Executive Summary / Key Takeaways

• Encompass Health is the nation's largest owner and operator of inpatient rehabilitation hospitals, strategically positioned to benefit from the growing, underserved demand driven by the aging U.S. population.
• The company's robust capacity expansion strategy, including de novo hospital developments, bed additions, and joint ventures, is a primary engine for growth, supported by strong free cash flow generation and a flexible capital structure.
• Recent financial performance highlights include a 10.6% increase in Q1 2025 net operating revenues and a 14.9% increase in Adjusted EBITDA, driven by strong volume growth (6.3% total discharges, 4.4% same-store) and favorable pricing.
• Technological advancements, particularly the use of prefabrication in hospital construction, offer quantifiable benefits in speed to market (~25% faster) and potential future cost savings (~15%), enhancing the efficiency of the growth strategy.
• Key risks include navigating the complex and evolving regulatory landscape (Medicare reimbursement, RCD/TPE audits) and managing labor costs in a competitive environment, although the company is actively addressing these challenges.

The Foundation: Addressing a Growing Need in Post-Acute Care

Encompass Health Corporation stands as the preeminent provider in the U.S. inpatient rehabilitation facility (IRF) market, holding the largest ownership and operational footprint. Its core business is delivering specialized rehabilitative treatment to patients recovering from complex conditions such as stroke, neurological disorders, and major injuries. This focus positions the company directly in the path of a powerful demographic trend: the rapid aging of the U.S. population.

For over a decade, the age cohort most in need of IRF services has expanded at a significant 4% to 5% compound annual growth rate. Projections indicate the number of Medicare enrollees, predominantly aged 65 and older, will grow by approximately 3% annually, reaching around 73 million by 2030. This demographic wave creates a substantial and growing demand for inpatient rehabilitation, a demand that management contends remains considerably underserved, particularly given that the total supply of licensed IRF beds nationwide has been largely static over the same period.

Strategic Expansion and Technological Edge

To capitalize on this favorable supply-demand imbalance, Encompass Health has aggressively pursued a multi-pronged growth strategy centered on capacity expansion. This involves developing new freestanding de novo hospitals, adding beds to existing high-occupancy facilities, and forming strategic joint ventures with leading health systems. The company's pipeline remains robust, with plans to open 6 de novos and 1 satellite hospital in the remainder of 2025, adding 350 new beds, and anticipating adding approximately 120 beds to existing hospitals in both 2026 and 2027 in response to sustained strong volumes and increasing occupancy levels.

A key differentiator in executing this expansion is the company's adoption of prefabrication technology in hospital construction. This approach, exemplified by recent hospital openings, offers tangible benefits. While initial costs are comparable to traditional methods, full prefabrication significantly enhances speed to market, reducing the time from laying the first module to opening by approximately 25% compared to conventional construction. Management anticipates that as the process is further refined, future prefabricated projects could yield around a 15% cost saving compared to traditional builds. This technological edge accelerates the realization of cash flow from new facilities, directly supporting the company's growth objectives and providing a competitive advantage in bringing needed capacity online faster.

Competitive Landscape and Positioning

Within the post-acute care landscape, Encompass Health operates alongside a mix of direct and indirect competitors. Direct rivals include large diversified players like Select Medical (SEM) and integrated health systems like UnitedHealth Group's (UNH) Optum, as well as more focused home health and hospice providers like Enhabit (EHAB) and Amedisys (AMED). EHC differentiates itself primarily through its scale as the largest IRF operator and its emphasis on high-quality, specialized rehabilitative care, often backed by disease-specific certifications.

While competitors like SEM may demonstrate slightly better operational efficiency in some areas, EHC's extensive network and integrated approach (though primarily focused on inpatient rehab post-separation from its home health segment) contribute to stronger patient outcomes and care coordination, particularly in complex cases. The capital intensity and regulatory hurdles associated with building and operating IRFs act as significant barriers to entry, favoring established players like EHC and SEM. EHC's strategic joint ventures with acute care hospitals are also a competitive response, leveraging partnerships to expand its footprint and integrate more closely with referral sources. The company's focus on technology, including its ERP conversion to Oracle Fusion, aims to enhance operational efficiency and data analytics capabilities, areas where larger, more integrated competitors like UNH/Optum currently hold an advantage.

Financial Performance Reflecting Strategic Execution

Encompass Health's recent financial results underscore the effectiveness of its strategy. For the first quarter of 2025, net operating revenues increased by a robust 10.6% to $1,455.4 million compared to $1,316.0 million in the prior-year period. This growth was primarily fueled by a 6.3% increase in total discharges and a favorable 3.9% increase in net patient revenue per discharge, reflecting both strong volume and improved pricing. Same-store discharges, a key indicator of performance in existing facilities, grew a healthy 4.4%.

Operating expenses saw increases in absolute terms, with Salaries and benefits rising 7.1% to $762.3 million and Other operating expenses increasing 6.7% to $217.5 million, largely due to labor cost increases and costs associated with development activities. However, due to the strong revenue growth, these expenses decreased as a percentage of net operating revenues, demonstrating operational leverage. Depreciation and amortization increased 12.7% to $79.2 million, reflecting ongoing capital investments in new and existing facilities. This performance translated into a significant 33.7% increase in Income from continuing operations before income tax expense, reaching $238.6 million, and a 40.6% increase in Income from continuing operations to $197.0 million. Adjusted EBITDA, a key metric for management, grew 14.9% to $313.6 million.

Liquidity, Capital Allocation, and Shareholder Returns

The company maintains a strong financial position with ample liquidity to support its growth strategy and return capital to shareholders. As of March 31, 2025, Encompass Health had $95.8 million in cash and cash equivalents and approximately $953.0 million available under its $1.0 billion revolving credit facility. The capital structure is flexible, with no significant debt maturities until 2028, excluding a remaining $100 million on its 2025 notes. The net leverage ratio stood at a comfortable 2.1 times at the end of Q1 2025, down from 2.2 times at year-end 2024.

Capital expenditures remain focused on growth, with $163.0 million spent in Q1 2025 and a full-year expectation of $755.0 million to $790.0 million, including $215.0 million to $225.0 million for maintenance. Free cash flow generation is robust, providing capacity beyond growth investments. The company continues to return capital to shareholders through quarterly cash dividends, recently declared at $0.17 per share, and share repurchases under its $500.0 million authorization, with $32.1 million of repurchases completed in Q1 2025.

Outlook and Key Considerations

Based on its strong Q1 performance and continued optimism regarding market demand, Encompass Health has raised its full-year 2025 guidance. The company now anticipates net operating revenues between $5.85 billion and $5.925 billion, Adjusted EBITDA between $1.185 billion and $1.220 billion, and adjusted earnings per share between $4.85 and $5.10.

Key assumptions underpinning this outlook include an estimated 2.7% net increase in Medicare payment rates effective October 1, 2025, based on the proposed rule. The guidance also factors in anticipated pre-opening and ramp-up costs for new facilities, expected to be heavily weighted towards the second half of the year ($18 million to $22 million), and the full-year impact of strategic initiatives like the Oracle Fusion ERP conversion ($5.5 million to $6.5 million) and NCI expense from joint ventures ($6 million to $7 million). While labor markets are showing signs of normalization, the guidance assumes SWB per FTE inflation will settle in the 3% to 3.5% range, with benefits expense growth expected to remain elevated in Q2 before easing later in the year.

Risks and Challenges

Despite the favorable market dynamics and strong performance, Encompass Health faces significant risks. Operating in a highly regulated healthcare industry means constant exposure to changes in Medicare reimbursement policies and increased scrutiny through audit programs like the Review Choice Demonstration (RCD) and Targeted Probe and Educate (TPE). The inconsistent application of review standards under RCD, particularly in states like Alabama, creates uncertainty regarding future claim collectability.

Recruiting and retaining qualified clinical staff, especially nurses and therapists, remains a challenge in a competitive environment, potentially leading to increased labor costs and impacting capacity utilization. While the company is focused on improving retention and managing contract labor, labor market conditions can fluctuate. Competition from other post-acute providers and acute care hospitals expanding their services also poses a risk to maintaining volume growth and market share.

Conclusion

Encompass Health is strategically positioned to capitalize on the undeniable demographic tailwind of an aging U.S. population and the resulting demand for inpatient rehabilitation services. The company's aggressive and well-executed capacity expansion strategy, bolstered by the efficiency gains from prefabricated construction, is driving robust top-line growth and operational leverage. Recent financial results demonstrate strong performance, and the raised 2025 guidance reflects management's confidence in the continued demand and their ability to execute.

While regulatory risks, particularly around Medicare audits, and labor market pressures require careful management, Encompass Health's market leadership, focus on quality outcomes, and disciplined capital allocation strategy provide a solid foundation. The company's ability to generate significant free cash flow, maintain a flexible balance sheet, and return capital to shareholders underscores the strength of its business model. For investors seeking exposure to a growing segment of the healthcare market, Encompass Health presents a compelling thesis grounded in favorable demographics, strategic execution, and operational excellence.