurance any sale will take place. See Note 7, Property and Equipment, to our accompanying consolidated financial statements, for additional information about the Birmingham acute care hospital and the Digital Hospital, including a discussion of impairments relating to these facilities.

 

During 2003, 2002, 2001, and 2000, net operating revenues from our Medical Centers comprised 66.4%, 68.7%, 68.8%, and 61.9% of corporate and other’s net operating revenues. In the discussion that follows, the Richmond Medical Center, Metro West Hospital, the Digital Hospital, and Alabama Sports Medicine and Orthopedic Center are all part of this category.

 

    Other Patient Care Services. In some markets, we provide other limited patient care services, including operation of a gamma knife radiosurgery center and physician management services. The gamma knife treats conditions such as benign and malignant brain tumors, without any incision or physical entry into the brain. We evaluate market opportunities on a case-by-case basis in determining whether to provide additional services of these types. We may provide these services as a complement to our facility-based businesses or as stand-alone businesses.

 

During 2003, 2002, 2001, and 2000, net operating revenues from other patient care services comprised 4.2%, 2.4%, 12.2%, and 32.6% of corporate and other’s net operating revenues. The high percentage of net operating revenues from this category in 2000 stem from our occupational medicine facilities, which was sold in March 2001.

 

92


Table of Contents
Index to Financial Statements
    Non-Patient Care Services. We also provide certain services that do not involve the provision of patient care, including the operation of the conference center located at our corporate campus, operation of medical office buildings, various corporate marketing activities, our clinical research activities, and other services that are generally intended to complement our patient care activities. During 2003, 2002, 2001, and 2000, net operating revenues from non-patient care services comprised 29.4%, 28.9%, 19.0%, and 5.5% of corporate and other’s net operating revenues. The growth in this category’s net operating revenues is primarily due to earned premiums of HCS, Ltd. (“HCS”). HCS handles medical malpractice, workers’ compensation, and other claims for us. HCS is a wholly owned subsidiary of HealthSouth Corporation, and, as such, these earned premiums eliminate in consolidation.

 

    Corporate Functions. All our corporate departments and related overhead are contained within this segment. These departments, which include among others accounting, communications, compliance, human resources, information technology, internal audit, legal, payor strategies, reimbursement, tax, and treasury, provide support functions to our operating divisions.

 

For 2000 through 2003, this segment’s operating results were as follows:

 

     For the year ended December 31,

 
     2003

    2002

    2001

    2000

 
                 (Restated)     (Restated)  
     (in thousands)  

Corporate and Other

        

Net operating revenues

   $ 228,287     $ 215,866     $ 248,631     $ 333,829  

Operating expenses*

     741,493       813,775       475,771       496,360  
    


 


 


 


Operating loss

   $ (513,206 )   $ (597,909 )   $ (227,140 )   $ (162,531 )
    


 


 


 


     (not in thousands)  

Full time equivalents

     2,406       2,726       3,417       4,327  

* Corporate overhead is not allocated to our operating segments. Please see Note 24, Segment Reporting, to our accompanying consolidated financial statements. Includes the effect of minority interests in earnings of consolidated affiliates and equity in net income of nonconsolidated affiliates.

 

Corporate and other’s primary operating expenses include salaries and benefits and supplies. Salaries and benefits represents the most significant cost to the segment and includes all amounts paid to full- and part-time employees at our corporate headquarters (excluding any divisional management allocated to each operating segment) in Birmingham, Alabama and our medical centers, as well as all related costs of benefits provided to these employees. Supply costs include all expenses associated with supplies used by our medical centers when treating patients and food service and other supplies associated with the operations of our conference center. All general and administrative costs related to the operation of our corporate office are included in other operating expenses. The most significant general and administrative expenses relate to insurance including property and casualty, general liability, and directors and officers’ coverage.

 

Net Operating Revenues

 

The increase in net operating revenues from 2002 to 2003 is due to having a full year of revenues from Metro West, a hospital acquired in November 2002, offset by cancellation of certain physician contracts associated with Alabama Sports Medicine and Orthopedic Center due to relationships and conflicts of interests, as well as high costs associated with these contracts. An increase in earned premiums of HCS also contributed to the net operating revenue increase.

 

The sale of our occupational medicine facilities in March 2001 decreased 2002’s net operating revenues by approximately $24.4 million, while the sale of the Richmond Medical Center in June 2001 decreased 2002’s net operating revenues by $26.9 million. These decreases in revenue were offset by an increase in earned premiums of HCS.

 

93


Table of Contents
Index to Financial Statements

Similarly, the decrease in net operating revenues from 2000 to 2001 was also caused by the sale of our occupational medicine facilities and Richmond Medical Center. The sale of our occupational medicine facilities decreased 2001’s net operating revenues by $77.4 million, while the sale of the Richmond Medical Center decreased 2001’s net operating revenues by $32.7 million. These decreases were offset by an increase in earned premiums of HCS.

 

Operating Expenses

 

LOGO

 

Salaries and Benefits

 

From 2000 to 2003, full time equivalents within our corporate and other segment decreased by over 1,900 due to the divestiture of our occupational medicine facilities and Richmond Medical Center, as well as employee terminations at our corporate headquarters in 2003.

 

Salaries and benefits decreased by $41.5 million, or 22.4%, from 2002 to 2003. This decrease is due primarily to management and administrative terminations at our corporate headquarters during 2003 as a consequence of the events of March 19, 2003. Full time equivalents at our corporate headquarters decreased by 387 from 2002 to 2003. However, we incurred $70.6 million in professional fees associated with the reconstruction and restatement of our financial records in 2003, as discussed below.

 

From 2001 to 2002, salaries and benefits increased by $30.4 million, or 19.7%. With the sale of our occupational medicine facilities and Richmond Medical Center in 2001, our 2002 salaries and benefits decreased by approximately $20.2 million. However, these decreases in costs were offset by rising costs associated with workers’ compensation costs and group medical insurance, resulting in the net increase in salaries and benefits from 2001 to 2002.

 

Salaries and benefits decreased by $82.0 million, or 34.7%, from 2000 to 2001 due primarily to the sale of our occupational medicine facilities and the sale of the Richmond Medical Center in 2001.

 

Supplies

 

Supplies expense increased by $33.0 million, or 106.8%, from 2002 to 2003 due to the acquisition of Metro West hospital in November 2002 and the incurrence of a full year of its operating expenses during 2003. Supplies expense did not change significantly from 2001 to 2002. However, from 2000 to 2001, supplies expense

 

94


Table of Contents
Index to Financial Statements

decreased by $28.6 million, or 51.7%. This decrease is primarily due to the sale of our occupational medicine facilities and Richmond Medical Center in 2001.

 

All Other Operating Expenses

 

As noted earlier in this Item, we began funding Source Medical for the HCAP software development in 2001. Amounts given to Source Medical for software development approximated $11.8 million, $25.3 million, and $81.3 million in 2003, 2002, and 2001, respectively. These amounts are included in Other operating expenses in our accompanying consolidated financial statements. For more information regarding Source Medical, please see Note 9, Investment in and Advances to Nonconsolidated Affiliates, to our accompanying consolidated financial statements.

 

From 2002 to 2003, all other operating expenses had a net decrease of 10.7%. All other operating expenses in 2003 include the following items:

 

    Impairments. During 2003, the corporate and other segment recorded long-lived asset impairments of approximately $128.0 million. This impairment charge represents the excess of costs incurred during the construction of the Digital Hospital over the estimated fair market value of the property of $25 million, including the RiverPoint facility, which shares the construction site and would be included with any sale of the Digital Hospital. We based the fair value estimate on an appraisal that considered alternative uses for the property as of December 31, 2003. We have continued construction on the Digital Hospital and incurred additional costs of approximately $36 million in 2004, thereby increasing the value of the property. We have subsequently determined that the additional construction costs have increased the fair value of the property to $40.5 million at December 31, 2004. As a result, we will take an additional impairment charge in 2004 of approximately $20 million.

 

    Government and Class Action Settlements. As noted above in “Consolidated Results of Operations,” we recorded a charge of $170.9 in our corporate and other segment in 2003 due to our settlement with the SEC and estimated settlements related to other government and class action litigation, including estimated legal fees associated with these activities.

 

    Professional Fees—Reconstruction and Restatement. As noted throughout this annual report, significant changes have occurred at HealthSouth since the events of March 19, 2003. The steps taken to stabilize our business and operations, provide vital management assistance, and coordinate our legal strategy came at significant financial cost. During 2003, professional fees associated with the reconstruction and restatement of our previously issued reports approximated $70.6 million and were recorded by the corporate and other segment. These fees offset the reduced salaries a