HMS Holdings Corp
Q3 2013 Earnings Call Transcript

Published: 8 Nov 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. Third Quarter 2013 Earnings Call. [Operator Instructions] I will now turn the call over to Jzaneen Lalani from HMS Holdings. Ms. Lalani, you may begin.

[Jzaneen A. 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 could 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, November 8, 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 will 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. Growth in Q3 was in line with expectations, with double-digit growth year-over-year for the quarter. As we move into the fourth quarter, we have a clear line of sight into our full year performance, which, while improving year-over-year, will not be as strong as we had initially anticipated. As a result, we are revising 2013 guidance, which Walter will discuss in more detail. Typically, in the third quarter, we provide you with guidance for the next fiscal year. We know that 2014 will bring new opportunities across our business, including the ACA-driven Medicaid growth and increased demand for our products in the commercial market. We are also facing uncertainty related to the Medicare RAC contract and the current program rule changes. The broad range of outcomes on this contract is so wide that any guidance for 2014 we give today would not be meaningful. Instead, we will provide you with insight into the growth levels we anticipate from the various areas of our business and expect that CMS will have clarified its intentions around this contract by the time we hold our February 2014 earnings call, at which time we would provide our full year 2014 guidance. After Walter discusses our Q3 financials and revised 2013 guidance, I'll discuss sales in the quarter, followed by a review of the headwinds and tailwinds impacting our business. I'll conclude with a discussion of our plans for margin expansion and provide an outlook for growth and increased profitability in 2014 and '15. Walter?

[Walter D. Hosp:]

Thank you, Bill, and good morning, everyone. I'll start by walking through our P&L and key financial items for Q3 and then provide a deeper dive into the revenue growth rates we saw in our major business areas in the quarter. Third quarter revenue was $127.8 million, up 12.8% over the prior year. This compares favorably with the consensus estimates for the quarter of $127 million. Year-to-date revenue was $370.2 million, up 8.7% versus the prior year. Looking at expenses for the quarter, total cost of services were $86.8 million, an increase of $8.4 million or 10.8% over the prior year. The growth of expenses is in part due to costs necessary to support the implementation of new contracts and continued long-term spending to strengthen our infrastructure. As I mentioned last quarter, we've also been focusing on our overall cost structure and reshaping our organization to ensure that resources are commensurate with the opportunities in each market. In the third quarter, we recorded onetime nonrecurring charges of $4.2 million related to legal and restructuring expenses. These charges amount to a $0.03 reduction in both GAAP and adjusted EPS in the third quarter. Compensation expenses related to the cost of services was $48 million for the quarter. As a percentage of revenue, this expense was 37.6% versus the 35.5% in the prior year. Growth in this line item is attributable to an increase in headcount of 140 employees over the same quarter last year, bringing us to 2,414 employees. Of this increase, the majority of additional positions were added to support growth in the Medicare RAC transaction buy-ins, new contract implementations and increased investments in IT and infrastructure development. Data processing expenses increased 23.1% or $1.8 million over the prior year to $9.7 million. This increase is related to hardware and software upgrades. Occupancy costs decreased $0.1 million to $4.4 million, a decrease, as a percentage of revenue, from 3.9% last year to 3.4%. The financial benefits of the downsizing and relocation of our New York data center are beginning to show in our third quarter results. Direct project costs decreased 25.7% or $3.7 million year-over-year to $10.8 million due to lower temporary personnel expenses, lower data costs and lower subcontractor expenses. Other operating costs increased $2.8 million or 88.7% year-over-year to $6 million. A large part of this unfavorable variance was due to a 2012 third quarter reversal of $2.3 million related to a prior acquisition contingency payment. Amortization of intangibles associated with acquisitions was $7.9 million for the quarter, a decrease of $0.3 million year-over-year. Selling, general and administrative expenses for the quarter was $19.7 million, a $5.5 million or 39.1% increase. During the quarter ended September 30, 2013, we averaged 200 corporate employees, an 8.3% decrease over our average of 218 corporate employees during the quarter ended September 30, 2012. Increased costs primarily related to $3.4 million in legal-related expenses, $0.3 million in consulting fees and a $0.5 million increase in employee severance and termination benefits. Excluding severance expenses, compensation expense increased by $1.1 million. Data processing expenses increased by $0.2 million in the quarter. Income taxes were $7.5 million for the quarter, compared to $6.1 million for the same quarter last year. The effective tax rate for the quarter was 39.4% versus 36.8% last year, although on a full year basis, we expect a 39.3% effective tax rate compared to a 39.4% for the full year last year. The decrease is primarily due to state taxes and apportionments. Net income for the quarter was $11.5 million, an increase of $1 million compared to the same period in 2012. Fully diluted weighted average common shares outstanding for the third quarter were 89.2 million shares. Fully diluted GAAP net income per share was $0.13 compared to $0.12 in the prior year quarter. The $0.13 compares to a consensus forecast of $0.15. Adjusted EPS was $0.20 for the quarter, the same as the prior year period. This compares to a consensus forecast of $0.22. Adjusting for the $0.03 impact on nonrecurring expenses, the result is $0.01 ahead of consensus estimates for the quarter. I would also note that we ended the quarter with cash and short-term investments of $130.8 million. And as of yesterday, that number had increased to $143 million of cash on hand. On a year-to-date basis, operating income of $56.9 million was down 8.7% from prior year-to-date, and net income of $28.9 million was down 5.3% from the prior year. Net cash from operations was $75.2 million for the first 9 months in 2013 versus $53.8 million through the third quarter of last year. We also made principal payments of $35 million in the third quarter on our outstanding debt balances and a total of $60 million in debt repayments during the current year period. We'd now like to take a closer look at the revenue growth in the quarter. The first point I'd like to make on this slide is that our total revenue growth rate is in line with expectations. Again, in this quarter, we have a wide range of growth rates. If you compare the third quarter growth rates to the second quarter of this year, you see a positive trend. As I've mentioned, total revenue for the quarter increased 12.8% to $127.8 million. Looking at revenue growth from a market perspective, year-over-year growth in our Medicaid market was 1.7% in the quarter. The overall growth rate has improved but is a bit below our forecast. Historically, we've divided the Medicaid market into our State Government and Medicaid managed care or MCO market. As you can see, the growth rates range from a minus 3% for State Government to 11.1% growth in MCO, mostly attributable to the shifting lives from fee-for-service to managed care. Our federal business decreased 13.9% in the quarter year-over-year but is showing improved growth rate from Q2, which is expected to continue in the fourth quarter, when the impact from federal contracts that we canceled or chose not to bid will be fully lapsed. Our HDI revenue growth rate was 45.7% year-over-year in Q3. This result was above expectations and came from growth in both the Medicare RAC and the commercial parts of the business. However, in subsequent quarters, we will expect a decline in revenue from the Medicare RAC due to the program changes that Bill will go into more detail in just a moment. Looking at our revenue growth in the quarter from a product perspective, revenue growth from our Medicaid Coordination of Benefits, or COB business, was down slightly year-over-year. And as Bill will explain momentarily, we expect to see higher growth rate in COB in 2014. Our Program Integrity products across the entire company grew 29.2% year-over-year in the quarter. This includes both ACI and the federal markets. If we adjust for these 2 areas, Program Integrity growth in the quarter was 22.9%. For 2013, with 3 quarters completed, we are adjusting our guidance, as shown on this chart. We are tightening the revenue range from $495 million to $525 million to a range of $495 million to $510 million. For GAAP EPS, we are lowering the range from $0.57 to $0.63 to a range of $0.44 to $0.51. For adjusted EPS, we are lowering the range from $0.89 to $0.95 to a range of $0.75 to $0.82. The EPS adjustments reflect the expected lower range of revenue results and the nonrecurring legal and restructuring charges I mentioned before. It also reflects an anticipated decrease in the revenues under the Medicare RAC contract in the fourth quarter. That concludes my review. And now I'll turn the call over to Bill.

[William C. Lucia:]

Thank you, Walter. I'll start with a discussion of our key sales for the State Government market. This quarter, HMS re-procured Coordination of Benefits contracts in 3 states

[Operator:]

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

[Ryan Daniels:]

Bill, let me start with a couple, just on the Medicare RAC re-procurement. I think you said in your prepared comments CMS has now indicated they anticipate on ordering that in February. Is it your impression that you would be able to then start fairly quickly? Or would that then allow kind of a 90- to 120-day protest potential so that it might not even start until June of 2014?

[William C. Lucia:]

Ryan, that's a good question. What we did hear from CMS is they're expecting awards by February. But the challenge will be, of course, if there are protests, and then how long those protests are mitigated. What CMS does have in place is a contract with each of the existing RACs. So if they choose to, like they do in many federal procurements, allow the existing work -- existing vendors to continue working, then under the modifications we talked about with the moratorium, if they allow us to continue to work on new claims through a protest period, then, obviously, we would have revenue through that period. That's not currently in the plans. But it does -- but based on what we know today, and using some common sense about continuing to bring dollars back to Medicare Trust Fund, we think that's possible.

[Ryan Daniels:]

Okay, that's helpful color. And then if we can think about the RAC business, obviously, a ton of uncertainties with timing and restrictions and region and pricing. I guess, the one thing I want to get your thoughts on, if they do put increased restrictions, obviously, it would be applicable to all the different RAC providers. Would that change your outlook on pricing, i.e. the potential that pricing maybe would have to go up for vendors if they're in handcuffs a little bit more about what they can do?

[William C. Lucia:]

Well, I mean, we probably wouldn't want to put our pricing discussion out publicly, but I would say that we will do what every other RAC vendor will do, and that's look at the scope of work, look at the CMS' intent on what audits they'll allow us to do and the ADR limits and all the other factors, and we'll make pricing recommendations according to that. That's probably the best I can say, but that's what we do on any contingency fee bid today.

[Ryan Daniels:]

But let me ask you a little different. Would it be your intention to try to maintain the margins of this business on a go-forward basis? Or given all the noise, may you have to accept some margin depression in RAC?

[William C. Lucia:]

I don't -- we may have some temporary margin depression on RAC if we maintain additional staff through a lower-volume period. But I don't anticipate that the margins on the RAC contract should go down over the long haul. Now we're talking about a 5-year contract, so margins could be lower in the first year or 2 and then grow as their contract grows.

[Ryan Daniels:]

Okay, no, that's helpful. That's what I was looking for. Maybe one more and I'll hop off. Just in regards to your color commentary on the revenue growth with the state governments, it seems like the vast majority of the reason for the slowdown, despite the Medicaid RACs ramping in '14 and despite the Medicaid growth, is that just because the lives are moving into commercial? And now based on the way you're reporting, those lives moving will impact the State Government negatively and then boost the commercial? Is that the way we should think about that?

[William C. Lucia:]

Yes. I mean, I don't remember the correct number, but a significant population has moved in the last 3 years. And we're actually feeling pretty confident that if we come out of next year with a relatively flat state government market, we'll have really mitigated that move of managed care. And we're doing that through both the RAC implementations and then new sales of Fraud, Waste and Abuse. Now I will say that I think, in a year, everybody who's had to deal with managing exchanges is going to come up for air and realize that people have been enrolled in the wrong programs based on income disparity or other factors. And there will be other needs to perform our eligibility services. So we have great hopes for the State Government business, but we think it's a win just keeping it flat with all of the lives that have exited.

[Operator:]

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

[David H. Windley:]

To follow up on that last question, would it be possible, as we think historically about your Medicaid COB business, that largest business, how much of that stays in the State Government bucket? And how much of that would go into commercial as you're categorizing going forward?

[Walter D. Hosp:]

Yes, so it's been -- this is Walter. Historically -- well, for 2012, it was a 1/3-2/3 split, roughly, 1/3 from MCOs to 2/3 in state. Clearly, as we get into 2014, that mix is going to change and get closer to 50-50. In fact, we may exit the year where it's close to that breakover point. And then in 2015, when you account the -- all these lives shifting over and the growth and our sales plans, we should be able to cross over at that point.

[David H. Windley:]

Okay. So maybe to put a finer point on Ryan's question, if I then look at that state bucket, if the state piece of COB is down to kind of half of the total and Medicaid RAC is ramping pretty nicely, I guess, I'm trying to think about the relative size of the 2. Can you give us a sense of what your assumption is on Medicaid RAC growth specifically?

[Walter D. Hosp:]

We don't -- we're not giving that detail of the forecast at this point. It is rolled up in the overall growth, again, excluding the Medicare RAC contract with the 10% to 11%. Next quarter, as we clarify that and we give you specific numerical guidance here, we can talk about that. But increasingly, we'll discuss Medicaid RAC and more of the Medicaid program integrity programs. You heard from Bill's comment, it's not just the RAC contract, but other services that we're beginning to sell to our state marketplace as well. Medicaid RACs are, as I had made prior comments before at various investor events, they're developing not as strongly as we wish. And in 2014, we'll be looking at the more profitable ones to bolster and the ones where the results aren't as strong, we'll be having to make questions about whether or not we want to re-procure them. But that is part of the equation working with states and the Medicaid services because we have more products that are even being sold outside of those RAC programs themselves.

[David H. Windley:]

Okay. And then I'll ask one more and drop out. On the growth in HDI, 45%, I think, 46%. Is it possible to split that out between the commercial piece of that and the Medicare RAC piece of that?

[Walter D. Hosp:]

Well, the best number we can give you is that this year, we're expecting the Medicare RAC contract to generate approximately $100 million in revenue.

[David H. Windley:]

Okay. And I apologize, one more. So just to clarify, did I understand you correctly in saying if I exclude Medicare RAC, that you expect margin to be up 5% to 6%, meaning 500 to 600 basis points in margin improvement year-over-year, excluding Medicare RAC?

[Walter D. Hosp:]

That's correct.

[Operator:]

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

[Richard C. Close:]

Just a point of clarification on the 10% to 11% growth number that was, I guess, discussed with respect to 2014. That 10% to 11% is excluding the Medicare RAC, is that what you're saying?

[Walter D. Hosp:]

That's correct. Yes, that's that right now.

[Richard C. Close:]

Okay. With respect to the, I think you mentioned, $15 million in expense reductions that you're expecting here for 2013, and I think you mentioned more in 2014, can you discuss a little bit what those are in terms of the buckets that, that comes in?

[William C. Lucia:]

Richard, this is Bill, I'll talk about that. So some of it was further flattening the organization. So we believe that it makes sense for us to be as close to our customer as possible. So we removed different levels within the organization, we closed offices that were non-required and where we had duplicity in services. So we're getting a pretty large bump from consolidations of offices. Of course, when they move into the Irving headquarters, which we own, we don't incur new occupancy fee. We lose the rent from the old offices. A layer of management's removed. The other thing we're doing is, really, renegotiations of all of our vendors, our service delivery vendors. And then lastly, earlier this year, we hired a new executive over our operations, and she's been combing the company primarily to make sure that we have higher throughput throughout the organization, we are relying less on temporary expenses, temporary labor, and still delivering our throughput. So we've gained extreme efficiencies, primarily in our operations area. So it's really coming from a lot of different areas. Next year, our focus will be on better deploying our technology to further reduce operating expenses.

[Richard C. Close:]

Okay. And I guess, my final question really centers on the 2-midnight rule and better understanding the potential impact. Obviously, as it relates to setting of care, that was really a big bucket for all the RACs to go after and, let's say, some low-hanging fruit there. But you guys are an analytics company, I guess, in its truest form, to some extent. So I'm curious whether you can discuss with us, as you look back retroactively, your interpretation of how much the change of this rule would've impacted HDI's Medicare RAC revenue. You're saying you expect like $100 million this year in revenue. But if you sort of laid over the 2-midnight rule going back, would that revenue be $50 million? Any type of, I guess, color around that?

[William C. Lucia:]

Well, let me give you -- so I'm going to tell you what we know based on what me know today, right? Because the rule -- I mean, daily, we're getting different directions from CMS, and I think that's because they are having a challenge maneuvering through, bouncing all their stakeholders, right? The hospitals, the RACs, legislators and beneficiaries. What we know today, the reduction in volume for us of audits is about 40% to 50%. But I wanted to put a caveat on that in that there may -- we may just be doing -- that represents all short-stay audits versus short-stay audits for patient status. And once we get further clarification about what we're allowed to do and not allowed to do during the moratorium, we may be in a better position to tell you the impact. But I think across the board, for the RACs in general, it's about 40% to 50% of volume is the short-stay audits.

[Operator:]

Our next question comes from the line of Robert Willoughby of Bank of America.

[Elizabeth Blake:]

This is Elizabeth Blake, in for Bob Willoughby. Just on the Medicaid COB guidance for next year, could you provide more color what exactly is in that, what portion is reform? We're just trying to get an idea for what the downside risk would be there.

[Walter D. Hosp:]

So just to clarify, Elizabeth, you're asking about Medicaid COB growth and what our assumptions are behind the growth from reform?

[Elizabeth Blake:]

Yes, within the 8% to 10%, what are your assumptions?

[Walter D. Hosp:]

Well, as Bill mentioned, we see the forecast by CMS and by Kaiser putting that Medicaid expenditure growth in the 10% to 12% range. And our forecast is below that because we don't see the impact in our revenues until after they've been enrolled and after that expenditures have occurred, although we get some upfront with our cost-avoidance products. So first, I would mention that it's very much back end-loaded in the year, and the assumption levels have to do with being driven by the amount of lives, as we've said, a little over 9 million lives expected to come into the program. Early indications are from the exchanges that, that is maybe not a number that's going to be very far off. And so we don't have an explicit number that's carved out for just that, because we have a mix effect going in and out there of the lives shifting over as well. But it's in that neighborhood of assuming less than -- for us, revenue growth less than the growth in the Medicaid expenditures that we're seeing from these public sources.

[William C. Lucia:]

Really, what we've done, and we don't have the number on the top of our heads, but we've done a bottom-up, market-by-market analysis of the lives, the expected lives going into our health plans versus fee-for-service, because some lives are still going into fee-for-service. And the reported growth per stay, based on either state data or Kaiser Family Foundation data or CMS, and did our model based on that. Now we were -- in our view, we're conservative because we know that, in some instances, it takes up to 6 months to get claims for us to process. So -- but we built the model ground up, and then we looked at the guidance from CMS, the between 10% and 12%. And we assumed that we'd stick with our model, and if we started to see upside from that, we'll end up changing our -- once we issue guidance in 2014, we would end up changing our guidance as appropriate.

[Elizabeth Blake:]

So 6 months of the 10% to 12% impact, it's fair to say that roughly 5% to 6% of that 8% to 10% would be reform right now?

[Walter D. Hosp:]

It's not unfair to ballpark that way.

[Elizabeth Blake:]

Okay, great. And then just on the federal business, are you still forecasting a return to positive growth this year, or should we be kind of modeling more declines next quarter?

[Walter D. Hosp:]

Well, that depends on a number of specific contracts there. We'd be cautious about it. As I mentioned, we are lapsing sort of year-over-year differences from contracts we had to walk away from, but we've also -- interestingly, we've faced some things like when the government shutdown hit, that affects some processing times for that federal business. So I would be cautious in terms of presuming growth early this year. But next year, we do expect that to grow in the -- up to around a 10% range, high single digits.

[Robert M. Willoughby:]

Walter, it's Robert Willoughby, sitting in for Elizabeth Blake here. Can you just review what your capital deployment plans are for next year? I know you don't want to give the guidance as yet, but what can we assume you're doing with the cash, near term?

[Walter D. Hosp:]

Well, cash, we generate significant cash flow still. And so -- and have quite a bit. As I mentioned, we have, at the end of the quarter, $130 million in cash. We paid down another $35 million in debt. So in the short-term nature of things, we have sufficient cash to handle all our growth needs. We have a $500 million revolving credit facility as well. So the priorities are for the internal investments, so we have in a range of $10 million to $15 million of capital investments for maintenance capital, if you would, and to invest in the IT consolidations that we've mentioned. M&A, obviously, is sort of first call on that capacity, the additional financing capacity. And we have in place a $50 million share repurchase program that we haven't necessarily activated on as of to date that could utilize some of that cash as well. So to wrap up, it's more than adequate. It's the internal investments, but that only takes a small amount of it. It's the M&A opportunities that we are systematically trying to address and then, potentially, share repurchases.

[Robert M. Willoughby:]

I wonder, Walter, why now wouldn't be the time to make a bolder statement on the share buyback, given where the valuation is and some of the disappointments here and just the unknown going forward. Isn't now the time to put a line under devaluation in the stock with a repurchase?

[Walter D. Hosp:]

We have regularly -- regular conversations with our board regarding a share repurchase program we just put in the last quarter, the $50 million. Again, sort of timing restrictions and what have you, we haven't been able to activate on it. But we will regularly review that program.

[Operator:]

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

[Jamie Stockton:]

I guess, maybe, the first one, Walter, as we think about the profitability of the company and the portion of it that comes from the Medicare RAC contract, would -- you've said that it's 20% of revenue this year. Would it be safe to assume that it's more like 25% or 30% of the overall company's profitability?

[Walter D. Hosp:]

We don't break out profitability by area or particularly by contract there. But we have said in the past is that HDI's sort of operating margins were in the 25% levels there. So you can get some indication of that from what we've said in the past.

[Jamie Stockton:]

Okay. And then on the re-procurement, everybody seems to be sitting around waiting for this RFQ to drop. Is it possible that CMS -- or, I guess, maybe just what are your thoughts on the potential for CMS to award a contract based on the first RFQ? Or do you believe that they absolutely have to put out another RFQ?

[William C. Lucia:]

They can amend it. This is Bill. They can amend it. When the RFQ was protested, CMS agreed to take corrective action in order for the protest to be dropped and that satisfied the GAO. So CMS can amend the RFQ to fix the areas that were problematic in the original RFQ, which means that it could come out any day now, which is what we've probably been hearing now for a few weeks.

[Jamie Stockton:]

Okay. And then just 2 more quick questions, one on Coordination of Benefits. It seems like it was down sequentially. I understood that last year because of 5010 transition issues. Was there maybe a disproportionate impact of lives transitioning to managed care or something like that, that might have impacted that business this quarter?

[Walter D. Hosp:]

Yes, I mean, look, we've been -- the last -- this quarter and last quarter, I've broken out sort of the quarterly growth rates to be able to answer some questions that's specifically around that. But the proviso that I gave today and I always have to give is that our business is very, very lumpy. And quarter-to-quarter, particularly sequential quarter-to-quarter, you can get all sorts of aberrations in there that are not indicative of the growth trend of the business, right? So we can have periods where sequentially it goes up and down, you've seen that historically in the past, and yet, the overall growth rate for the year is fine. So again, just a big caution on any quarterly numbers on that indicating it. We're seeing strength in our COB business. I mean, there's no question to that. We're looking at the underlying transaction volumes. We're looking at enrollment in Medicaid. Yes, there's a lot of noise because of these transitionings of lives, when to put them through there, and sometimes there's delays in terms of the lives when they leave a state client and show up on managed care clients. We can see operational noise and disruption that occurs from that as well. So a big caution in terms of extrapolating that, but I can't argue with the numbers.

[Operator:]

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

[Frank Sparacino:]

Walter, just curious if there's any update you can provide with respect to how you're looking at reserves today and going forward.

[Walter D. Hosp:]

Sure. So you'll see on our balance sheet that we have approximately $40 million of reserves. These, again, are reserves for appeals that come with the program. We can continue to add from them because, as you saw, HDI had a very strong quarter as well, and with that comes the addition of reserves to that. So we will even add to it -- or expect to add to that before year end. And then, of course, it starts to maintain itself, let's say. Given that we've had the contract extension that goes out to December of 2015, what you will see at year end is pretty much the peak period. And then as we are now obliged to do, continue the process appeals and, for successful appeals, return our fees associated with successful appeals, we'll begin to see that reserve being drawn down. In terms of the adequacy of it, I think it's -- well, all I'm allowed to say, really, is that they are adequate reserves. But I can say that I do not lose any sleep at night with the level of reserves that we have.

[Frank Sparacino:]

Is the best way to look at that number in 2014, from a modeling standpoint right now, is just to ignore it?

[Walter D. Hosp:]

I would say yes, because I don't expect to see anything that passes through the P&L as a result of that. A proviso is that every quarter, we look at experience, and we have to make adjustments and what have you. But it's such a significant reserve against the volume that has been processed thus far, and as you've seen, it's been growing. And when we start to reduce it, because there'll be drawdowns on it, if you would, for successful appeals, that doesn't flow through the P&L. So the true-up for those reserves really come at the end, in 2015, and that's when the reality of whether they've been higher than needed or lower than needed will require some adjustment. So I would see that more as a 2015 tracking item. And one other things I'd mention is that, obviously, we expect to win a new contract. Under that new contract, we'll examine the program, the new rules, reestablish what we need for reserves and our approach to that. And it may be a different approach because it's a different contract under different rules. But that would be potential to add to reserves for appeals.

[Frank Sparacino:]

Okay. And then just lastly, I think it was -- I don't know if it was Bill or you who commented about the expense reductions this year of $15 million. And just wondering, going into 2014, you said it would be greater, but can you sort of quantify what the expectation would be?

[Walter D. Hosp:]

Well, I think they're quantified in the expanded operating margins of 5% to 6% next year. And that is -- because it's not -- and that is more than just cost-cutting and operation monies. It's the yield improvements out of our operations that Bill has mentioned. It's the technology consolidations and improvements in the way we're moving data. It's the physical space consolidations that we've been doing overall. So as we had indicated in prior quarters, and now we're talking about specific one-off charges in this quarter to begin to address this, we have opportunities to not only improve the efficiency and the yield and the output, which really improves revenue growth, but do that at costs that not only don't require proportionally higher investments but, in some cases, can have lower costs.

[Operator:]

Our next question comes from the line of Charlie Strauzer of CJS Securities.

[Charles Strauzer:]

If you could just expand a little bit, too, on the talk of this transition from Medicaid to managed care. And Bill, is there any thought there -- has the thought process changed, I should say, as to when you think the majority of that transition will kind of stop?

[William C. Lucia:]

That's a good question, Charlie. Now that we think we're through the largest transitions, but there are states that -- I mean, Alabama's talking about doing it. Mississippi is talking about it. There are also states that have gone from managed care back to fee-for-service, like Oklahoma and Connecticut. So you can't really pinpoint it. Over the years 2012, '13 and '14, 11 million lives transferred. I would say, out of new lives entering the program, it's probably 80%, 70% to 80 % of the new lives entering the program, but there are still lives going into fee-for-service. If so I don't know if we can say the transition will ever be done, but I think there will be adds and subtracts through the process over the next couple of years.

[Walter D. Hosp:]

And on a negative basis, Charlie, just to mention that, I went through the proportionality of 2012 looking at 1/3-2/3 and MCOs versus states, and then approaching the 50-50. Once we reach that sort of breakeven point, the trend is working for us in terms of, well, a number of factors

[Frank Sparacino:]

Great. And then picking back up on the subject of the cost saves. Obviously, if you are awarded a different Medicare RAC region, you probably have some new costs to ramp that would probably offset those costs savings, is that correct?

[William C. Lucia:]

I don't think so. I mean, we -- HDI has the infrastructure to be able to really enter any new region. While we may need to get -- it's not like the state, where we need to get nurses who are certified in that state. We already have a national network of providers and an insurance -- physician panel. There may be some -- like any other RACs, there may be some testing with the new MAC on the interfaces. But we've worked with more than one of the MACs already. So I don't think there's that big of a downtime with a new region. If we rewon our existing region, it will be expanding. So we'll just get upside from that as well.

[Frank Sparacino:]

Excellent. And just switching gears to the commercial side, Bill, when you talk to customers about making kind of these RFQs and things like that, what are the kind of the limiting factors you think that are preventing a more rapid growth in kind of acceptance in the commercial market?

[William C. Lucia:]

Well, the commercial has -- I mean, it's not like we are entering a virgin market. There are probably 50 different vendors, at least, that provide some sort of cost containment, recovery or utilization management service to the commercial market today. We're one of them, but we're growing because the customers that have used us for COB work get consistent recoveries. They're the kind of recoveries that you can bank on and make sure that they're going to -- and if you're publicly traded, you know that it's going to be a couple of pennies EPS, right? So when they look at who they're going to buy their next set of services from and you have a reliable recovery stream, you do look to HMS. Not all of the plans use RFQs and RFPs. When we're in an RFP process, we're very successful. In other processes, it's just really an upsell or a direct sale to a client. So while our products fit, we're now in the process of building the sales team to have a much faster penetration.

[Operator:]

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

[Bret D. Jones:]

Walter, I wanted to circle back on Jamie's question on the COB business. And I understand there's lumpiness from quarter to quarter but I remember last quarter, we talked about there being a high level of confidence with TCOB [ph] up sequentially. And I'm just wondering, was there something that shifted out that you're aware of or anything unusual that would have happened in the quarter?

[Walter D. Hosp:]

There's almost something unusual in every quarter if you put it against the forecast. In other words, there's always variances on that. But I'm going to turn to Bill to answer this one.

[William C. Lucia:]

Yes, let me add a little color. So as you know, we got through the 5010 debacle and have resolved most of those carrier problems. But there are challenges with 2 large carriers and PBMs right now. Really, it's just technology challenges on their side. We expect that's in the order of $4 million to $5 million in revenue to us. So obviously, it's very large, since we're a small contingency fee. So $4 million or $5 million in a quarter could definitely impact that. So that said, there's always a couple of million each quarter that doesn't -- we don't get because of delays in carrier processing, but this one spikes out above that.

[Bret D. Jones:]

Was this a new issue with the PBMs, or is this going all the way back to 5010, and these 2 PBMs still haven't resolved it?

[William C. Lucia:]

It's been a long period of time. And we've been working very closely with both of these processors to make sure that we can test -- they can test our claims appropriately for the system, and we're pretty confident we'll have this resolved in Q4.

[Bret D. Jones:]

Great. I also wanted to ask on the HDI growth, which was much stronger than I expected. I remember a couple of quarters ago, when there was a -- it looked like the program would be put on hold for a while, there was an acceleration in the record request. And I'm just wondering, are we seeing a catch-up of this? Is this more onetime, or is this really the new steady state where the Medicaid RAC business has grown?

[William C. Lucia:]

I mean, some of it was making sure that we could maximize as much work, knowing that this moratorium was coming up. Initially, when the RACs renegotiated the extension, the extension that allows us to support appeals through 2015, we felt that prior to that, the CMS was really shutting the program down or putting it on a hiatus through a procurement period. So we negotiated to keep it running, and I think this is probably true of all of the RACs, we just put as much through the process as possible to make sure that we could get those recoveries in. So that's what you're seeing in the Q3 results.

[Bret D. Jones:]

Okay, great. And then I just wanted to ask, in terms of the current RAC requests, are they still supposed to end at the end of this month? Or -- I know you talked about how that could still be extended. I just want to make sure that's the current projection is that they will end at the end of this month.

[William C. Lucia:]

The -- we're not allowed to submit any new letters to providers after that.

[Bret D. Jones:]

That's what I was referring to, sorry.

[William C. Lucia:]

But there's still a tail of work that we're doing that will be generating revenue through -- clearly, through the first quarter of next year or until the new contract starts.

[Bret D. Jones:]

Okay, great. And then one last question, quickly, on -- I know we talked about the Medicaid RAC, Medicaid RAC market size being somewhere around $100 million. Does the short stay admission rule, the 2-midnight rule, affect what do you think the market opportunity is within that business? I would assume it would have a similar type of impact that you're talking about on the Medicare side with Medicaid.

[William C. Lucia:]

That's a good question. A lot of -- let me take commercial first, because a lot of commercial carriers start to model their reimbursement policy based on CMS. I don't think there will be any moratoriums outside of what's being done at CMS because they're trying, with the providers and the MACs, with new reimbursement policy. But we do -- what the states do feel, and I can't say this is consistent, but there are a lot of states that are concerned that the hospitals are getting audited by so many different entities that they are a little wary of auditing hospitals. So depending on the state -- and we've said before, once you've seen one Medicaid RAC, you've seen one Medicaid RAC. Depending on the state, they'll make different decisions about this type of audit. We haven't really had any states that have said, if we proposed short-stay audits, that have said "No, you can't do a review."

[Maria Perrin:]

This is Maria Perrin, I'll add on that. So far, none of our state Medicaid clients have told us to follow the new Medicare RAC rule. But Bill is right. The focus from Medicaid RAC, before, has really been anything we can do on nonhospital providers, where possible, as well as financial and reconciliation audits to the extent that we can alleviate some of the burden on the medical necessity audits that they're going through from other auditors.

[Operator:]

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

[David H. Windley:]

So I guess I wanted -- I did a little bit of math. And I guess I was wondering, on Medicare RAC, obviously, a lot of moving parts and things that you can't predict today. But in just very broad strokes, are you expecting that, that business will make money, break even or lose money in 2014?

[William C. Lucia:]

I'm going to answer this, I think, the way we said it earlier, just because guidance from CMS has been changing almost daily. And it's because they're implementing a new rule, it's very difficult for us to get our arms around what their real plans are. But I can tell you that all the stakeholders are very interested in getting this resolved, but we're not going to provide any further guidance on what we expect that contracts perform because it's just changing too rapidly. Once we get some stability, and we think that will be done by February, we'll be able to give a better answer on that. Of course, if something's resolved earlier, we will definitely communicate that to the investment community.

[Walter D. Hosp:]

And Dave, clearly, throughout the year -- look, first quarter and going into second quarter, it's more likely that we're going to not make money than that we will. But it's the second half of the year that is the real question mark on all these things. So yes, we'll have impact in the first half of the year. And we're prefacing that we will just not quantify that at this point, given everything that's open.

[David H. Windley:]

Got you. And your reference there is obviously moratorium-related, the obviousness of the first half, correct?

[Walter D. Hosp:]

It's moratorium and procurement and working through rule changes, getting specificity of what it means on the business. It is a very complex set of situations, making it not just tricky, almost crazy to try and forecast accurately.

[David H. Windley:]

Right, understood. And if we go back 6 or maybe even 9 months in terms of protest and thinking about just the answer you just gave about the potential for them to shut the RAC program down for a period of time, there was discussion about furloughing employees and things like that. What type of cost contingency plans do you have in place for the RAC program as all these things are so much in the air?

[William C. Lucia:]

Well, we're still working at a pretty full volume right now. But as we -- as the volume starts to decrease -- and remember, they haven't stopped all auditing, they've just stopped patient status auditing for short stays. We're still doing minor surgery audits and that arena and then, of course, all other types of audits. But CMS publishes maybe a little different than what they give us in technical direction letters. But we'll start to see that trail down, and as we do, we'll start furloughing employees. And the HDI business has a fair amount of variable spend. It's clinicians and coders that are -- it's based on volume. So as the volume starts to decrease, we'll be able to decrease staff at a pretty rapidly -- at a pretty rapid rate. We don't -- we clearly don't want to lose all of our talent because that talent is applicable in our commercial and Medicaid market. And as we see rises in -- or new sales on the commercial space or a need to apply nurses to a -- or clinicians to a Medicaid RAC project, we would do that. So because of our broad footprint, we may be a little better able to manage this transition.

[David H. Windley:]

That's helpful. And one last one. Would you be willing to quantify, in the commercial -- I guess, what I'm trying -- in part of my prior question, trying to understand commercial, the origin of the dollar a little bit, commercial state versus Medicare. And you're putting -- or call it for-profit or publicly traded Medicaid managed care clients in commercial. I'm wondering if you could help us to understand how much of commercial is related to an underlying commercial member versus a state-sponsored member in that bucket. Does that make sense?

[Walter D. Hosp:]

I just want to clarify from -- I mean, you say down to an individual there.

[David H. Windley:]

Well, I just -- it's dollars related to the coverage of a person in a commercial plan as opposed to a person in a Medicaid plan.

[William C. Lucia:]

I don't think we have those numbers in front of us. But we have, in our commercial business, we have basically 4 major sectors

[Walter D. Hosp:]

In that, said differently, it's the MCO business, as you have historically known it, the commercial clients of HDI, and that revenue's in there as well as a host of -- and we've been getting to say it in prior quarters that we've been getting straight commercial accounts as well. I'd also point out that this regrouping of our revenues is very consistent with how we manage the market. And MCO is, in some cases, a standalone MCO, but in many cases, a unit of a larger commercial health plan. The contracting, the client services requirements, the product deliveries, all those are much more consistent with a commercial perspective than it is with a state government. So -- Maria would like to add a comment.

[Maria Perrin:]

Yes, and just adding on to Walter's comment, more and more, our sales in this market are across multiple lines of business for a health plan. So you have one contract that you will get, not only our Medicaid lives, but Medicare Advantage and the group health lives under the same contract.

[Walter D. Hosp:]

So this realignment is consistent with how we're running the business.

[David H. Windley:]

Got it. That's very helpful. And the reason I asked the question is you've talked historically about error rate in the 3 buckets, Medicare and Medicaid and commercial. And it seems like the most under-penetrated and biggest open-ended opportunity is in that commercial bucket, and that is somewhat hidden by lumping all those 3 together in the commercial bucket now.

[Walter D. Hosp:]

Well, it may be, but we lay out that there's a large amount of errors in commercial. There's not the uniform, definitive voice, though, that you can get at Medicaid and Medicare in defining that. But in terms of where we are and the growth prospects, we absolutely agree, that is one of the biggest growth opportunities we have in front of us.

[Operator:]

Our next question comes from the line of Ryan Daniels of William Blair.

[Ryan Daniels:]

One quick follow-up. And I apologize, I know the call is going long, but putting together some of your commentary, I guess, directed to you, Bill, you said you have relationships with 170 managed care organizations. You also referenced about 50 providers in the market. And I think, if we look at HMS in your offering set, it's probably the broadest of anyone today. So I'm curious, I guess, really if number one, you're seeing consolidation among some of these managed care organizations to go to a single vendor where it gives you an advantage and what that's doing to your win rate. And number two, kind of very big picture on the new HIPAA regulations, which started, I don't know, 3, 4 weeks ago. It seems like that might be a catalyst for you to start getting higher win rates or more consolidation. So just any color there, and I'll jump off.

[William C. Lucia:]

Thank you. That's a good question. We are finding that, I'll call it, the middle market, so if you take the very largest national carriers out of the mix who do a lot internally and then use many, many vendors, there is a need in the middle market to consolidate the vendors they use. And part of it may be driven -- and we had thought it would be driven by the new HIPAA omnibus rule, primarily because it has very, very strict guidelines on security and privacy that, if you're a 2 million member health plan and you use 20 vendors, you're giving 20 vendors PHI data, and you have to then audit your downstream vendors to make sure that they have appropriate security standards in place, and there's more rigor around that. So there's a much higher administrative cost to a vendor -- I mean, to a carrier to have 20 -- 10 to 20 vendors than to have 1 or 2. And that happened for us favorably in a couple of plans this year, and that's part of our strategy because we have also have the technology to link together all of the recovery activity that the plan does itself. But that's a very good insight into what may drive consolidation of vendors in the market.

[Operator:]

And that concludes our Q&A session. I'd like to turn the conference back over to Mr. Bill Lucia for any closing remarks.

[William C. Lucia:]

Well, I'd like to thank everybody for joining our call today and supporting the company. We look forward to speaking with you in February and reporting on our fourth quarter and full year results. Thanks again.

[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 your day.