HealthSouth In Rehab

By rights, HealthSouth (HLSH ) should be dead. The victim of crooked accounting that, when set straight, lopped $3.9 billion off shareholders' equity, this hospital and medical-services company could easily be pushing up daisies in the corporate graveyard. That it's not may owes mostly to U.S. health care's sclerosis. How else could a company keep getting paid by its top client, Uncle Sam, after having cheated big time on its bills?

For that and other sins, HealthSouth has settled with a host of government agencies. It still faces shareholder suits, and while former CEO Richard Scrushy in June beat criminal charges that he directed the fraud, the company itself remains a subject of federal criminal investigators. It's cooperating with the feds, yet nearly three years since HealthSouth started emitting its foul odor, the company's stock still is traded over the counter in the Pink Sheets, where few choose to stoop.

So why do I see potential for investors? Mostly because of the demonstrated persistence of demand for the services that HealthSouth offers. Despite the scandal, its underlying business appears, at worst, to be in stable condition. This year, if management's estimate pans out, earnings before interest, taxes, depreciation, and amortization, or EBITDA, will top $630 million. At that, HealthSouth's EBITDA margin would come in at 17%, up from 14.3% in 2001.

HEALTHSOUTH OBVIOUSLY PRESENTS unusual risks, perhaps chief among them the low visibility into its operations. Auditors still haven't finished work on a 2004 10-K report, never mind current quarterly reports. Those, plus a 2005 10-K, are not expected before early 2006. Until then, the shares won't be eligible for listing on NASDAQ or the New York Stock Exchange, where they traded before. Another worry is HealthSouth's balance sheet, which is weighed down by net debt of $3.2 billion.

Just the same, news on July 13 that the feds have quit prosecuting Scrushy criminally (a civil securities-fraud suit remains) may be a blessing in disguise. Scrushy could push hard to get his old job back, and that would prove a fresh distraction. But the board vows to resist, and new CEO Jay Grinney is anxious to look ahead. A veteran of HCA, Grinney is careful not to disrespect federal investigators or civil plaintiffs. But the other day when I pressed him on how far along he is in settling the legal problems, he said: "We're probably in the 70% to 80% range." He aims to have the rest settled by yearend.

His largest operating challenge is a new Medicare rule limiting admissions to in-patient rehabilitation facilities for victims of stroke, accidents, and other perils. In-patient rehab is HealthSouth's largest division. Grinney expects, however, that as the rule also bears down on smaller rivals HealthSouth will become a consolidator. Two other divisions -- outpatient rehab and ambulatory surgery centers -- are better set for growth but today suffer profit margins that are below industry averages. That leaves room for improvement. As for HealthSouth's fourth division -- diagnostic imaging centers -- it's a live possibility for a sale to raise cash and cut debt.

Near 5.65 a share, HealthSouth's total enterprise value (market capitalization plus net debt) comes to $5.5 billion, or 8.7 times the company's goal of $630 million in EBITDA this year. Capital IQ, a unit of Standard & Poor's (MHP ), puts the industry's average multiple at 9.8. At that, the stock would be worth upward of 7.35 or so. HealthSouth, it seems, has cheated death.

By Robert Barker

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