A white paper on the divestiture of its outpatient physical therapy segment by HealthSouth.

Why should private-practice outpatient PTs care about the recent HealthSouth divestiture of its outpatient physical therapy segment?

HealthSouth is the largest outpatient physical therapy provider in the United States, and its actions and performance can serve as a bellwether for conditions affecting other, smaller physical therapy practices.

In 1984, HealthSouth began its growth trajectory with its first outpatient physical therapy clinic. In 2001, prior to the first evidence of its accounting scandals, HealthSouth had built or acquired outpatient surgery centers, diagnostic imaging centers, and inpatient rehabilitation hospitals—in addition to outpatient physical therapy facilities.

On March 18, 2003, HealthSouth corporate offices were raided by the FBI following allegations of accounting fraud. Subsequently, the firm was delisted from the New York Stock Exchange and new management began a radical financial and operational restructuring to avoid bankruptcy.

Figure 1.

Why Does HealthSouth Want to Sell Outpatient Physical Therapy?

The HealthSouth 2006 Annual Report refers to the pending sale of its outpatient physical therapy division as a "significant financial deleveraging event" that will restore HealthSouth's growth potential.

Many of the factors that affect HealthSouth's outpatient physical therapy division are similar to factors that affect the typical private-practice outpatient physical therapy company. There is, however, one crucial difference: company size.

Before we look at the differences, we should first look at the similarities. HealthSouth's outpatient revenue and earnings show a clear downward trend in outpatient net operating revenues (before interest and taxes) and operating earnings (profit) over the last 3 years (Figure 2). This trend applies to large and small firms alike.

HealthSouth closed on its sale on April 30, 2007, when Select Medical Corp assumed control of 582 facilities in 35 states. After the sale, HealthSouth plans to refocus its efforts on its most profitable segment: postacute inpatient rehabilitation.

Figure 2.

"Show Me the Money!"

In a remarkably succinct, one-paragraph passage in its annual report,¹ HealthSouth describes the motivation behind the sale and, at the same time, illustrates a major dynamic that is permeating the rehabilitation industry. I plugged the numbers into an Excel spreadsheet and used the Chart function to display graphically what the numbers imply (Figure 2).

Outpatient physical therapy revenues are declining at the same time that managed care revenues, as a percentage of total revenues, is increasing. A majority of HealthSouth physical therapy revenues now come from managed care.

As employer health care costs grow faster than the overall economy, American and US-based employers are increasingly shifting to lower-priced managed care plans for their employer-sponsored health care for their employees. Much of the decline in total outpatient revenues seems to be driven by the dramatic decrease in revenues from managed care. Increasing managed care penetration and declining reimbursement are the prevailing forces in the physical therapy industry.

What Went Wrong?

HealthSouth grew in the late 1980s and through the 1990s based on the mantra of economies of scale—that is, that firm size confers a sustainable competitive advantage based on declining unit costs for items like salaries, rents, and other operating costs.

While this operational dynamic is true for many firms in many industries, it appears that for outpatient physical therapy firms the scale efficiencies gained are not sufficient to offset the prevailing forces described above.

The implication for private-practice PTs is that smaller is better.

Scale economies are probably not as important in the delivery of outpatient physical therapy services as they were once thought. Smaller practices can weather downturns in revenue better than larger physical therapy firms, since the owner can quickly scale back on variable expenses (like supplies). Small practices may also be able to begin and end projects more quickly, depending on their profitability.

Many practices may occasionally see drops in patient volume such as that brought on by seasonal variation or by the entry of a competitor like a physician-owned physical therapy facility. Consider the data in the following charts that shows the variation in profits for two firms across the business cycle.

Figure 3.

Boom or Bust!

For the "Hard Times" and "Good Times" charts (Figure 3), the following assumptions apply:

• Firm B is 10 times larger than Firm A (in capacity).
• Firm B has a higher rate of managed care discounts than Firm A.
• Fixed costs do not change over the business cycle (in the short run).
• Fixed costs in physical therapy include salary costs.

During "Hard Times," Firm B suffers a loss while Firm A manages to break even. Firm B swings lower in hard times and swings higher in good times.

During "Good Times," Firm B is able to spread its higher fixed costs over a greater number of patients, which results in a lower total cost per patient ($55.34) and greater profits.

If you foresee hard times ahead, then you should invest in making your current operation as efficient as possible (eg: automated clerical processes, outsourced noncore competencies like billing and fewer full-time staff, etc). You should also divest from low return or money-losing projects. If you foresee good times ahead, then you should invest in operating capacity (eg, more clinics, more equipment, and more staff, etc).

HealthSouth is divesting its operating capacity, which implies a forecast of hard times ahead for outpatient physical therapy.

The pending HealthSouth divestiture is the most recent reaction to a growing industry trend of declining reimbursement and greater managed health plan penetration.

Outpatient physical therapy clinic owners would be wise to pay attention to the prevailing forces in the industry and to make their investments accordingly.

C. Timothy Richardson, PT, is a physical therapist in Manatee County, Fla. Richardson is not, nor has ever been, an employee of the HealthSouth Corp. He has owned and managed multisite physical therapy clinics for 10 years. He can be reached at .