Too Good to Be True

Why HealthSouth CEO Scrushy began deep-frying the chain's books

At the back of HealthSouth Corp.'s (HRC ) palatial headquarters campus overlooking Birmingham, Ala., Richard M. Scrushy built a tribute to himself: a small museum depicting the story of how, as a former respiratory therapist, he started the company with $1 million in seed capital and turned it into a wildly successful $4 billion hospital empire.

The Scrushy museum is unlikely to record the latest chapter in the HealthSouth saga. Securities & Exchange Commission and Justice Dept. investigators have accused Scrushy, 50, of cooking his books to inflate profits by at least $1.4 billion since 1999. The government complaint describes the most brazen sort of fraud: a group of people gathering in a room and simply making up numbers. Scrushy has denied the charges, but several of his former lieutenants, such as former Chief Financial Officer William T. Owens, have pleaded guilty and are cooperating with the investigation. Scrushy, founder and CEO, was fired on Mar. 31.

How did HealthSouth go so wrong? Company officials declined to comment, and Scrushy did not return phone calls. But you don't have to search far for a motive. A close look at the company's operations shows that its business model was deeply flawed and had been for years.

Scrushy built HealthSouth on the premise that generous government reimbursements would always be available to hospital operators, and would grow. For 10 years after HealthSouth went public in 1986, that assumption held. Fueled by an aggressive acquisition strategy giving ever greater access to the government honey pot, HealthSouth posted yearly double-digit profit increases. The stock soared an average of 31% a year between 1987 and 1997.

But in 1997, Congress slashed Medi-care reimbursements to hospitals. For the next two years, HealthSouth's operating margins and profits nose-dived, a humiliating loss of face for a cocky, flamboyant entrepreneur. After that, the only way for Scrushy to meet Wall Street's inflated expectations, say health industry experts, was to cheat. "The model for hospitals simply doesn't work," says Don DeMoro, executive director of the Institute for Health & Socio-Economic Policy, a think tank. "It's a business dependent on government subsidy, and those subsidies are falling."

Reimbursements weren't the only problem with the HealthSouth strategy. Even the notion of building a national hospital chain has been discredited, say many health-care economists. HCA Inc. (HCA ), the largest hospital operator, has abandoned a national strategy, preferring now to cluster facilities in a handful of growing markets. "Our research has shown that for the most part, hospital mergers don't make money," says David Dranove, a Northwestern University health-care economist. "There is no advantage to size."

Now HealthSouth faces an almost certain breakup. The company says that it doesn't know if it's making money -- or if it ever has. Creditors are declaring HealthSouth in default. Everyone expects bankruptcy within weeks. That suggests HealthSouth is about to be carved up and sold off to competitors. "More than likely, HealthSouth's dominance has come to an end," says Frank Morgan, a health-care analyst at Jefferies Group.

But back in the 1960s, health care looked like a no-lose proposition to a 17-year-old boy pumping gas in Selma, Ala. With his first wife pregnant, Scrushy hungered for a better opportunity. He found it by taking a job as a respiratory technician working alongside his mother. Later, after graduating from the University of Alabama at Birmingham, he landed an entry-level position at Houston-based health-care company Lifemark Corp. In no time, the hard-driving Scrushy was running the company's pharmacy, physical rehab, and merger departments.

Scrushy was ready to strike out on his own by 1984. He persuaded Citicorp Venture Capital Ltd. to give him $1 million in seed money to start what would become HealthSouth. It became the first national chain of orthopedic hospitals and outpatient centers. The strategy fed off two converging trends. Injuries to feet, knees, and hips were soaring as the population aged and more people exercised later into life.

That meant a big percentage of HealthSouth patients were eligible for Medicare, a good place to be in the 1980s when government health-care subsidies were taking off. Through its Medicare and Medicaid programs, the feds paid a big part of the bill for treating the elderly and the poor. Those payments also included funds for maintaining and building hospitals and treatment centers. The government wanted to ensure that there were facilities for the country's growing elderly population. In essence, it helped to finance HealthSouth's expansion.

As HealthSouth grew, its stock soared. In the early 1990s, Scrushy was using the stock as currency to buy competing rehab centers and to expand into outpatient surgery, occupational medicine, and hospitals. But his core business remained rehab, with its big Medicare business. By 1997, Medicare accounted for 37% of HealthSouth's revenues and had helped expand margins to 31%.

Scrushy's wealth soared along with HealthSouth's stock, giving him an estimated net worth of $300 million in the late 1990s. And he flaunted it. He conducted business aboard his 92-foot yacht, Chez Soireé, which he kept moored alongside his vacation home in Palm Beach. And he was just as ostentatious at work, opening the 74-acre hilltop campus in 1997 and building a fleet of 11 corporate jets.

As he assumed the trappings of wealth, Scrushy became an increasingly imperious leader, say insiders. He publicly berated financial analysts who dared to challenge his forecasts of continued growth. Staffers feared him, too. Scrushy would pop up unannounced at his rehab centers for surprise inspections. Like a drill sergeant, he would run a finger along the tops of a picture frame, then wipe it on the blazer of the center's administrator. Any visible mark meant points deducted -- and possible dismissal.

But although the reign of terror continued, behind the scenes HealthSouth was facing a crisis. The trouble began in 1997, when conservative Republicans in Congress pushed through a $115 billion reduction in Medicare spending over five years. HealthSouth was especially vulnerable, since well over a third of its revenue came from Medicare reimbursements. The pain was immediate. The next year, HealthSouth's net income fell 86%, to $46 million. Says Jefferies' Morgan: "This was really the first time HealthSouth blew up."

Scrushy scrambled to recover. He cut salaries and froze hiring. HealthSouth turned from buyer to seller, unloading underperforming businesses, such as occupational medicine and a 200-bed hospital. Scrushy renegotiated the pricing in a contract with Owens & Minor Inc. by offering the medical-supply distributor more business.

Still, none of these measures was enough. Subsidies were down, probably permanently, and HealthSouth no longer had the currency, in cash or stock, to grow through acquisition. "Acquisition covered up a lot of sins," says Morgan. "It allowed the company to layer on a lot of growth without necessarily digesting any of its purchases."

Now Scrushy would have to do what he had never done before: squeeze earnings out of operations. He tried running ever more patients through his rehab facilities. In 2000, say insiders, Scrushy summoned his administrators, doctors, nurses, and case managers to the company's headquarters, where he drilled them in a new routine. Every doctor would now report at 8 a.m. sharp on Monday to see patients. Surgeries would begin on Tuesday, followed by rehab on Wednesday. It was an assembly line that cut patient's stays to an average of 17.5 days in 2001 from 21.5 in 1998. That lowered costs while raising revenue, as more people were treated at every hospital.

At first Scrushy's fast-in, fast-out strategy appeared to work. Although sales rose only 3% in 1999 and 2000, operating earnings soared an incredible 143%. Now investigators say that these fantastic numbers were just that -- fantasy. Fraud, not efficiency and cost-cutting, accounted for the huge discrepancy between sales and profits. In the end, that should have been apparent, given the shifting dynamics of the hospital industry. It's an old lesson: If the numbers look so good they strain credibility, there's probably a reason.

Corrections and Clarifications In the subheading of this story about HealthSouth Corp., we should not have said "Why HealthSouth CEO Scrushy began deep-frying the chain's books." Richard M. Scrushy was charged by the Securities & Exchange Commission with inflating HealthSouth's profits, but he denied the charges, as the story itself makes clear.

By Charles Haddad in Atlanta, with Arlene Weintraub in Los Angeles and Brian Grow in Ocala, Florida

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