HMS Holdings Corp
Q1 2013 Earnings Call Transcript

Published: 26 Apr 2013

[Operator:]

Good morning. My name is Ben, and I will be your conference operator today. At this time, I would like to welcome everyone to the HMS Holdings Corp. First Quarter 2013 Earnings Call. [Operator Instructions] I would now turn the call over to Jzaneen Lalani from HMS Holdings. Ms. Lalani, you may begin.

[Jzaneen Lalani:]

Good morning, and thank you for joining us today. As you know, we distribute our earnings release through our website, hms.com, under the Investor Relations tab. Under that tab, you will also find the supplementary slides that accompany our call today. This call is also being webcast. Please click on Events & Presentations under the Investor Relations tab to access the webcast. We will make a replay of the call available on our website later today. Before I turn the call over to Bill, let me remind you that some of the information presented today regarding the company's future expectations, plans and prospects are considered forward-looking statements under the Safe Harbor provisions of the Private Securities Litigation Reform Act of 1995. These statements are based on the company's current expectations and actual events may differ materially from those expectations. We refer you to the company's filings with the Securities and Exchange Commission, including our annual report on form 10-K and our quarterly report on form 10-Q, which identify important risk factors that cause actual results to differ materially from those contained in the company's projections or forward-looking statements. All information on this call is as of today, April 26, 2013. And the company disclaims any intent or obligation to update any forward-looking statement as a result of developments occurring after today's call. During this call, we will also be referring to several non-GAAP measures. The press release issued this morning includes a reconciliation of these measures to GAAP measures and is available under the Investor Relations tab on our website, hms.com. With that, I'll now turn the call over to Bill Lucia, President and CEO of HMS Holdings.

[William C. Lucia:]

Thank you, Jzaneen. Good morning, everyone. And thank you for joining us today. I'll be hosting the call this morning along with Walter Hosp, our CFO; and Maria Perrin, our Chief Marketing Officer. As you read this morning, we are adjusting our 2013 guidance, primarily as a result of issues related to 2 Federal government procurements. First, the extended delay in the Medicare Coordination of Benefits award resolution; and second, the unexpected transition plan in the Medicare RAC reprocurement and related program changes impacting that contract. Before I talk more about this, I'm going to turn the call over to Walter for a review of our financials. Then I'll discuss sales, the factors impacting our decision to adjust guidance and finally, our thoughts around HMS's strategic opportunities. Walter?

[Walter D. Hosp:]

Well, thank you, Bill, and good morning, everyone. Before I start, I'd like to mention that I'll be walking through our P&L for Q1 as usual, but will also provide a deeper dive into the revenue growth rate we saw for our major business areas in Q1. I will be highlighting some of the key financial items, but will not go through a detailed review of our balance sheet and cash flow statements, in response to investor requests that we spend more time discussing revenue. I would also like to make a general comment about our first quarter. As most of you know, we have historically had seasonality in our business, where our first quarter revenues are the lowest of the year and lower than our fourth quarter revenues in the prior year. This is the case again this year. We also do not provide quarterly guidance, so analysts are on their own in developing estimates for how the year will lay out quarter-to-quarter. The first quarter revenue results of $116.6 million, up 8.7% over prior year, was well below the consensus view of $123.8 million. I would like to point out that part of the difference from consensus is attributable to the difficulty in forecasting our first quarter revenues. And this is evidenced by the unusually wide range of analysts' forecast, which range from $119.8 million to $128.8 million. I'll explain more about the revenue results on the next slide. Looking now at expenses for the quarter, total cost of services were $85.5 million, an increase of $9.1 million or 12% compared to $76.4 million in the prior year. Compensation expense related to the cost of services was $43.9 million for the quarter. As a percentage of revenue, this expense was 37.7% versus 36.6% in the prior year. Growth in this line item is attributable to the growth in headcount by 360 employees over the same quarter last year to 2,655 employees. Of this increase, only 21 positions were in the SG&A area and the rest were added to support the implementation of Medicaid RAC programs, growth in transaction volumes and increased investment in IT and infrastructure development. Data processing expenses increased 32% or $2.2 million over the prior year to $9.1 million. This increase is related to higher transaction volumes and an increase in depreciation expenses resulting from the movement of a data center out of New York City to a co-hosted facility in Texas. Programming expenses were also higher as we implement the many new contracts we have won. Occupancy cost increased $0.5 million to $4.6 million and increased slightly as a percent of revenue from 3.8% last year to 4% in the quarter. We are in the final stages of completing the downsizing of our New York City office beyond the data center move I mentioned, which will cut our New York occupancy costs by 2/3. The financial impact of this line item will begin to show in our third quarter results. Direct project costs increased 3.3% or $0.4 million year-over-year to $13.3 million. These costs increased primarily from higher data costs and chart fees related to medical record requests. Other operating costs increased $1.5 million or 29.5% year-over-year to $6.6 million. Most of this increase was related to increased professional fees, temporary personnel and office and postage expenses. The amortization of intangibles associated with acquisitions was $7.9 million for the quarter, a decrease of $0.2 million year-over-year. This decrease was primarily due to intangibles from prior acquisitions, having become fully amortized. SG&A expenses increased $0.9 million or 6.3% versus last year to $15.8 million. All of the increase in this line item came from increased salary expenses. Income taxes were $4.6 million for the current quarter compared to $4.9 million for the same quarter last year. The effective tax rate for the quarter was 39.7% versus 41.1% last year, and this decrease is primarily due to state taxes and apportionments. Net income for the quarter was $7 million, equivalent to the net income of $7 million for the same period in 2012. Fully diluted weighted average common shares outstanding for the first quarter was 88.8 million shares, and fully diluted GAAP net income per share was $0.08, also equivalent to the $0.08 for the same period last year. The $0.08 compares to a consensus forecast of $0.11. Adjusted EPS was $0.15 for the quarter versus $0.16 in the prior year, down 6.3%. This compares to a consensus forecast of $0.18. I would also note that we ended the quarter with cash and cash equivalents of $139.2 million, with cash on hand, as of yesterday, of $142 million. Net cash from operations was $16 million for the quarter versus $15.5 million for the first quarter of last year. And we also made scheduled principal payments on our outstanding debt balances of $8.8 million in the quarter. We'll now take a closer look at revenue growth in the quarter. As mentioned, total revenues for the quarter increased 8.7% year-over-year to $116.6 million. If we adjust for both our Federal business and HDI, this year-over-year growth rate is 8.5% versus a 7.1% growth rate in Q4 of 2012. Looking first at our market, year-over-year growth in our Medicaid market was 8.5%. We had low-single digit growth in our state government area, offset by nearly 20% growth in our Medicaid managed care or MCO market. This difference in growth rates is primarily a result of the significant transition of lives from state Medicaid programs to Medicaid managed care. The comparable growth rate for the fourth quarter of 2012 was 6.7%. Our Federal business decreased 33.2% year-over-year. We are still being impacted from certain Federal contracts that we chose not to rebid or which we had to cancel when we acquired HDI. As this year-over-year impact from a loss of these contracts lapses, we will see this growth rate improve. Our HDI revenue growth rate was 22.9% year-over-year, which is in line with our expectations. And looking at our product revenue growth in the quarter, Medicaid COB grew 5.2% versus the growth rate of just under 1% in the fourth quarter. We are still impacted in this area from the significant changes in the Medicaid program, mainly historically low Medicaid expenditure growth and the transition of lives to Medicaid managed care. Our program integrity products across the entire company grew 12.1% year-over-year. This includes HDI and Federal in this definition and if we adjust for these 2 areas, program integrity growth in the quarter was 19.9% versus 25% growth rate in Q4 of 2012. That concludes my review and I will now turn the call over to Bill.

[William C. Lucia:]

Thank you, Walter. I'll start with a review of our key sales in the State Government market. In Connecticut, we extended our contracts for third-party liability, as well as the recovery audit services through 2017. In addition, we were successful in expanding this contract to add our Fraud, Waste and Abuse system and services. The state will now be using our software and together, we will be targeting millions of dollars in potential provider Fraud, Waste and Abuse. This is the third state that has selected this new technology solution, and we're expecting to see continued procurement activity in this market. In Medicaid RAC, we're very pleased to announce that after a long procurement process, the state of Texas has awarded HMS the entire RAC contract. You might recall that we had been awarded half of the state, with the other half going to another vendor. The state's recent decision to award the entire contract to us underscores our leadership position in this market and the value that the market places on HMS's recovery audit expertise. South Carolina recently announced their intent to re-award the RAC contract to HMS. This is our first win of an existing RAC contract via competitive reprocurement. This win reflects our client's satisfaction with our results, including our unique ability to identify overpayments across multiple claim sites. And lastly, we have been notified of Michigan's intent to award HMS the reprocurement of our TPL contract. This was also competitively bid. We continue to have a 100% client retention rate in Medicaid COB. Now I'd like to spend a few minutes reviewing our Medicaid RAC business. In addition to securing new sales, we made significant headway in activating RAC contracts from the first quarter. In fact, 50% of our contracts entered production status in Q1. Today, we have 16 contracts in production, with another 14 in active implementation. We are pleased with this progress, as it demonstrates not only increased focus from state, but also our ability to deal with the many challenges related to the development of this program. These challenges are similar to those experienced during the initial phase of the Medicare RAC program, including getting access to quality data, implementing the complex processes to begin audits and the resulting considerable pushback from providers, primarily hospitals. So as I've said before, if you've seen one Medicaid RAC, you've seen one Medicaid RAC. Each state is approaching the program differently. What HMS brings to the table is consistency in approach and knowledge of best practices. Now HMS will begin standardized Medicaid RAC reporting in the second quarter of 2013 in order to better track audit activity, recoveries and appeals. This may compel states to accelerate RAC activity in order to demonstrate progress with their program. While we're pleased with the progress of the Medicaid RAC market, it has taken longer than we anticipated to get contracts executed, mobilize client resources, and this has led to delays in initiating audits. Note that we have been very much in the investment phase in Medicaid RAC, incurring high project start-up costs that is impacting Q1 earnings. We have mentioned on earlier calls, we see revenue ramping up in the second half of this year and margin ramping up in 2014. Moving to the managed care sales, we were selected by 4 health plans to provide power coordination of benefit services, including Affinity Health Plan in New York, with 250,000 Medicaid members, Heath Plus of Michigan and Performance Health Technology in Oregon, a TPA covering approximately 100,000 Medicaid members. And Paramount Advantage, a health plan in Ohio, selected HMS to provide COB services for their 100,000-member plan that is expected to double in size next year. We also secured a contract with Capital Health Plan in Florida to perform medical bill audit services for their commercial book of business. And we are progressing in our sales strategy for credit balance audit services. Our strategy for growth has been to deploy auditors in geographic regions where they can be leveraged on multiple contracts. In quarter 1, we demonstrated the effectiveness of this strategy by securing contracts for credit balance services with Blue Shield of California and Neighborhood Health Plan of Massachusetts, based on our established presence in those markets. Now, in MCO expansion sales, we will be performing data mining services and an expansion of our contract with WellCare. Value Options in Texas expanded our contract to include coordination of asset services, and we added Medicaid lives in Kansas and Washington through our scope as part of United Healthcare's expansion into those states. While we continue to expand our footprint in the Medicaid MCO market, we are excited about our opportunities in the related commercial risk space, and I'll talk about that a little later on this call. Now I'd like to turn to a discussion of some of the uncertainties influencing our current view of 2013 and why we think it's prudent to adjust guidance for recent developments. The most significant of these uncertainties is related to 2 large Federal government procurements. The Medicare Coordination of Benefits award resolution and protest and the Medicare RAC reprocurement, which, combined, account for about 90% of the revenue reduction from previous guidance. First, let's talk about the Medicare Coordination of Benefits award. We do expect this procurement to ultimately be resolved in our favor, but the timing is still too uncertain. CMS is now expected to complete its review by the end of this month. However, the procurement process could be delayed further and the award may be subject to an additional protest. It's difficult to predict the exact timing of resolution, so we are moving the $50 million in revenues associated with this contract out of 2013 and into next year. Second is HDI's reprocurement of the Medicare RAC contract. HDI submitted its response timely, but also protested the actual procurement, which is common place in this type of government contracting. We primarily argued that the solicitation was defective due to unequal treatment of bidders. Specifically, the incumbent contractors would bear a greater financial burden in handling the review of appeals than would a new contractor. This week, the GAO accepted the protest and has 100 days to issue its decision or until about July 15. CMS recently announced that it intends to withhold the award until the protest has been resolved, which is also standard during a protest. There are both procurement and operational issues related to this contract that will have a negative impact on revenues in 2013. Regarding the procurement, CMS's recommended transition plan would require incumbent contractors to stop mailing any new audit letters to providers much earlier than we had originally anticipated. This early stop date does not provide a bridge for CMS to the new contracts. The current transition policy, as written, puts at risk about $1 billion in recoveries to CMS, resulting from this abrupt end of audit activity by the 4 RAC vendors, not a prudent move in an era of budget deficits and proposed cuts to the Medicare program. On the operational side, there is a new rebilling rule in the Medicare RAC program that would allow hospital providers to take inpatient claims denied for medical necessity and rebill them as outpatient claims. Our recoveries and therefore fees, may be negatively impacted by this new rule. The impact could be mitigated in part by the fact that providers would give up the right to appeal, which means that HDI may be able to release some reserves for appeals. The timing of the impact on RAC revenue, if any, under the existing contract is still undetermined. It will, however, impact results in any new RAC award. We remain confident in retaining the award of the Medicare COB contract and we're working closely with CMS to mitigate the negative impact, the Medicare RAC procurement and related transition processes on the results of the program and the RAC vendors. However, the combination of the uncertain timing of these events, coupled with the fact that each one has a wide range of outcomes, forces us to be more conservative about the impact to HMS in 2013. In the context of this guidance decision, I'd now like to talk about our Medicaid Coordination of Benefits business. While it is a much smaller factor in our guidance adjustment, it is worth noting. This quarter, we saw the resumption of higher growth rates, due in part to the fact that most of the 5010-related claims processing challenges have been resolved. This uptick is counterbalanced by the migration of fee-for-service lives to managed care, as well as the lower-than-anticipated Medicaid program growth we previously reported. As Walter mentioned earlier, this product area grew 5.2% in Q1 versus a year-over-year growth rate of less than 1% in the previous quarter. So while our core business remains financially strong and is expected to grow as a result of the Medicaid expansion in 2014, '15 and beyond, we are lowering our guidance to a 6% to 8% growth rate for the full year. We are still experiencing the temporary negative effects of the very large migration of fee-for-service lives to managed care that began in 2012. A key cause of this effect is the significantly lower spend per member in managed care than in fee-for-service. Also, we're more heavily penetrated across our client base in the government market than in the managed care market. For example, in our state government market, over 40% of our clients buy 4 or more of our Coordination of Benefits services, while in the MCO market, now, only 17% of our clients buy 4 or more of our COB services. Of course, we continue to expand the scope of our managed care contracts and over time, as the market matures, we expect these contracts to be as expansive as our government contracts. Now with all of that as a backdrop, let me walk you through our revised guidance numbers. For the full year, we now expect revenue between $495 million and $525 million, fully diluted GAAP EPS of $0.57 to $0.63 a share and adjusted EPS of $0.89 to $0.95 a share. The difference in the revised guidance is $75 million in revenue. $50 million is attributable to the Medicare Coordination of Benefits contract. $15 million is attributable to the net impact to HDI of the Medicare RAC procurement and program changes. And the remaining $10 million is mainly related to Medicaid Coordination of Benefits. Now while 2013 remains a somewhat challenging year for HMS, primarily due to the 2 large Federal procurements, we remain confident about the opportunities ahead. Already, under the ACA, 23 states have decided to expand their Medicaid program, and 5 are leaning towards expansion. The Congressional Budget Office projects that the number of people gaining coverage through Medicaid in 2014 will be about 8 million. A large subset of these lives and the associated claims will be flowing through our systems as a result of our existing contracts with the states and managed care plans. We are, however, expecting that these lives will come on gradually; some states will need time to establish their outreach efforts and update their eligibility systems. Therefore, the number of additional people entering the program in 2014 could be smaller than projected. And we expect that ramp to happen in the second half of the year, with much greater impact in 2015. In addition, the newly eligible individuals entering the Medicaid program will have higher incomes than the current Medicaid population and therefore, may be more likely to have access to employer-sponsored insurance, positive for our Coordination of Benefits business. And as we've seen over the years through our managed care contracts, newly eligible Medicaid members are likely to be heavy utilizers of services at the beginning of the eligibility period, as they seek to fulfill a pent-up demand for medical services. As we've discussed in the past, we remain steadfast on building a more diverse company, able to serve each of the largest health care payers in the nation, Medicaid, Medicare and commercial. We charted this course 5 years ago and remain convinced that the products and services we offer are the most effective in the industry and are applicable to each of these large markets. Let's take a look at -- a closer look at the opportunities we see in our future. Medicaid is expected to grow significantly over the next 10 years and by 8 million lives in 2014 and '15 alone. And this has a flowthrough positive impact on HMS, both in our core business and in our Medicaid RAC business. Our impact on the program will be increasingly significant, as legislators and policymakers seek to control Fraud, Waste and Abuse in the program. And as the new eligibility rules become more complex due to the ACA, errors are more likely to happen, and states will need to verify accuracy for all stakeholders. Our new robust eligibility verification system can help states further automate their processes at time of enrollment or retrospectively to assure that the right people are in the right programs. Regarding Medicare, the U.S. population of people 65 and older is expected to increase 33% by 2020, impacting total enrollment and utilization of services. People are living longer in the nation and will require more chronic care services. And the Medicare program continues to be a prime target for health care fraud. Even as Medicare cuts are being considered by the administration, CMS continues to focus on identifying and reducing errors and chasing fraud, waste and abuse. And finally, there's the commercial market, the largest health care payer, where our products and services continue to gain traction. We have a growing sales pipeline for a wide range of services, including Fraud, Waste and Abuse identification and recovery and our newer Segregation and Fraud, Waste and Abuse analytics engines, both offered on a subscription basis. We continue to invest in our sale structure and products for this market. And as I mentioned before, we're now offering credit balance audit, data mining and complex clinical audits to the commercial risk plans, leveraging our already proven results in Medicaid managed care. In summary, the overwhelming majority of the 2013 impact and therefore, changing guidance, is related to the Medicare COB award and the RAC procurement and transition issues. In fact, most of the uncertainty around our business this year is a function of unexpected twists and turns in the Federal government procurement process, which we could not reasonably have anticipated. Our Coordination of Benefits business is growing slower this year, but that growth will increase in 2014 and beyond and benefit from the ACA. We continue to remain focused on launching innovative solutions, implementing new clients and carefully managing operating expenses through efficiencies so that we are well positioned in 2014 when healthcare reform is implemented. We look forward to reporting on our progress over the course of this year. Ben?

[Operator:]

[Operator Instructions] Our first question comes from the line of Ryan Daniels of William Blair.

[Ryan Daniels:]

Let me start on the Medicare RAC reprocurement. I'm curious if you could give us a little bit more detail on the potential work stoppage. Is that really aligned with kind of the August date to stop the current contract ahead of the potential February date to restart? Or is something happening where you'll need to actually slow down your claims request earlier than August?

[William C. Lucia:]

Ryan, this is Bill. Let me take that question. It's actually a little confusing, and I'll give you some history. We -- of course, all of the RAC vendors communicate with CMS about what's the best practice. And as we look at this last year, with CMS's intent to put the procurement out relatively early this year, with RAC awards scheduled for about July, we felt they were making very prudent decisions on a wind-down of the existing RAC and getting new RAC contracts up and running so there'd be an overlap and no loss of recoveries to the Medicare Trust Fund. Unfortunately, both the procurement, we had to protest based on what we mentioned in the call. But also because of their intent to award in July, they felt they should stop work earlier. So their current plan is to have auditors stop mailing letters around the end of May. Now that can change obviously, if CMS decides that they want to continue to protect the stream of audit activity and then push those dates out further, as the protest rolls out and the new awards are given. At that -- at this point, the protest could cause a number of outcomes. The procurement could be recalled and redone. There's a lot of things that could happen within the next 100 days. So our hope would be that CMS would just continue to have the RAC process so there's no lapse in auditing to providers and there's no lapse in recoveries to the Medicare Trust Fund.

[Ryan Daniels:]

Okay, that's helpful color. And then if there is this lapse, what do you do from a cost standpoint? I mean, obviously, you've got individuals on your payrolls that you're going to need in 2013 and beyond. Do you take something out of the FA playbook and furlough some of your staff? Or how do you manage your cost structure when there's this artificial gap?

[William C. Lucia:]

Well, we probably do that and others. I mean, here's the approach we would take. And it's beneficial that we're at the point where the Medicaid RAC contracts are starting to ramp up. And we have a number of large states now engaging us to do complex clinical reviews. That review, while the program rules are different, that review is very similar to what we do in the Medicare RAC. So we have been in a conscious effort of training RNs and coders at HCI and then migrating them to HMS as needed. So that will probably be our first step is to move that staff into the HMS Medicaid RAC program, already trained, able to get up and running rather quickly, and then if we're forced to, based on a stop work, and it depends on the period of time, we would end up doing furloughs and have people take all of their vacation and all the other things that would happen. The other important note though is we have a $32 million reserve, most likely, in the industry, the most conservative reserve. And so as our risk of appeals starts to reduce, we will be able to, at some point, start to release those reserves.

[Ryan Daniels:]

Okay. Helpful color again. And then maybe one more and I'll hop off to let others ask some questions. Just if we think of this $15 million, for Walter, in the guidance reduction related to the Medicare RAC, are you effectively, at this point, assuming that you do get that ability or need to stop mailing in May? Or is there some kind of expected probability that you're putting in some numbers and then prorating it at some risk level of having to stop these RACs? Just any color there to give us a view of how conservative that is.

[Walter D. Hosp:]

Yes. So there are obviously, at this juncture, there are various scenarios that could happen, depending upon contracting. And as Bill said, the official rules right now are stopping at the end of May, but that could change over time, right? So when we look at establishing the numbers, we are looking at a revenue impact, potentially larger than $15 million, offset again by releasing some of these reserves. So what we're giving you is the net impact of this. Now we've looked through multiple scenarios here and currently, we're looking at various outcomes on that. This is our best prudent estimate at this juncture.

[Operator:]

Our next question comes from the line of Richard Close from Avondale Partners.

[Richard C. Close:]

Yes. With respect to staying on this same subject, Walter, what allows you to release the reserves, if you can walk us through that process?

[Walter D. Hosp:]

Well, I'm going to keep this at a high level because it's a very complex issue on that. But our current contracts call for accounting for and being responsible and liable for reserves through the end of the contract period, which is the end of February next year, okay? Where the -- where there are no changes to the program, at that point, we would do a summing up and see what the liability was and then adjust the reserve accordingly. Now having said that, one can anticipate that this year, once we have some more clarity on what the final set of rules are going to be here. As was also mentioned, we are protesting a certain provision, so we need -- of the procurement. We need resolution on that to be able to do it. But at any point in time, we can look at the reserves with the current set of rules that come out and resize the level of reserves appropriately.

[Richard C. Close:]

With respect to the potential change in the Part A, Part B rebill, can you talk a little bit about that, how do you size that potential revenue impact or give us any type of historical information with regard to the Part A medical necessity, in terms of setting, for HDI?

[Walter D. Hosp:]

For this year, the impact on that is somewhat modest, it's there, and we've taken into account in our estimates. It's more of an impact on the program going into the future. As you know, there's -- it was attributable to a large amount of the corrections of the overall program by all the RAC vendors in the past and the RAC vendors also have other opportunities to pursue on that. So we're really talking about 2014 impacts and beyond that would show up in our financial results.

[Operator:]

Our next question is from the line of Dave Windley of Jefferies.

[David H. Windley:]

So on guidance, Walter, the reduction in revenue, if I take the Medicare COB contract and the margins that you've previously discussed there, the EPS, I think, contribution from that would have been sub $0.05, probably $0.03 or $0.04, but so more than half of the revenue that you're reducing and about half of the EPS that you're reducing, you had a shortfall of some revenue and EPS in the first quarter and I guess, the punchline here, my question is, I kind of account for the full EPS reduction with those 2 things, the first quarter shortfall and the Medicare COB removal, but there's some revenue left and I'm wondering how is it that EPS doesn't come down a little bit further for the remaining revenue reduction that is part of the guidance here?

[William C. Lucia:]

Right. Well, it's a very complex analysis. And we have a range of outcomes here on this. You're right in that the $50 million of revenue that -- given that, that contract was assumed to have 10% operating margin, it's a very small impact on EPS related to that. And you can do the math on that, but it's very close to $0.03 per share. When you get to the impact of the Medicare COB contract, there, again, it's rather complex with various scenarios, with cost-cutting responses potentially that can't be redone and also the release of reserves, which, as you know, would flow right through to the bottom line. There is a cost element to that. And then we also -- the adjustment for $10 million in our Medicare COB business, that is -- we've taken into account adjustments on margins there. But also, there are components of variable costs that we're able to incorporate in the adjustments to margins.

[David H. Windley:]

Okay. So repurposing some cost and then also, the key there that if you release those reserves, those are essentially pure profit. Is that cash...

[William C. Lucia:]

Correct.

[David H. Windley:]

Okay. I suppose -- you mentioned, on the cost side of things, you mentioned a couple of times in the prepared remarks, the downsizing of New York, the relocation of data centers to Texas. Is there a net savings there above and beyond what you would have included in guidance coming into this year? I guess I'm curious about how much savings you're getting there.

[William C. Lucia:]

Yes. I wouldn't add an incremental adjustment for that because, clearly, these projects were planned. They're being implemented. They're being implemented on time. Whenever you move a data center and -- yes, we've mostly moved jobs from New York down to Dallas and on order of close to 200 jobs. The net impact on financials are -- on that are to pay a price for that up front and then you begin to get the savings. On our SG&A, on our infrastructure savings, on our occupancy costs, one of the better things that we have done is buy this 10-story building here in Dallas and we've been moving people in. And now it's a building fully occupied with HMS employees. And so the incremental cost there of not paying rent and just filling up our building here will provide the benefit. But that's baked in the numbers.

[David H. Windley:]

Okay, and then final question and I'll drop. Clearly, there are a lot of moving parts on Medicare RAC. Your guidance is changing from that. But if I go back to coming into the year at 20%, 21% growth in Medicare RAC or HDI, I guess, I should say, our expectation was that, that would be a higher growth rate in the early part of the year and then wind off as you ran into the procurement slowdown later in the year. I guess I'm curious about why the growth rate from fourth quarter to first quarter declined so dramatically. Was it related to a lot of these other things that have been discussed on the call? Or are there other issues? Are we hitting some level of maturity in Medicare RAC activity that is -- that if procurement wasn't even happening, we would be seeing this kind of slowdown?

[William C. Lucia:]

So just to establish a few things, you're right, we were saying for all of HDI, the expectation was around the 20%, 21% growth rate. Most of that is the Medicare RAC, but there's also commercial business in there that factors into the growth rate. We -- the growth rate has dropped from the fourth quarter to the first quarter. It's obviously above -- the 22.8% is above the full year guidance number. And when we set those number, we had said that, we're in a procurement year, there can be a lot of changes that happen and, low and behold, they are. And so we'll have to adjust accordingly as we see the rules and the procurement steps in this project happen. The quarter-over-quarter change though, if you look back last year, you would see that despite HDI growing very significantly throughout the year, there are quarters where it was flat sequential growth. The issue surrounding that is that there is a, I'd call it a lumpiness associated with some of the processing and some of the claims in the backlog, the improvement of new correction scenarios, et cetera. I guess, what I'm pointing out is that, that is -- that it's happened before and we still saw a large growth rate, if you look to last year as an example.

[Operator:]

[Operator Instructions] Our next question comes from the line of Deepak Chaulagai from Dougherty & Company.

[Deepak Chaulagai:]

Quickly on the Medicare RAC, Walter, what was the revenue mix there? Was it still 80-20 of the HDI revenue? Or was it a little bit different?

[Walter D. Hosp:]

Well, coming in to the year, it was roughly, for HDI revenue, it's an 80-20 split. And that's what we've recorded last year. Obviously, that proportion changes as you have higher-growth commercial business than what the Medicare RAC was. Now this adjustment, which is, you're right, completely out of the RAC there, will change that proportionality.

[Deepak Chaulagai:]

But in Q1, it was still 80-20?

[Walter D. Hosp:]

Roughly, yes.

[Deepak Chaulagai:]

Okay. And then just one quick on the, I guess, Q1 dynamic with Medicare RAC. A competitor of yours -- I guess not a competitor, but a subcontractor, had indicated there were some issues related to the Medicare processing systems delays that impacted, temporarily impacted Q1, and some of that revenue, they expect to see in Q2. Did that impact you in any way and do you expect that -- if so, do you expect that impact to be recovered in Q2?

[William C. Lucia:]

It did impact us. We quickly rebounded from that and we'll expect to see some of that back in Q2, but I think we're beyond that issue.

[Deepak Chaulagai:]

Yes, okay. And one last one on the Medicare RAC. The time line, if you think of the May time line, which you alluded to, where you stop sending letters, and you expect contract awards in July, is it -- the work stoppage applies throughout the rest of the year? When do you -- is it still February of next year when you start the new audits? Or is it 3 months, it's 4 months? How should we think about the time line there?

[William C. Lucia:]

I mean, the original intent was that, with the RFQLs and responded to in early April, that awards would come sometime in May or June, contracts would start in July. So that a work stoppage around the end of May only gives about -- it gives the existing RACs a couple of months to clean up portfolio and the existing records that are out on the market, and new RACs can start up in July. Now start-up is not always very quick, depending on if you're in a new region, you're working with a new Medicare administrative contractor. So some of that could be a ramp-up, but that's a much smaller gap if that happens. But however, what's happening now is, because there is a protest, this will -- there will be no awards until, at a minimum, July. And I don't know how that would even be feasible because if the GAO makes a decision July 15, that decision will be moved forward with the existing procurement, reprocure, amend the procurement. I mean, there's many outcomes, as we spent most of the call talking about the complexities of the Federal government procurement. So our desire and of course, we would hope that CMS would continue to expand the additional work because they have 4 RAC contractors with contracts available through the end of February, they would continue that work, continue to expand the dates by which we can engage with providers and get that closer to the point of when a new RAC contract would be awarded. Again, that protects the fiscal integrity of the program.

[Deepak Chaulagai:]

And then when the new contract is awarded, you obviously can start to work right away. It's just a matter of the uncertainties related to when that new contract would be awarded, based on the protest, et cetera?

[William C. Lucia:]

Sure, there are. There are -- once the awards are made, there could be additional protests. And they could, at that point, say it's a stop work order again, so CMS then would have to revisit, do we give the existing RACs additional time and additional ability to mail audit letters. But remember, this was originally -- the original plan made a lot of sense. They have RAC contractors with contracts that terminate February 2014. So that's ample overlap time to wind down contracts and wind up new ones. The challenge is that this will probably take longer than they had anticipated.

[Deepak Chaulagai:]

I guess what I don't understand is -- and probably there is no way to concretely answer this, but if you retain your Region D and others, let's say, 2 or 3 other ones retain their own regions, why would there be any disruption above and beyond, from a CMS thought process perspective, why should there be a much longer disruption than necessary?

[William C. Lucia:]

There really wouldn't be. If they re-awarded the existing RAC vendors their existing regions, there would be very little delay. I mean, there could be delay depending on when they ask the existing vendors to stop mailing letters, but there would be very little delay and there would be a rapid start-up time because the vendors are already working in those regions. The good news about the regions and the reprocurement is that they were more normalized. So where in the past, we have, I believe, 20% of the Medicaid claim -- Medicare claim expenditures in the nation, they more normalized it so that each vendor had about 25%.

[Deepak Chaulagai:]

One last on the core Medicaid COB contract. You mentioned some of the components there, movement of lives from fee-for-service to Medicaid managed care, and you said something about you're seeing some firming up of the Medicaid spending growth. So if you could just give us some sense of what components or how much or to what extent that impacted, one way or other, in Q1 and where you are with the HIPAA 5010 issues there, that would be very helpful.

[William C. Lucia:]

Well the HIPAA issues are behind us. I mean, there are still some backlogs that we're working through, but they're minor at this point. The Medicaid growth rate that we've experienced we're really referring to what we've seen in the last, I'd say, over the last 12 months. Because remember, we lag the processing. So a claim that was adjudicated yesterday may not reach our doorsteps for 6 months, depending on when the provider submits the claim, those types of things. So we run in a lag. So we're still seeing the impact of that lower-than-anticipated Medicaid growth rate. What we're starting to see in our enrollment files, our eligibility files, is that eligibility is ticking up. Now, of course, not in every state and not every plan, but eligibility is ticking up. What that tells us about the future is that Medicaid growth rate and expenditures will tick up. And -- but for our guidance for the year, because we still run in this lag mode, we're being more prudent and keeping that growth rate at that 6% to 8%.

[Deepak Chaulagai:]

And then the movement from fee-for-service to Medicaid managed care, I know 2012 was very pronounced in that aspect. I'm assuming you are seeing some remnants of that in your 2013 results. Should we expect to see that moderate over the course of 2013 and perhaps the effect is less pronounced in the back half?

[William C. Lucia:]

Yes. I believe that's what's going to happen. Our -- the reports that we've seen show that a much smaller number of lives are migrating in 2013. In fact, about less than 1/3, probably less than a 1/4 of the lives that migrated in 2012. There will be incremental lives in 2013, but a much smaller impact. And it usually takes a year to 18 months, depending on the market, the plans they go to, the type of members that have been migrated for this to work through and normalize, in terms of administrative operations. So we're looking to the second half of this year to start to rebound from that. The one item I mentioned that we have, which is a long-term opportunity, but it's been a short-term headwind, is that when a member moves from fee-for-service in a state that has purchased 7 Coordination of Benefit services from us, and it moves to free health plans that have purchased 2, we have an opportunity to upsell, but that -- as the market matures, those upsell opportunities will come to fruition. So that's the other issue we're dealing with as we go through this transition.

[Operator:]

Our next question comes from the line of Bret Jones of Oppenheimer.

[Bret D. Jones:]

I also wanted to go to the core COB business. And just to make sure I understand this. If I think about it from an apples-to-apples basis, 1Q '12 was missing $4 million to $6 million of revenue related to the HIPAA-related claims. And then it sounded like all $5 million that we talked about slipping out of the fourth quarter of '12 was recognized in the first quarter. One, is that correct? And if so, that implies almost a 9%, 10% decline in Medicaid COB growth, and I'm just wondering if you could comment on that.

[William C. Lucia:]

Yes, no. There's a difference in your numbers. What we said in Q4 was that there was less than $5 million left in sort of the HIPAA 5010 backlog. So it's not $6 million or $7 million, it's less than $5 million. In fact, it's closer to $3 million there. So if you make that adjustment for it, yes, our 5.8% growth in Q1 should be brought down. But as we've said in every quarter, there are all sorts of issues and aberrations that go on and lumpiness that can happen in the quarter. So what we can say is that we are seeing, quarter-to-quarter, an improvement in the growth rate. Albeit modest, but it is not the picture you painted there with those adjustments.

[Bret D. Jones:]

Okay, okay. I just wanted to make sure I understood that correctly. And then if I move to the RAC reserve, I was just wondering, when I think about the reason for the reserve, it's to cover appeals, and these appeals are taking anywhere from 1 plus years, 1 to 2 years at least, because there's a backlog in the appeals. I'm just wondering the ability to release the reserves and have you made an estimate for how much of that $32 million could be released.

[William C. Lucia:]

We have various scenarios on when and how these things could be released. We can't say that right now because there are certain procurement changes that impact the ability to do that. One of them is a protest that we've launched here about the rules regarding that. We need the resolution of that to look back at the reserves and re-examine the assumptions there. The issue though that would give you confidence that we have that ability is that the current contracts, again, call for a liability that expires at the end of February. We have $32 million on the reserves. Yes, there's a reserve -- an appeals backlog that's going to eat into that. There's no question about that. Having said that, at the appropriate point here, there'll be contractual clarity of both -- well, there's clarity now of the existing contract, but there'll be clarity of the transition over to new contract. And when we do that, we're working with a different set of assumptions and ongoing scenario here regarding those reserves.

[Bret D. Jones:]

So you don't have to wait for the appeals to work their way all the way through the process then?

[William C. Lucia:]

We do for the contract period.

[Bret D. Jones:]

Okay. Even if the appeals extend beyond the contract period?

[William C. Lucia:]

The current contract calls for a termination at the end of the contract period. We have no further appeal for the process. That's the current contract.

[Bret D. Jones:]

Okay. I'll move on and maybe we could circle back afterwards. I just -- the last question I wanted to ask was, can you quantify, if we were to think about Region D and the upsizing of Region D, have you been able to quantify what that increase would be, related to the loss of the potential for DME going national?

[Walter D. Hosp:]

We -- the reason we haven't quantified that is there's the increase in Region D, which provides 3 additional states, 2 of which are very heavy utilizers of the Medicare services and we think a great population for us. There is a reduction in DME from the program and then there's also the impact of the rebilling rule. So we're -- we'll be running our analytics around that, but we really want to wait until the procurement's over. Our preferred state is that we retain our region, but that could change.

[Bret D. Jones:]

Oaky. Can you just give us a sense for what DME is represented? I know it's been a fairly small segment of claims, but can you give us a sense of how much that's represented in 2012 maybe?

[William C. Lucia:]

Well, yes, the -- out of the total claim volume, out of Medicare, it's 7%. Now a much lower percentage in that, somewhere in the neighborhood of 2% or 3%, is the amount of dollars that a RAC have gotten from this pool. So you're not looking at a pool of claims that has generated significant dollars. It will reduce the long-term opportunity by that amount, but these are also very difficult dollars to go after because they're small claim amounts and wouldn't normally be prioritized by the RACs as something to go after. It is a priority for CMS, however, because there are very high error rates in there. And I think that's what's behind their thoughts when they carved this out into a specific contract. And they'll have one vendor look at it all nationally and be focused on this.

[Operator:]

Our next question is from the line of Frank Sparacino from First Analysis.

[Frank Sparacino:]

Walter, I think I just may have missed this. Did you give the reserve number?

[Walter D. Hosp:]

Well, the reserve number, so it's $32 million at the end of the first quarter. There is a portion in our liability section, approximately $23 million, and then the remainder is up and offset on accounts receivable. So that the reserve in the receivables component is related to outstanding receivables from CMS. So we have 2 places on the balance sheet where you do it. If you add them up, it's $32 million.

[Frank Sparacino:]

Great. And then on the Medicaid RAC, just to understand, Bill or Walter, so when you talk about the states that are in production today, what does production mean? I assume it means a various range of where you're at in the various contracts, but just wanted to understand that.

[William C. Lucia:]

Good question. Production, to us, today means there's audits on the street. So we can't -- it's not full run rate. It may not even have generated revenue this quarter, but it's audits on the street. So we've got -- we've -- and let me explain a little bit about the process to get to that point. So we run all the data through all of our analytics engines, we present what we call scenarios, but basically, findings of areas we believe we should audit. We have quite a dialog with the state. We often educate the provider community, and then we are able to release an audit to the street. So there's a -- you could imagine how long the lapse time to get to that point. That's why even though I'm unhappy it's taken this long, we are happy that we have got half the contracts to that point. And then of course, after that is the actual audits are performed. Providers, of course, have appeal rights, fair hearing processes, but we actually do recovery. So that's why we're looking at the ramp in revenue more towards the second half of the year.

[Operator:]

Our next question comes from the line of Jamie Stockton from Wells Fargo.

[Jamie Stockton:]

I guess, maybe just a quick one, Walter, on HDI. Did you actually give us the revenue number for it during the quarter?

[Walter D. Hosp:]

I did not give you the actual revenue number. We are at $107 million last year. And if you just hold one second, in the quarter, we were about $29 million.

[Jamie Stockton:]

Okay. And then just a couple of questions on the reprocurement for Medicare RAC. It seems like there are a lot of questions about whether or not past performance matters to CMS in this program or if it's just price. So if you could talk about that, I would appreciate it.

[Maria Perrin:]

Yes. This is Maria Perrin speaking. The -- there's a very large hurdle to pass technical before price is even a consideration. So past performance does matter, along with many other technical factors, including system abilities, the experience of the personnel, references and other matters. So I think the way to look at it is a very small pool of vendors who actually get past that technical threshold before they can even try to outwin each other on price. The other thing -- I might add one more comment that could be important to you. The way the procurement was structured was on a GSA schedule, so that limited the amount of vendors that could actually qualify to bid. So in order to be in this pool of vendors, you have to have had an existing GSA schedule for the recovery audit-type services that the contract requires. So that greatly limits who can actually even submit a bid for the contract.

[Jamie Stockton:]

Okay. And then maybe just one more question, also on the Medicaid RAC program. In the past, I think you guys have used some subcontractors under the old contract. Would you expect to use any subcontractors materially under the new contract?

[Maria Perrin:]

No. We will likely not use many. To the extent that we can meet any requirements for small business, we will do so. But otherwise, we're not planning a substantial amount of work to be given to subcontractors.

[Jamie Stockton:]

Would that have any implication, Walter, this may be a question more for you on kind of, if you assume that the pricing remains relatively stable versus the contingency fee you guys have gotten historically, would that be a positive for margins on the contract in the future, if you were to essentially insource what you had previously outsourced?

[Walter D. Hosp:]

Certainly. Because when you use third parties, it's -- we have the capabilities to do it. This is a requirement of the protest and the original procurement 5 years ago. So that -- we review that favorably. But it's part of a mix here. This is very complex, 5 different contracts to bid on, different regions, so there are many variables to that equation.

[Jamie Stockton:]

Do you have just a very rough number for what portion of the Medicare RAC business had historically been subcontracted out?

[Walter D. Hosp:]

I don't have that at my disposal right now.

[Operator:]

Our next question is a follow-up from the line of Richard Close of Avondale.

[Richard C. Close:]

Yes. Just with respect to the pool of qualified vendors, do you have a rough estimate in terms of that number?

[Maria Perrin:]

There were less than 2 dozen that actually held the GSA schedule that was required. And several of those are not currently operating in the recovery audit space, so they would not qualify in terms of the experience requirement. So we expect it to be a very small pool.

[Richard C. Close:]

So who you have qualified is obviously the 4 existing vendors plus PRGX as a subcontractor?

[William C. Lucia:]

That much, we know. Would that be the end of it or could there be a few others? There may be. But we just don't know at this point.

[Richard C. Close:]

Okay. And then with respect to the Medicare COB, you pulled, I guess, the -- pulled $50 million out of that. That seems pretty conservative from the standpoint if there's some sort of resolution, that would be, obviously, upside to the current guidance. Am I thinking about that correctly?

[William C. Lucia:]

That's correct, at this point.

[Richard C. Close:]

And how quickly would that contract be able to ramp? Because I know you were previously doing work on that and then there was a work stoppage, but...

[Maria Perrin:]

Yes. I'll answer that, Richard. We -- because it's cost plus, we start incurring costs and therefore, revenues from day 1. So as soon as the stop order is listed, we will be able to start generating revenues on that contract. And we -- based on the work we've done so far, we fully expect to meet the start-up time lines, which would be about 90 days from the list of the stop work order.

[William C. Lucia:]

As I mentioned before, Richard, that roughly, the revenue is about $5 million a month once you get started, but that's also at a 10% operating margin. So it doesn't -- we're not talking about a large bottom line potential upside here.

[Richard C. Close:]

Okay. And then my final question, Walter, is with respect to the $15 million net on the Medicare RAC, and obviously, you've gone through various scenarios and a lot of different moving parts here. But if you could help us in terms of characterizing how conservative have you been with that $15 million net? Do you -- I mean, is that middle-of-the-road? Or do you think you've really cut it to the bone?

[Walter D. Hosp:]

I would not say we've cut it to the bone because there are multiple scenarios here. If the CMS proposed rules go into effect and there's absolutely no changes or an extension of the May -- end of May deadline and things like that, the impact could be higher. There are again the results of the protest. There's not only the -- well, there's that, there's the general procurement in terms of transitioning factors that CMS could change at any point in time here, all right? So we have -- and then there is what is reasonable to assume in terms of release of reserves. I will tell you that the $15 million is again net of the reserves, so the revenue impact is higher than that. So it is a, I think, a fair estimate, maybe a little bit on the prudent side. But I would not tell you it is a full downside scenario nor is it the full upside scenario, which you could make a case, if everything breaks a certain way, that we would have little to no impact on the year.

[Richard C. Close:]

And just to be clear, on the reserve portion of it, that doesn't assume -- that $15 million doesn't assume a full release of all the reserves, correct?

[Walter D. Hosp:]

Absolutely not. Absolutely not. It's relatively -- well, I don't want to say tiny portion, but it's a small portion. It's much less than half.

[Operator:]

Ladies and gentlemen, this does conclude our Q&A session. I'd like to turn the conference back over to Mr. Bill Lucia for any closing remarks.

[William C. Lucia:]

I'd like to thank everybody for joining our call today. We're looking forward to speaking with you and reporting on our second or quarter results in the future. Thank you.

[Operator:]

Ladies and gentlemen, thank you for your participation in today's conference. This does conclude the program, and you may all disconnect. Have a great rest of the day.