Kindred Spirits Sag

Government payout talk hammers the specialty hospital chain.
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Long-term care providers, particularly

Kindred Healthcare

(KND)

, could be in for some long-term pain.

Long-term acute-care hospitals, or LTACHs, face potentially huge Medicare cuts beginning in the next fiscal year. The Centers for Medicare & Medicaid Services on Thursday proposed freezing standard reimbursement rates -- while slashing payments for lucrative short-term stays -- for LTACHs starting in July. Clearly, some never saw the second measure coming.

"The proposed 'flat' update for the standard Medicare reimbursement rate to LTACHs is likely to go over fine with providers who had generally been painting a bearish picture (i.e., a potential rate cut) but is not as likely to be taken well on the Street, as analysts appeared to be more constructive overall," wrote JP Morgan analyst Andreas Dirnagl, who continues to maintain an overweight rating on Kindred's stock. "The real concern and confusion, however, is related to a new and unexpected proposal regarding revisions to the payment adjustment formula for short-stay outlier (SSO) cases. ... This proposal apparently came as just as much of a shock to the industry as to us."

Analysts estimate that low-cost SSO cases currently account for more than 35% of all long-term hospital discharges. Thus, they foresee a material hit coming to companies like Kindred. Kindred itself admitted that "the proposed rule is significant."

Dirnagl has yet to even figure out how big that hit may be. However, one of his competitors offered a possible -- and frightening -- scenario.

"We estimate that the proposed changes could reduce Kindred's annual

earnings before interest, taxes, depreciation and amortization by approximately 50%, under a worst-case scenario," wrote Wachovia analyst William Bonello, who has an underperform rating on the stock. However, the "reduction could be less ... if Kindred has a lower percentage of short-stay outlier patients than the industry as a whole, or if it proves to be more profitable to avoid short-stay patients than to treat them at reduced rates."

Investors raced for the exits, leaving shares of Kindred down 24% to a two-year low of $20.39 on Friday.

Ventas

(VTR) - Get Report

, a real estate trust that leases facilities to Kindred, tumbled 6.4% to $31.49 despite the company's assurance that its "aggregate annual base rent can never decrease" under its rate-resetting process. Kindred competitors

HealthSouth

(HLSH)

and

RehabCare

(RHB)

weathered losses as well.

Deep Cuts

CMS itself has indicated that it plans to reduce payments to long-care facilities by 11% overall. Even Bonello, who is bearish on Kindred's stock, had been looking for a rate increase instead.

Bonello estimates that the standard rate freeze alone will whack 25 cents -- or roughly 15% -- from Kindred's projected 2006 earnings. However, he says, the SSO change could lead to a "substantially greater" drop in profits for the year.

Under its new proposal, CMS plans to start reimbursing long-term hospitals for just 100% of their estimated costs -- down from 120% currently -- on SSO cases. In addition, the agency wants to raise the bar for high-cost SSO cases that trigger bonus outlier payments. The new "outlier fixed-loss amount" for such cases would climb from $10,501 to $18,489 if the measure goes through.

Moreover, Bonello notes, CMS has "additional concerns" about long-term hospitals as well. Specifically, he suggests, the agency feels that long-term hospitals have "attempted to circumvent" a rule that limits certain hospital referrals and may seek new restrictions to close that perceived loophole going forward.

Jefferies & Co. analyst Frank Morgan says that CMS and MedPac -- which advises Congress on Medicare-related issues -- have "never been fans" of the long-term care sector, anyway. Still, he fully expects CMS to face a tough battle from lobbyists for the group.

Meanwhile, Dirnagl has offered some cautious words of hope.

"We make one very important note here, and that is that the release last night is only a proposal, which historically includes the 'worst-case' scenario for providers who then have a 60-day comment period ... to respond to CMS and influence potential changes," he wrote. "The final rule is expected to be released in early spring."

But in the meantime, Bonello continues to stress Medicare-related risks for the industry as a whole.

"While we believe that Kindred has a well-run, well-positioned LTCH business -- with significant potential for market expansion and margin improvement," he notes, "we also expect LTCHs to face increased Medicare pressure over time."