Investor Alert

Dec. 12, 2007, 11:17 a.m. EST

Musings on Medicare

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Morgan Keegan & Co.

THERE HAS BEEN NO MEDICARE LEGISLATION proposed yet in Congress, yet the House is planning to adjourn on Saturday. Maybe it's just us, but it seems that if they want to make some needed changes before Jan. 1, they probably need to propose something.

We expect legislation imminently.

The shape of that legislation is unclear, since it appears Congress will not go through the usual committee process but instead craft a bill via direct House-Senate negotiations. In this report, we look at the Medicare exposure for the health-care-services companies in our coverage.

Healthcare Services Group /zigman2/quotes/200556023/composite HCSG -1.86% : No direct exposure. Only risk is if severe Medicare cuts drive nursing-home customers unexpectedly into Chapter 7 bankruptcy. There is nothing proposed that would come remotely close to this.

Pediatrix Medical Group: Very limited Medicare exposure, through its one anesthesiology practice. The risk, which is probably not material to our estimates, is that the 10% physician fee cut scheduled for Jan. 1 will not be rescinded, as this would adversely affect the anesthesiology practice. As we've said in the past, a 10% physician fee cut is not tenable -- not in a presidential election year, and not with the risk of doctors closing their practices to Medicare patients. We are confident it will be eliminated. So we see no risk to Pediatrix.

RadNet /zigman2/quotes/203055435/composite RDNT +6.05% : There will likely be two types of Medicare adjustments for imaging providers: Cuts to technical (facility) fees; and tougher credentialing. The former will reduce revenue per scan, probably for high-cost modalities. Credentialing would likely work in RadNet's favor, as it would probably squeeze small competitors, including nonradiologist doctors owning imaging equipment, resulting in share gains for RadNet. We have heard nothing to suggest that the Medicare environment for imaging providers in 2008 will be as challenging as in 2007, when the industry was hit by cuts from both the Deficit Reduction Act and the hospital outpatient prospective payment system. Our model assumes overall pricing for RadNet will be about flat in 2008, and we believe that's a safe assumption.

RehabCare Group: The company has considerable Medicare exposure but, relative to our model, very little potential downside. Its contract-therapy division will be adversely affected if Congress does not enact two changes critical to the provision of Part B (outpatient) therapy, which accounts for about a third of the company's contract-therapy business. The first is the elimination of the 10% physician fee cut, since therapists are paid via the physician schedule. As we stated above, we are not concerned about the fee cut. Second, Medicare beneficiaries are subject to annual caps on their Part B therapy benefit, but Congress has enacted exceptions to the caps that cover most nursing-home patients. The exceptions sunset on Dec. 31, and absent a renewal, patients may "hoard" their benefit and reduce their demand for therapy services. Our discussions indicate that extending the exceptions is a virtual given, as they are popular with both legislators and beneficiaries. Our model assumes both favorable developments.

RehabCare is also subject to the nursing-home market basket. On Oct. 1, nursing homes received a 3.3% Medicare payment increase. We assume that some of that will be given back on Jan. 1 to help pay for the physician-fee-cut elimination. If the cut is deep (the House proposed eliminating the entire 3.3% increase this summer), it will likely adversely affect the negotiated rates RehabCare's Contract Therapy division receives for Part A (inpatient) therapy, which accounts for about two-thirds of the business.

Finally, RehabCare's hospital-rehabilitation services (HRS) division is subject to the 75 Percent Rule, which limits the type of patient that can be admitted to rehabilitation hospitals and has adversely affected census and, therefore, profitability.

We believe the current share price reflects investor ambivalence toward the freeze efforts. As a result, we view this as a binary event. If the freeze is enacted, we expect RehabCare shares to rise. If it isn't (which is what we assume for modeling purposes), we expect the shares to lose ground.

Sun Healthcare Group: A 75 Percent Rule freeze would be negative for nursing homes prospectively, since some of the patients that the 75 Percent Rule excludes from rehab hospitals (notably hip- and knee-replacement patients) wind up in nursing homes. However, the magnitude is not huge, and Sun would be affected only in the third of its markets where there is a local rehabilitation hospital. Sun has the same exposure to the physician-fee schedule and Part B therapy caps as RehabCare in its contract-therapy business. The difference is that contract therapy accounts for over half of RehabCare revenue and about 40% of earnings before interest, taxes, depreciation and amortization [Ebitda]; for Sun, it's about a tenth that amount. So on an order of magnitude basis, contract therapy isn't a big-ticket item for Sun.

The Medicare market basket is, though. Most of Sun's Medicare revenue-per-patient day is driven by patient acuity, not price increases. Nonetheless, the market basket by itself accounts for about $14 million in annual revenue, or 19 cents in earnings per share.

Relative to our model, the full elimination of the market basket would be dilutive by two cents to three cents to EPS per quarter. We believe the market would view a market-basket reduction in excess of 150 basis points negatively. No reduction, while favorable, strikes us as unlikely.

-- Robert M. Mains, CFA<BREAK /> -- Herb Tinger, CFA

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