Encompass Health Corporation (EHC)

Executive Summary / Key Takeaways

• Encompass Health has engineered a durable moat as the largest inpatient rehabilitation facility operator in a structurally undersupplied market, with discharge growth consistently outpacing demographic trends and a 690-bed pipeline that will deepen its scarcity premium.

• The company's operational leverage is inflecting as scale efficiencies compound: Adjusted EBITDA margins expanded faster than revenue growth in Q3 2025 (11.4% vs. 9.4%), while premium labor costs dropped to their lowest level since Q1 2021, demonstrating that capacity additions are driving unit economics improvement rather than dilution.

• A first-mover land grab in Florida—accelerated during the pandemic—has created a self-reinforcing competitive advantage, with 15 prioritized marketplaces and prefabricated construction methods delivering 25% faster time-to-market while competitors face elevated capital costs and regulatory barriers.

• Medicare concentration risk (80.7% of Q3 2025 revenue from Medicare and Medicare Advantage) is mitigated by the 2026 Final IRF Rule's 2.9% rate increase and the VA Community Care Network's 25.6% growth, but remains the primary variable that could compress margins if reimbursement policy shifts.

• Trading at 10.83x EV/EBITDA with net leverage at 2.0x and generating $582.5 million in year-to-date adjusted free cash flow, the capital structure supports both aggressive expansion and shareholder returns, though valuation leaves limited room for execution missteps.

Setting the Scene: The IRF Scarcity Engine

Encompass Health Corporation, originally incorporated in Delaware in 1984 as HealthSouth Corporation, has spent four decades building what is now America's largest inpatient rehabilitation hospital network. The company operates 170 hospitals across 39 states and Puerto Rico, treating approximately one in three IRF patients nationwide. This scale is crucial because inpatient rehabilitation is not a commodity business—it is a highly regulated, capital-intensive service that requires specialized clinical expertise, established referral relationships, and compliance with Medicare's stringent 60% rule governing patient eligibility.

The business model is straightforward but economically powerful: Encompass Health captures patients discharged from acute care hospitals who require intensive rehabilitation for stroke, neurological disorders, brain and spinal cord injuries, and complex orthopedic conditions. Over 90% of admissions originate directly from acute care referral sources, creating a captive demand funnel. The company generates revenue primarily through Medicare (64.1% of Q3 2025 net operating revenues) and Medicare Advantage (16.6%), with the remainder from commercial payors and other sources. This concentration is both a blessing and a curse—Medicare provides predictable volume growth from demographic tailwinds, but also exposes the company to regulatory reimbursement risk.

What makes this model compelling today is a supply-demand imbalance that has been decades in the making. The U.S. population aged 75 and older is growing at approximately 4% annually through 2030, while the supply of licensed IRF beds has increased only nominally over the past decade. Approximately half of stroke patients nationwide are still discharged to skilled nursing facilities (SNFs), despite clinical evidence favoring IRF-level care for better outcomes. This gap explains why Encompass Health has achieved ten straight quarters of same-store discharge growth above 4%, a rate that far exceeds underlying demographic expansion. The company is not just riding a wave—it is capturing market share from lower-acuity providers by demonstrating superior clinical outcomes and cost-effectiveness.

The competitive landscape reinforces this scarcity premium. Select Medical (SEM) operates a smaller IRF footprint within a diversified post-acute portfolio, while HCA (HCA) and other acute care systems lack the specialized focus and national scale to compete effectively. Barriers to entry are formidable: each new hospital requires $50+ million in capital, years of regulatory approvals, and established referral networks. Encompass Health's joint venture model—66 of 170 hospitals are JV partnerships with acute care systems—further entrenches its position by aligning incentives with referral sources. This structure transforms potential competitors into partners, securing patient flow while sharing capital costs.

Technology, Products, and Strategic Differentiation

Encompass Health's competitive advantage extends beyond scale into clinical and operational technology that drives measurable outcomes. The company has deployed AI and predictive analytics across multiple domains, reducing nurse liaison documentation time by 20 minutes per patient evaluation through iPad-based tools. A fall risk model implemented in 2020 has improved fall rates by 30%, while the REACT acute care transfer model has reduced unnecessary transfers by 24% since 2020. These improvements are significant as they directly impact length of stay, readmission rates, and ultimately, reimbursement rates under value-based purchasing initiatives.

The company's construction innovation—fully prefabricated hospitals—represents a structural cost advantage that competitors cannot easily replicate. The first 61-bed prefab hospital opened in Houston in Q4 2024, with a second following in Athens, Georgia in Q1 2025. This method delivers a 25% enhancement in speed-to-market while maintaining cost parity with conventional construction. In an industry where time-to-market determines return on invested capital, this advantage is significant. The prefabrication strategy also allows Encompass Health to expand into underserved markets more rapidly, as evidenced by the September 2025 opening of its first Connecticut hospital in Danbury.

Quality metrics serve as both a clinical differentiator and a reimbursement safeguard. Q3 2025 discharge-to-community rates reached 84.6%, discharge-to-acute rates were 8.6%, and discharge-to-SNF rates were 6%—all exceeding industry averages. For six consecutive years, Encompass Health has been named "America's Most Awarded Leader in Inpatient Rehabilitation" by Newsweek and Statista. These accolades are important because Medicare's quality reporting requirements increasingly tie reimbursement to outcomes. Superior performance creates a virtuous cycle: better outcomes attract more referrals, which drive volume growth, which spreads fixed costs over a larger base and improves margins.

The Oracle (ORCL) Fusion ERP conversion completed in October 2025, while not a revenue driver, eliminates a major operational risk and enables workflow efficiencies across finance, supply chain, and HR functions. Management noted the conversion occurred without significant disruption, a non-trivial achievement for a company with 170 hospitals. The system is expected to enhance procurement efficiency and labor management, though management wisely refrains from quantifying specific ROI, treating it as table stakes for scaling operations rather than a profit driver.

Financial Performance & Segment Dynamics

Encompass Health's financial results in 2025 demonstrate that capacity expansion is translating into accelerating profitability, not just top-line growth. Q3 2025 consolidated net operating revenues increased 9.4% to $1.48 billion, while Adjusted EBITDA grew 11.4% to $300.1 million. The 40 basis points of EBITDA margin expansion (20.3% vs. 19.9% prior year) is particularly significant because it occurred during a period of heavy investment in new hospital openings and bed additions. This is the operational leverage thesis playing out in real time.

The revenue mix reveals a strategic shift toward higher-value services. Inpatient services, representing 96.6% of revenue, grew 8.4% in Q3 2025. Outpatient and other services surged 44.3% to $50.2 million, driven by Medicaid supplemental payments. While this line item is smaller, its growth rate signals successful diversification into adjacent revenue streams that may provide buffer against Medicare reimbursement pressure. The 10.6% year-to-date revenue growth to $4.39 billion, combined with 14.5% Adjusted EBITDA growth to $932.3 million, shows margin expansion accelerating as the year progresses.

Labor cost management represents the single most important operational achievement. Salaries and benefits decreased as a percentage of net operating revenues despite absolute increases, driven by reductions in contract labor and sign-on/shift bonuses. Premium labor costs fell $5.6 million year-over-year to $27 million in Q3 2025, while the Employees Per Occupied Bed (EPOB) metric reached 3.42, approaching the 3.4 target. This is critical because staffing is the largest cost component in healthcare delivery, and the post-pandemic labor shortage had previously compressed margins. The return to pre-pandemic turnover rates (RN turnover 20.2%, therapist turnover 7.8% in Q3 2025) indicates that Encompass Health's compensation and retention strategies are working, creating a sustainable cost structure that competitors still struggle to achieve.

Cash flow generation validates the capital-intensive expansion strategy. Year-to-date adjusted free cash flow increased 16.5% to $582.5 million, despite a Q3 dip due to working capital timing related to the ERP conversion.

Net leverage remains at 2.0x, well below the 4.5x covenant maximum and at a level management considers optimal for balancing expansion with capital efficiency. With no significant debt maturities until 2028 and $873 million available on the revolving credit facility, the balance sheet provides ample firepower for the 14-hospital, 690-bed pipeline while supporting the dividend (0.65% yield, 13.18% payout ratio) and share repurchases.

The capital allocation framework is evolving toward optimization. Management has indicated that leverage below 2.0x would trigger consideration of more aggressive shareholder returns, suggesting the current expansion phase is balanced against capital efficiency. The $180 million in additional current deductions from the One Big Beautiful Bill Act, generating approximately $50 million in cash tax savings in 2025, provides incremental capital for reinvestment. This tax benefit, combined with the 2.9% Medicare rate increase effective October 1, 2025, creates a favorable near-term reimbursement environment that funds capacity additions.

Outlook, Management Guidance, and Execution Risk

Management's 2025 guidance, revised upward after Q3, reflects confidence in both volume growth and operational leverage. The revised range projects net operating revenue of $5.905 to $5.955 billion (up from prior guidance) and Adjusted EBITDA of $1.235 to $1.255 billion, implying full-year EBITDA margins of approximately 21%. Adjusted earnings per share guidance of $5.22 to $5.37 represents meaningful growth, while adjusted free cash flow guidance of $730 to $810 million suggests Q4 will be exceptionally strong as working capital normalizes post-ERP conversion.

The bed addition outlook is aggressive but disciplined. The company expects to add approximately 127 beds to existing hospitals in 2025, with 150 to 200 beds planned for both 2026 and 2027. This is important because management considers bed additions the highest return on invested capital opportunity. Hospitals become candidates for expansion after sustaining occupancy above 80%, and the private room portfolio (57% of beds by Q3 2025) can efficiently operate into the mid-90% occupancy range. The 140 beds added year-to-date, combined with seven new hospital openings in 2025, demonstrate that the company is pulling growth levers simultaneously without sacrificing margins.

The pipeline beyond 2025 includes 14 hospitals with 690 beds, with recent additions in Fishers, Indiana (2027) and Lebanon, Tennessee with Vanderbilt Health (2028). This visibility is unusual in healthcare and reflects the long development cycles for IRFs. The active pipeline of over 40 projects suggests the announced backlog is just the beginning. Management's comment that competitors face "a lot less palatable" economics due to elevated construction costs and REIT financing requirements indicates that Encompass Health's scale and balance sheet are creating a competitive moat that will widen as it continues to invest while others pause.

Execution risks are concentrated in three areas: reimbursement, staffing, and integration. The Review Choice Demonstration (RCD) program creates uncertainty, with management acknowledging they "cannot predict the impact, if any" on Medicare claim collectability. While this is a known risk, the company's engagement with CMS and MACs suggests active mitigation. Staffing shortages have abated but could return, particularly for physiatrists where the market remains tight. The ERP conversion, while successful, still has "bugs to be resolved" that could temporarily impact operational efficiency.

Risks and Asymmetries

The concentration in Medicare and Medicare Advantage (80.7% of Q3 revenue) is the most material risk to the investment thesis. A shift toward site-neutral payments or reduced IRF reimbursement would directly compress margins and potentially make some hospitals uneconomical. The company's mitigation strategy—demonstrating superior outcomes and cost-effectiveness—has historically been effective, but cannot fully insulate against regulatory fiat. The 2026 Final IRF Rule's 2.9% increase provides near-term protection, but the 2027 rulemaking cycle could introduce headwinds.

Medicare Advantage penetration, now at 55.4% of Medicare beneficiaries, poses a subtler threat. MA plans have incentives to steer patients to lower-cost SNF settings, potentially eroding IRF volumes. Encompass Health's ability to maintain growth despite this headwind is impressive, but if MA plans intensify prior authorization requirements or narrow networks, the company's same-store discharge growth could decelerate from the current 4%+ pace. The VA Community Care Network's growth (25.6% in Q3, now 18% of managed care volume) provides a partial offset, but cannot fully replace traditional Medicare volume.

Competitive pressure is intensifying, though management downplays the threat. Select Medical and HCA have publicly stated plans to add IRF beds, and the acquisition of Amedisys (AMED) by UnitedHealth (UNH) in August 2025 creates a vertically integrated competitor that could steer patients to owned facilities. However, the high barriers to entry—capital intensity, clinical complexity, and regulatory hurdles—limit the pace of new supply. Encompass Health's first-mover advantage in key markets like Florida, where it purchased land and accelerated development after CON law changes in 2021, creates local scale advantages that are difficult to replicate.

The joint venture model, while strategically valuable, introduces complexity. The company consolidates eight variable interest entities and faces noncontrolling interest expense that grows with JV profitability. The Augusta hospital contribution to Piedmont Healthcare created $6-7 million in annual NCI expense, and future JV expansions will share economics with partners. This is a rational trade-off for referral security and reduced capital requirements, but it caps the company's share of incremental profits from its fastest-growing facilities.

Valuation Context

At $116.22 per share, Encompass Health trades at 21.89x trailing earnings and 24.31x forward P/E, a premium to traditional healthcare providers but a discount to high-growth medical technology companies. The EV/EBITDA multiple of 10.83x sits between Select Medical's 12.14x and The Ensign Group's (ENSG) 24.68x, reflecting Encompass Health's pure-play IRF focus versus competitors' diversified models. The price-to-free-cash-flow ratio of 29.05x appears elevated, but must be contextualized against the 16.5% year-to-date growth in adjusted free cash flow and the $730-810 million full-year guidance.

Relative to peers, Encompass Health's valuation appears justified by superior margins and growth. The company's 9.34% profit margin and 16.49% operating margin significantly exceed Select Medical's 2.05% and 5.35%, respectively.

Return on equity of 24.41% demonstrates efficient capital deployment, while the 0.84x debt-to-equity ratio provides balance sheet flexibility that more leveraged competitors lack. The 0.65% dividend yield, while modest, represents only 13.18% of earnings, leaving substantial capital for reinvestment.

The enterprise value of $14.31 billion (2.47x revenue) reflects the market's recognition of the scarcity premium. As the only pure-play, scaled IRF operator, Encompass Health commands a valuation that incorporates its ability to consolidate a fragmented market. The key question for investors is whether the multiple expansion potential from margin improvement and market share gains outweighs the reimbursement risk inherent in the Medicare-dependent model.

Conclusion

Encompass Health has constructed a compelling investment case built on structural market scarcity, operational leverage, and disciplined capital allocation. The company's ability to generate 11.4% EBITDA growth on 9.4% revenue growth while simultaneously opening seven new hospitals and adding 140 beds demonstrates that scale is enhancing, not diluting, profitability. The demographic tailwinds of an aging population, combined with a nominally growing supply of IRF beds, create a durable growth runway that extends well beyond 2030.

The central thesis hinges on two variables: reimbursement stability and execution of the capacity expansion pipeline. The 2026 Medicare rate increase and VA contract growth provide near-term protection, but long-term policy shifts remain the primary downside catalyst. On execution, the company's track record of opening prefabricated hospitals on time and achieving target occupancy rates suggests the 690-bed pipeline is achievable, though staffing and integration risks persist.

For investors, the risk/reward asymmetry lies in the margin of safety provided by the scarcity premium versus the valuation sensitivity to reimbursement changes. At current leverage levels and with strong free cash flow generation, Encompass Health has the financial flexibility to navigate short-term headwinds while continuing to build out its irreplaceable network. The stock's performance will likely be determined by whether the company can sustain its same-store discharge growth above 4% while expanding EBITDA margins toward the mid-20% range—a combination that would validate the premium valuation and reward long-term shareholders.