HMS Holdings Corp
Q4 2013 Earnings Call Transcript

Published: 28 Feb 2014

[Operator:]

Good morning. My name is Marcus, and I will be your conference operator today. At this time, I would like to welcome everyone to the HMS Holdings Corp. Fourth Quarter and Full Year 2013 Earnings Call. All lines have been placed on mute to prevent any background noise. After the speakers’ remarks, there will be a question-and-answer session. (Operator Instructions) I would now like to turn the call over to Jzaneen Lalani from HMS Holdings. Ma’am, you may begin the conference.

[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 management, 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, February 28, 2014. And the company disclaims any intent or obligation to update any forward-looking statements 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. On the call today is Bill Lucia, our President and CEO and Walter Hosp, our CFO. Walter will begin with a review of our financials and outlook then Bill will take you through sales for the quarter and a discussion of our key growth drivers. We will then open the call up for your questions. Walter?

[Walter Hosp:]

Thank you, Jzaneen and good morning everyone. I would like to begin by going through our income statement for the fourth quarter 2013 and then briefly review the full year P&L. This will be followed by a review of our quarterly trending and finally an outlook on 2014. Revenues for the quarter decreased 8.6% year-over-year to $121.6 million. This compares with a consensus revenue estimate of $131.5 million. Revenue in the quarter was lower than expected in the COB area due mainly to the processing delays and errors at two large PBMs, which caused revenue to move out of the quarter. This revenue decrease was partially offset by year-over-year growth of 11% in the Medicare RAC contract. As a result, COB declined 18.6% year-over-year while Program Integrity grew 3.9%. I will go deeper into the year-over-year comparison for the quarter more fully in the next slide. Looking at expenses for the quarter, total cost of services was $84.9 million, an increase of $0.3 million or 0.4% over the prior year. What you are seeing is essentially flat growth of expenses reflected in our restructuring and cost-cutting initiatives that began in 2013 and which are continuing in 2014. Compensation expense related to the cost of services was $47.8 million for the quarter. As a percentage of revenue, this expense was 39.3% versus 31.6% in the prior year. In the fourth quarter, we had an average non-SG&A headcount of 2,409 employees, a 1.6% increase compared to the 2,371 employees in the prior year period. Although compensation costs have grown year-over-year, this expense was nearly flat with the third quarter 2013 expense, again, as a result of our restructuring initiatives. Occupancy costs for the quarter were $4.6 million, down 1.8% from the prior year. We expect further efficiencies in occupancy cost as we continue to consolidate our offices and bring more functions to our Irving headquarters. Direct project costs were $10 million for the quarter, a decrease of $4.7 million, or 31.9% versus the prior year quarter. This decrease was a result of fewer temporary personnel, lower professional fees and lower medical record expenses in the Medicare RAC area. Selling, general and administration expenses for the quarter was $16.5 million, a $5.1 million increase over the prior year. This increase is attributable to higher compensation expenses, the companywide variable compensation and stock option plans and higher legal expenses, some of which are non-recurring. During the quarter, we averaged 211 corporate employees, a 2.3% decrease of our average 216 corporate employees over the prior year. Income taxes for the quarter were $6.8 million, a decrease of $6.3 million or 47.9% over the prior year. The effective tax rate for the quarter was 38.1% versus 39.7% last year. The decrease was primarily due to changes in state apportionments and permanent differences. Net income for the quarter was $11.1 million, a decrease of $8.9 million or 44.5% decrease over the prior year. Fully diluted weighted average common shares outstanding for the quarter were 88.4 million shares. Fully diluted GAAP net income per share was $0.13 compared to $0.23 for the same period last year. Adjusted EPS was $0.20 for the quarter compared to $0.27 or 25.9% decrease from the prior year. The $0.20 compared to the consensus forecast of $0.24. For the full year 2013 revenue was $491.8 million, an increase of $18.1 million or 3.8% over the prior year. This compares to a consensus estimate of $501.9 million. COB revenues were down 6.1% for the year and program integrity was up 19.5%. Medicare RAC revenues for the year were $108 million, approximately 22% of our total revenue. Our state government revenues decreased 6.1% for the year, while our commercial market revenue grew 11.8% over the prior year reflecting the continued shift of lives from fee to service to managed care. Looking at expenses for the year, total cost of services for 2013 was $345.9 million, an increase of $27 million or 8.5% over the prior year. Compensation expense related to the cost of services for 2013 was $185.8 million. As a percentage of revenue compensation expense was 37.8% versus 34.1% in the prior year. 192 positions were added over the same period last year bringing our average non-SG&A headcount to 2,421. The increase in personnel is primarily in IT and product delivery. You should expect to see a lower growth rate in compensation expense in 2014. Data processing expenses for 2013 were $37.1 million, an increase of $5.6 million or 17.9% over the prior year. This increase is primarily related to depreciation expense, hardware and software maintenance expense and hosting costs. Occupancy costs for 2013 were $18.4 million, an increase of $0.9 million or 5.4% over the prior. The increase was primarily related to our reallocation of our personnel – to a relocation sorry of our personnel to our corporate headquarters. Direct project costs for 2013 were $46.3 million, a decrease of $8.9 million or 16.2% over the prior year. This was primarily due to lower temporary personnel expense, lower subcontractor expenses and lower data costs. Other operating costs for 2013 were $26.5 million, an increase of $5.9 million or 28.7% over the prior year. This was primarily due to an increase in professional fees to support new program integrity and product delivery. SG&A expenses for 2013 were $68.7 million, 24.3% or $13.4 million increase over the prior year. During the year we averaged 208 corporate employees, 0.5% decrease compared to the average 209 corporate employees during the prior year. This increase was primarily related to a $6.2 million increase in compensation expenses for company wide variable compensation and stock option plan and higher legal related expenses of $6.6 million. Income taxes for 2013 were $25.6 million, a decrease of $7.2 million or 22% over the prior year. Our full year effective tax rate for 2013 was 39% versus 39.4% last year. Net income for 2013 was $40 million, a decrease of $10.5 million or 20.8% over the prior year. Fully diluted weighted average common shares outstanding for the year were 88.3 million shares. Fully diluted GAAP net income per share for 2013 was $0.45 compared to $0.57 in the prior year. The $0.45 compares to a consensus forecast of $0.50. Adjusted EPS was $0.75 for 2013 compared to $0.86 or 12.8% decrease. This is at the low end of our guidance and compares to a consensus forecast of $0.80. We ended the quarter with cash and cash equivalents of $93.4 million. We had cash on hand yesterday of approximately $102 million. This cash balance is after $25 million of share repurchases during the quarter in the open markets and repaying $35 million of borrowings under our revolving credit facility. We ended the year with $232.8 million in borrowings under our $500 million revolving credit facility. Let’s now drill down into the quarterly trending of revenues. First, I would like to reiterate that our business has been lumpy and subject to large variations in any given quarter. This is why we do not provide quarterly guidance and why we believe that looking at developments on a full year basis is more informative than looking at any given quarter. This is particularly important to keep in mind when comparing our year-over-year quarterly results. This slide shows our quarterly revenues for 2013 and 2012. Each quarter is significantly different in magnitude, but the average quarterly result in 2013 is slightly higher than 2012. What stands out is the significant decrease in the fourth quarter results year-over-year. As you may recall in 2012, we experienced processing delays from the industry transition to do claim formats. This has the effect of depressing Q3 revenues and disproportionately increasing Q4 results due to a catch up in claims processing by certain carriers. In 2013, quarterly revenue was more even and we did not see a seasonal increase in revenues. Now, let’s look at the same information without the Medicare RAC contract. Note the tight range of $96 million to $97 million in average revenue over the eight quarters despite the range of variances in any given quarter and particularly in Q4. We expect quarterly variations to continue in 2014, particularly in the second half of the year as new commercial accounts come online and we see the impact of the Medicaid expansion, along with significantly decreased revenue from the Medicare RAC. Now, let’s look at our key financial results by quarter for 2012 and 2013. You have seen the revenue already in the upper left and if you look at operating expenses in the upper right, the trend you see in expenses over 2013 has reversed in the fourth quarter of 2013. This is mainly a result of our efforts to bend our cost curve through reallocation of resources for the growth we expect to see in the later part of 2014 and throughout 2015. We will continue to rationalize our cost structure, reallocate resources towards higher growth areas, improve yields and reengineer our infrastructure to further remove costs. We foresee a significantly lower growth rate of expenses in 2014 than in 2013. Last November, we expected that by now we would have enough information on the Medicare RAC reprocurement to provide formal 2014 guidance. Revenue from the Medicare contract, RAC contract, which generated $108 million in 2013, will undoubtedly decline materially in 2014. With uncertainties around the procurement timetable and various scenarios around procurement results prevents us from being able to provide reliable guidance at this time. We are making significant adjustments in expenses that currently support this contract and will continue to monitor those activities throughout the year. Bill will provide an update on the procurement later in the call. We are, however, reiterating what we said last quarter regarding expectations for the rest of our business, which generated nearly $384 million in revenue in 2013. We expect the majority part of our business to see revenue growth of 10% to 11% and operating margin expansion of 5% to 6%. On this slide, we see 2013 revenues from a market and product perspective, along with projected 2014 growth rates for all but Medicare RAC. We have made significant strategic progress in diversifying our business from what was 100% Medicaid COB in 2006 to the broad market and product offerings we have today. We have unmatched scale in providing payment integrity solutions across the entire healthcare marketplace and are still in the early stages of growth in some markets. However, we have a more balanced product profile and believe that we will benefit from the high growth anticipated in the Medicaid and commercial markets. That concludes my financial review. And now I will turn the call over to Bill.

[Bill Lucia:]

Thank you, Walter. I will begin with a review of our key sales in the fourth quarter. Starting with our state government market, we won every TPL re-procurement this quarter maintaining our leadership position in the state Medicaid coordination of benefits market. Beyond continuing to protect their TPL business in states, our largest opportunity in the state government market comes from introducing new products and services to existing clients. In the fourth quarter we continued to execute successfully on our penetrate and radiate strategy, expanding the scope of state contracts with additional audits and eligibility services. And in the commercial market we expanded the audit services we currently provide to Blue Cross, Blue Shield of Michigan and expanded the scope of our Amerigroup, Molina and WellCare contracts to include additional lives and new services. We have a robust sales pipeline for this market going into 2014 with multiple large health plans showing interest in a variety of services including complex clinical audits, credit balance reviews, fraud, waster and abuse solutions and expanded coordination of benefit services. Now I would like to walk you through the external environment and the market factors impacting our business and driving growth. I will review the Medicare RAC procurement, Medicaid expansion fueled by the ACI and finally the large commercial market opportunity. Let’s start with the Medicare RAC contract held by our subsidiary HDI. The RAC story changes almost weekly so let me just (indiscernible) that before we talk to specifics. With the caveat that we are limited in the level of detail we can share given our role as a current and potential future RAC vendor and because we are in an open procurement. But I will try to give as much color as possible. Let’s start in December when CMS began its second Medicare RAC re-procurement effort and this time issued five separate RFQs through the GSA process one for each region. These constitute four regional Part A and B RACs and one national DME RAC. By mid-February all the bids had been submitted. And as most of you know we and another bidder filed protest relating to the payment terms under the new RFQs. Boiling it down to its simplest terms under the new RFQs, vendors would be permitted to invoice for contingency fees only after the second stage of appeals has been completed, a process that could take up to 420 days. This compares to our current invoicing practice at approximately 120 days. The protest is currently under review by the GAO. In January we executed another contract modification with CMS. As you may recall there have been a series of contract modifications that have pushed out both the termination date of the contract and the date through which we can submit records of improper payments. This most recent modification extended our current contract to June 1, 2014 and enabled us to request medical records for audit through February 21, 2014. The modification also extended the date for processing appeals to April 2016. Separately, at the end of January, CMS extended the moratorium on RAC audits related to the 2014 inpatient rule or to midnight rule through October 1, 2014. Then just last week CMS announced its decision to pause the operations of the Medicare RACs establishing June 1, 2014 as the last day that we can submit improper records for processing, effectively providing for no more extension to existing contracts and giving CMS an opportunity to focus on resolving the outstanding procurement protests and finalizing the terms of the new Medicare RAC contracts. So, what’s next? First is the resolution of the bid protests. The GAO’s website sets the first decision due date at April 23. However, as we know from past experience, there are a number of things that could change that timing. And of course once the decision is rendered, it is subject to further protest. So, the timeline to resolution is still unclear. What we are seeing is the confluence of events related to the overall RAC program and re-procurement process that makes it difficult to provide meaningful guidance on our results from this contract for 2014. But here is what we do know. First, HDI has a proven track record as the most effective of the four RACs, with a relatively low rate of successful appeals by providers. And second, CMS has stated their intention to award contracts to vendors whose scope represents the best value after evaluation. The key point here is that non-cost evaluation factors maybe more important than price. So, we believe past performance will be a critical measurement in this assessment and it will be very difficult for a vendor to win based on price alone. Taking these factors into account as a bidder, HDI remains extremely competitive in this procurement. Now, let’s look at the program results and projections. As you can see on this chart, the Medicare RAC program has proven to be one of the most effective means of identifying overpayments and recovering dollars back to the Medicare Trust Fund. With the Medicare payment error rate rising from 8.5% in fiscal year 2012 to over 10% in fiscal year 2013, it’s hard to imagine that the Medicare RAC program won’t be used as a vehicle for reducing the error rate going forward. We believe that CMS understands the value of the RAC program and will work with stakeholders, including providers and contractors to enhance the program to meet its objective of correcting improper payments, reducing the overall error rate and saving taxpayer dollars. We remain confident in the future of the program and our ability to win another contract. While the ever changing RAC story is a headwind for HMS in 2014, we believe it becomes a significant driver of growth again in 2015 when the new contracts are fully implemented and operational. Now, let’s turn to Medicaid. The Medicaid program, a major growth driver for HMS has been in a multi-year downturn in its rate of spending growth. According to CMS, annual expenditures grew an average of 7.2% from 2000 through 2009 before dropping to 2.2% in 2012. But this trend is expected to reverse in 2014 driven primarily by the implementation of the ACA. According to the Kaiser Family Foundation and CMS, Medicaid expenditures will resume growth in 2014 with the average increase expected to be between 10% and 12%. This increase is expected to drive higher growth rates in our largest product line, the Medicaid Coordination of Benefits. Medicaid expansion has begun in about half the states with an estimated impact of over 9 million new lives entering the program in 2014. Current estimates are that 4 million new Medicaid members have already enrolled at this early stage in the year. Many of the new Medicaid enrollees will enroll in Medicaid managed care plans, most of which are existing HMS clients. We have already begun to see the increase in Medicaid enrollment through the eligibility files we received from our clients. So we expect Medicaid growth to continue and to favorably impact our Medicaid COB and Program Integrity lines of business. And finally, there is the rapidly growing commercial market, including employer-sponsored insurance, exchange populations and government managed care programs. HMS’ experience with vast amounts of government healthcare data and the analytics we have built to mine that data places us in an excellent position to capitalize on this large market opportunity. We already have a strong foothold in the Medicaid managed care market and we continue to leverage our relationships with these plans to provide additional services and sell into their other lines of business by deploying our broad product portfolio. This market will also be expanding as Medicaid lives continue to migrate to managed care, Medicare Advantage enrollment increases and as the commercial market moves from a group and fully underwritten individual market to a group and heavily individual guaranteed issue market, via the state insurance exchanges. Early feedback from exchange activity is that the initial population tends to be older members for typically higher utilizers of services. We believe that this increased risk will cost carriers to be even more focused on utilization management and cost containment. Commercial carriers of all types will have an increased need for fraud, waste, and abuse services, as they seek to reduce administrative expenses and remained competitive in their markets. And with the increased focus on compliance and security raised by the HIPAA Omnibus Rule, carriers large and small look to HMS as a trusted and secured partner who can be all their cost containment needs while ensuring compliance with HIPAA standards. Our deep understanding of payment policies and our advanced analytics are transferrable to this market and we see this as our greatest growth opportunity. These attributes coupled with our proprietary datasets give us the competitive advantage as we extend our presence in this market. So let me outline our three-pronged strategy for expanding our footprint in the commercial market. One, we will be targeting new mid-sized and large health insurers in both the Medicare Advantage and the commercial risk space. And we’re investing in and positioning our sales team for more success in commercial market sales. Two, with about third of our annual growth coming from client expansion, we’ll continue to upsell services to existing clients. And three, we will focus efforts on innovating our product set for this market both through internal development and acquisition. We believe that this approach will position us well for additional growth in this market and increased profitability in 2015. 2014 marks our 40th year in business. Over the years, we’ve adopted steadily to the industry’s evolving needs and requirements, taking on new markets and expanding our product sales. As we look at our next growth opportunity, the commercial market, we bolstered our executive bench with industry experts that have a demonstrated track record in the market. HMS is now better equipped than ever to move our company forward and expand aggressively into this market. Our team is focused not only on delivering high quality value-added services to our clients today, but also on making sure we are positioned to anticipate and address their future needs. Semone Wagner, our Executive VP of Operations, and Cynthia Nustad, our CIO has significant experience in healthcare operations and technology in particular for commercial payers. Semone and her operations team has been instrumental in efforts to drive down cost, enhanced quality and improved throughput in the overall efficiency across our business. Cynthia our CIO is leading our efforts to consolidate technology platforms and increase our capacity to bring data analytics to all of our clients. Doug Williams joined HMS in December to lead the development of our commercial sales strategy. He has extensive experience in building and developing sales capacity in the healthcare industry. Doug developed and led IBM’s global healthcare practice and was most recently CIO at Aveta, which was acquired by in Optum in 2012. And Joel Portice joined us in December and is leading our government market and corporate strategy in development. His background in healthcare information management and data analytics is particularly relevant as we build our data analytics platform and product portfolio. Joel was most recently President at Verisk Health, a division of Verisk Analytics, where he was responsible for the overall operations of the company and its significant growth. This is a time of transition for the healthcare industry and with new additions to our executive team firmly in place. We’re looking forward to delivering and addressing the challenges and opportunities in 2014 and beyond. In conclusion, while growth in 2013 was not as strong as we would have like, it was in fact a year and which we advanced our strategic agenda. We held our leadership position in the state Medicaid market and achieved record results under the Medicare RAC contract, placing us in a favorable position for a new contract award. We also made notable sales progress in the commercial market. We began an enterprise wide reengineering of our operations focusing on improving yield and efficiencies restructured our cost basis and identified new opportunities for product innovation and growth across all our markets. 2014 will be a year dedicated to reinvigorating growth through sales, rationalizing all components of our organization, and further streamlining our costs to prepare for stronger revenue and EPS growth. Excluding Medicare RAC, we’ll see revenue growth in the low teens and operating margin improvements in the range of 5% to 6% year-over-year. So as we look forward to 2015, we’ll have the full year impact of the large number of new lives entering Medicaid as well as some new states adopting Medicaid expansion. Most of those lives will be a managed care plans boosting our commercial market revenues. We will be one year further into our commercial market strategy benefiting from the strong foundation established in 2014. Given our historical success under Medicare RAC contract, we do anticipate a new contract to be awarded to HDI in 2014 followed by increased revenues in 2015. In closing, we believe that our collective assets, data, technology, financial strength, market share, and our people deployed against very large and growing markets positions us like no other company provide intelligence, insight and results that improved the accuracy of payments across the entire healthcare enterprise. This is the end of our formal presentation and we’ll now take your questions.

[Operator:]

(Operator Instructions) Our first question comes from the line of Ryan Daniels from William Blair. Your line is now open. Please go ahead with your question.

[Ryan Daniels:]

Hi, guys. Thanks for taking the questions. No surprise I’ll start with someone on the Medicare RAC, I guess if we think about RAC revenues in 2014, I realized the visibility is tough given the one down in the contract and the uncertain timing on the renewal, but if we could assume there is no new contracts signed this year. Can you give us a view on what RAC revenues might look like in the first two quarters just based on your current understanding of all the restrictions?

[Walter Hosp:]

Sure, Ryan. This is Walter. Because of the changes in the program you know the moratorium that will put in place when the to-midnight rules were established back in October, that’s beginning to hit us in – as we said before in Q1 and Q2. But the quarterly run rate will be decreasing in Q1 and Q2, but you still see revenues from this contract developing crew there. And as Bill explained we will have revenues through June under this existing contract and after that it becomes questionable in terms of when the new contracts will get up and running, but that would be the source of additional revenue in 2014.

[Ryan Daniels:]

So Florida $108 million for the full year, half year would be $54 million, I mean, should we be thinking about that giving cut and half next year or is that a little bit too extreme so just first half of the year in the $20 million, $25 million or is that too conservative or that conservative enough if there is any color for the modeling you can provide there?

[Bill Lucia:]

With – obviously we hesitated to give a set number here because of everything that could happen and we don’t give quarterly guidance either on this. But I think the magnitude that you’re talking about is certainly profitable in some of the scenarios that we’ve examined. I wouldn’t say that if the huge upside from those numbers that you gave and I wouldn’t say that it could be largely different from that, but there is a wide variance around any set of numbers that you’re going to look at.

[Ryan Daniels:]

Okay, I appreciate that. And then two more on that, one just in regards to the RAC, will you furlough some of your staff now that there is a definitive end date and it looks like we don’t have resolution on the new contracts or how are you going to pivot some of the workforce costs there going forward to protect the margin if this thing keeps getting delayed?

[Bill Lucia:]

Ryan, this is Bill. We actually have – we are beginning this month to furlough some of the staff. First, we will be reassigning some of our staff particularly the clinical and audit staff to both our Medicaid RAC opportunities and our growing commercial opportunities. But you are correct we had begun the process of furloughing staff.

[Ryan Daniels:]

Okay, that’s helpful. And then one last one maybe big picture obviously, a descent stock repurchase in the quarter. Number one, can you remind us what’s outstanding there. And then number two, maybe talk about your cash flow priorities for ’14 as it relates to repos, debt pay down and maybe strategic transactions especially on the commercial side? Thanks.

[Walter Hosp:]

Yes, so it’s Walter again. As you know we generate significant cash and as we said in the quarter even ending – as I say recently we are around $100 million in cash and that’s after doing $25 million of repurchases under a $50 million authorization, so we utilized half of it. And then we paid down $35 million of debt in the quarter, which was beyond any requirements because it’s a revolving credit facility as well. Now, that’s – that still positions us very well. The revolver we can – we have more than half of that capacity available. When you talk about capital allocation first and foremost, it’s acquisitions. We have a very active M&A effort going on, reviewing many, many properties. As we said expect us to do acquisitions. They come as they come, but we have very active efforts that should result in that. That would be the first preference for use of cash. After that you have seen that we can do debt payments and also share repurchases. I put them roughly in that priority.

[Ryan Daniels:]

Okay, very helpful. Thanks guys.

[Operator:]

Our next participant in the queue comes from Dave Windley of Jefferies. Please go ahead with your question.

[Dave Windley:]

Hi, thanks for taking the questions. Follow-ups to Ryan’s largely, so taking his first question a little differently, if we were to jump ahead to a new contract period regardless of when that happens just kind of thinking about starting the data does happen. With the 2-midnight rule as it is assuming the kind of full moratorium on inpatient type – inpatient short stay claims is listed, can you talk about what you would think the revenue run rate would be as you get restarted. How much of the 2-midnight stay rule mop off of the $108 million that you did in 2013?

[Bill Lucia:]

Let me – this is Bill, let me try to answer that question. In the past the audits of short stays were between 40% and 50% of volume, but we have done a significant job in shifting our focus, redeploying our team towards other audit strategies, increasing our code validation efforts and we are seeing significant results from those. When the new contracts are implemented CMS’s commitment is that there will be an audit process for the new 2-midnight rule. I mean their plan was not that forever they would put a moratorium on this. There will be an audit process and in fact today they are doing probe and educate audits with the MAC. So we expect those audits will reemerge, regardless of the region if we re-win our existing region, we will have a – we will really have a higher run rate because it will be a larger region with a couple of more percentage points in Medicare spend. So I think anything that comes out of the re-procurement will be an emergence of full auditing. I think the issues that CMS has talked about are important ones. Providers that have higher error rates will be subject to more medical record requests than audit. Providers with lower error rates will have lower record requests. They are really trying to figure it out where the biggest problems are and make sure that they focus the auditors on the right result. So I can’t really give you a run rate, but I can tell you that we can get up and running very quickly in really any of the regions. Any new region, of course, would require some outreach provider associations in those states, but we really don’t expect significant downside.

[Dave Windley:]

Okay. Sticking with RAC, but a different subject, could you talk about Walter perhaps the reserve issue that we talked about in the past and your thoughts around the amount of reserve that you would be able to release over time as this contract comes to close?

[Walter Hosp:]

Okay. So reserves on just the existing contract, you will see in our balance sheet, the specific level of liability, estimated liability for appeals and closures at around $41.9 million and then there is about $13.9 million up in the estimated allowance for appeals in our AR balance. So, companywide, we have $55.8 million. I want to point out though that with our growing commercial business, the $6.4 million of that is on the commercial side. Okay. And for CMS, the total reserves at year end that we have for this existing contract is $49.4 million. We have been adding every quarter to that. We haven’t changed our reserve policy at all roughly reserving about 18% off the top of revenues on that. Our experience remains at much, much lower – much lower than that 18%, but there is still a lot of volume that has to go through the appeals pipeline. And we have with the existing contract extended balance of 2016. So those reserves need to be in place to cover to do recoveries or I should say return our fee portion for successful appeals, all throughout 2014, 2015 and into 2016. So, although I feel extremely comfortable with the level of reserves that we have, I wouldn’t set anyone’s expectation that we are going do any reversals to that.

[Dave Windley:]

Okay. And then our last question, it seems like there is many to ask. I will just ask one more. As it relates to Medicaid and you talked about and we are beginning to see enrollment growth, can we correlate your guidance that you provided for non-RAC, non-Medicare RAC, can we assume a certain number of new Medicaid lives coming into the system that would relate to your guidance, have you pegged it to a number or a range that we could be thinking about so we can watch that?

[Walter Hosp:]

Well, we initially – when we initially did our forecast for Medicaid, we assumed about half of the lives that the federal government was estimating of new Medicaid enrollees in the year, primarily because – they would not enroll at the beginning of the year. So we are pleasantly surprised by the reported numbers that about 4,000 have enrolled so far. What’s even more encouraging to us is we are seeing it in our data. So, but I would say that the number that’s enrolled already about 4,000 – I mean 4 million, between 4 million to 5 million is what we had baked into our numbers. And as we have said before, revenue really starts a couple of months after those new lives begin in our programs depending on the type of service whether it’s cost avoidance or a commercial insurance recovery.

[Dave Windley:]

Okay, good.

[Walter Hosp:]

So, we think we are right on track so far any new enrollment beyond that of course maybe upside to us in the future.

[Dave Windley:]

Very good. Thank you.

[Operator:]

Our next question comes from the line of Richard Close from Avondale Partners. Your line is open. Please go ahead.

[Richard Close:]

Yes. My first question is with respect to HDI and the intangibles associated with that, is there any evaluation of a potential impairment based on the timing of the Medicare RAC and step down in revenue?

[Walter Hosp:]

That’s clearly an issue we had to look at with our year end reporting financials and the answer to that is no, there is no impairment.

[Richard Close:]

Okay, great. Thank you for that. And then it just a question I guess the follow-up to Dave’s. It looks as though, your expectation is for 0% to 2% growth on the state business, but you are talking about seeing – beginning to see the Medicaid expansion in your data. And I guess if you could just help us how conservative is that 0% to 2% if you’re already seeing levels above what you initially expected?

[Bill Lucia:]

Well, Richard, the real issue is that most of the volume that we’re seeing coming in is going at the Medicaid managed care plan. So, that activity impacts our commercial area of more than it does the state business. However, there is still couple of states that are fee-for-service states with no plans to migrate the managed care, some of those have expanded, some are seeing the woodwork affect just the overall ACA implementation so, we’ll see some organic growth from that perspective and what we’re doing basically – basically doing out is regrouping and starting to package other sales into those states. I’ll give you an example of something that states really need to know, I haven’t started buying yet, but they really need to know as they are enrolling members into Medicaid or as the federal government is making somebody Medicaid eligible through healthcare.gov, they should know whether or not to have other third-party insurance, because they have many decisions they can make with that information. So, we’re out talking to states about improving our eligibility services by doing our services at the very beginning of enrollment. Those are the types of services that we see as advancing this year. So, I would say the numbers conservative, but I don’t think we can adjust it based on Medicaid expansion considering the lives are going into managed care.

[Richard Close:]

And my final question is CMS spoke at HIMSS yesterday and there was no delay in ICD-10, there is no delay in meaningful use to except for certain situations. But how do you think that factors into maybe the decision process on the Medicare RAC. It seems like CMS is definitely seeing firm that is – as a deals with intense lobbying and opposition from the provider market, and I’d just – get your perspective on how you think of that relates to the Medicare RAC lobbying?

[Bill Lucia:]

I don’t know if I could draw a connection between ICD-10 and HHS and CMS staying firm on that implantation date, but in Medicare RAC, but clearly CMS is responding to the political pressure placed on the agency by the hospitals, but the one thing that’s true about the audit programs our Medicare RAC program has been the most effective. That program alone has recovered more than the other programs that are managed by the federal government. So, I think what we believe is happening is the entire program does need some overhaul. The appeals process is a manual process. It’s onerous to providers. The recovery auditors are not always alerted when an appeal was filed or when a hearing is scheduled. GAO has outlined that as an area of improvement, CMS is stated – HHS is stated that it will be improving the appeals process that won’t happen overnight. So I think CMS is doing what it needs to do in terms of attempting to appeal all the stakeholders, but they do know that the Medicare recovery program is one way to identify and resolved in proper payment and even the 2-midnight rule, that rule was crafted – that new rule is crafted because RACs found an area where hospitals were billing improperly at a very high rate and CMS opted to develop a new reimbursement rules to solve that. So the RACs are a critical component of CMS’s future ongoing strategy. And while there will be changes we think in the end it will still be a very important program. I have to say there is probably political pressure though not us loud on the opposite side of this. As you know the RAC programs recovered significant dollars in the last year. And when you are talking about a program that cumulatively has recovered $6 billion, when those dollars start to shrink dramatically there is going to be quite a bit of concern and questions from congress because there is no other way to make that money up. And that’s significant during the time of a budget shortfall and concern about the longevity of Medicare. So I think that CMS is doing what they need to assure that they appease all stakeholders but still have a very strong audit program.

[Richard Close:]

Okay, thank you very much.

[Operator:]

Our next question comes from the line of Jamie Stockton from Wells Fargo. Your line is now open.

[Jamie Stockton:]

Yes, good morning, thanks for taking my questions. I guess maybe the first one Walter real quick the non-Medicare RAC business that you are saying the adjusted operating margin should be up 500 to 600 basis points in 2014., what’s the base level for 2013 that you are measuring that off of?

[Walter Hosp:]

We are hesitating to give an exact breakdown for 2013 on just what was operating margins in there, it’s been difficult – as we are going through changes it involves a lot of allocation of expenses going back and forth. Particularly since within HDI, we separated out our commercial plans and put that in that base line. So there is a mix effect going on there. That again we are very careful or hesitant to breakout for 2013. Having said that, I think you can look back at the new allocation given the slide we show you there with respective revenues and where our contributions have come from. Again as we look forward here to these – to 2014 they are multiple, multiple scenarios depending upon where the RAC contract comes in and how that can effect margins overall. I appreciate that any outsiders would love the bread crumbs leading right to what our forecast is. But again I am saying right now that we have to be very open about – very cautious about that right now because of the multiple scenario that can occur.

[Jamie Stockton:]

Okay, the appeals reserve, the sequential increase in it was that essentially you guys extending the, I guess exposure to having to deal with appeals through the end of 2016 in contract extension for Medicare RAC?

[Walter Hosp:]

No, no it’s really every quarter it was nothing – we did nothing different in the quarter than we haven’t done in prior periods. So the revenues that we generated in the quarter under the contract we took roughly 18% and added it to the appeals reserves. And any experience that we had in terms of processing appeals was taken out of the reserves. So again as I said earlier we just have a very low experience rate that’s drawing down these appeals and that’s why you have seen each and every quarter a building up on this. Now after we conclude this contract then at that point the reserves for this contract will start to decline over time because we won’t be adding to it. Then we will set up another reserve based upon the rules and regulations for the new contract and that will be added to our total and we will break it.

[Jamie Stockton:]

I guess I am just eye balling your presentation and the balance sheet, it looks like you did something like $25 million of Medicare RAC business during the quarter, but appeals reserve was up by $14.5 million or something like that sequentially.

[Walter Hosp:]

Well, you are including the commercial business in that analysis there. As I said there is $49 million – $49.4 million in reserves for just for CMS contract and $6.4 million in reserves for commercial. And that is growing and we are adding reserves regularly to that.

[Jamie Stockton:]

Okay. And then maybe my last question even though Medicare RAC was down sequentially and it sounds like the non-Medicare RAC portion of program integrity was very strong, can you give us any color on that?

[Walter Hosp:]

The Medicare RAC was down sequentially, but up year-over-year. And yes, the rest of program integrity has been growing and if you know, is very broad based across all markets because we’re looking that as a product lens on the business there. And there, you’re seeing growth part of it from the Medicare RAC contract, part of it from the commercial markets and even part from Medicare where that is growing versus COB.

[Bill Lucia:]

And that scenario where we have – we have significant robust sales queue, but also significant new signings, we just – in the commercial market, there are little more sensitive about their partners announcing the work they’re performing on their behalf. So, you probably won’t see us name names more than discuss the fact that we’ve expanded audit. We’ve expanded our audits into other major health insurance carriers.

[Jamie Stockton:]

Okay, thank you.

[Operator:]

Our next question comes from the line of Robert Willoughby from Bank of America. Please proceed with your question.

[Elizabeth Blake:]

Hi, good morning. This is Elizabeth Blake in for Bob today. Just to follow up on Dave’s questions on the RAC, so I guess we should be expecting, obviously profitability hits later in the year, as you presumably would be ramping up the new contract. Could we expect any kind of an EBITDA bleed into the first quarter of 2015, or can we expect a cleaner year at that time?

[Bill Lucia:]

Expect a much cleaner year.

[Elizabeth Blake:]

Okay, okay. Good to hear, alright and then…

[Bill Lucia:]

The timing for this – just, Liz, sorry, just to help you out there, I mean, the timing of all this impact, it builds it earlier we can ramp-up relatively quickly. So, this became a process would have to go with a very far and of the timetable with protest and maybe even some we don’t foresee before we wouldn’t begin to see residence in 2014 under new contract. It is possible, but it’s unlikely.

[Elizabeth Blake:]

Okay.

[Bill Lucia:]

If that happens, we were still then we’ll be geared up and 2015 would look much more like a regular year.

[Elizabeth Blake:]

Okay, thank you. And then, if you were to win a second region, versus keeping your same region, I guess albeit expand it a little bit. Can you talk about the differences and how that would like look, just kind of the timing of the ramp or it sounds like – obviously, it would be pretty quick if you just kept your same region, but a second region, how would that be a little different?

[Bill Lucia:]

Well, that’s a good question. It’s – we are awarded two regions, the HGI already has the experience of working with almost all of the math, because of some of the national work we’ve done through our contract. So my guess is that our ramp-up may be a little faster than it may take another RAC. The other – and of course one of the things about HGI which is unique and we’re competing against the fields of strong competitors, but the only company that is slowly based in healthcare. I don’t think that goes lost on the provider community, on CMS. We understand payment policy, we have 100s and 100s of clinicians and so I think our ability to be able to ramp-up understands our local policy, work with the MAC in that region is positive. The other thing that we’re excited about that we do in another region is that if you look at the effectiveness rate of the RACs, regionally HGI has had the highest effectiveness rate and if you acquired that against the region that may have had a much lower effective rate, we believe there’s dollars on the tablet and that we can provide a great service for the CMS and the RAC program in that region.

[Elizabeth Blake:]

Okay, great. And then final question, obviously, a lot of focus on 2-midnight, a performance last night was eluding to some 700 other claim types that have been approved by CMS and are kind of on the table here. I guess can you provide any specifics around what those claim types would be, and what you think the opportunity could be there to potentially offset some of the scope reductions you are seeing?

[Bill Lucia:]

Yes, I believe I think what they talked about was that they have about 750 different audit scenarios approved by CMS and I think our number is somewhere between 750 and 800 and that’s actually an audit scenario that we developed and CMS approves. Of course CMS threw the pauses in approving new ones, but we’re acquiring all of those in our activity up to the final mailing we were able to do in February. What we’ve heard is that CMS – once the new RACs are up and operational, CMS will be putting a lot of emphasis on new scenario approval or new audit strategy approval. So, that really is the way to continue to grow under a RAC environment is to identify new errors and make sure that we recover those errors behalf of the program.

[Elizabeth Blake:]

Okay, great. Thank you.

[Operator:]

Our next question comes from the line of Bret Jones, Oppenheimer. Please go ahead.

[Bret Jones:]

Good morning. Thank you for taking the questions. And I wanted to get back to the core business and the expectation for. I think it was 10% to 11% growth, specifically within COB, 8% to 10% in 2014, after a down year in 2013. Can you talk about the drivers there? I would think healthcare reform is one of them, but what have you embedded in there for reform, the switch from fee-for-service to managed Medicaid and also the assumption for the underlying Medicaid expansion growth excluding reform?

[Walter Hosp:]

Hi, so Bret, in that 8% to 10% as Bill said, let’s cover the ACA expansion on that and we said that we look at all the forecasts on there that seemed to be lining up, they are around 9 million lives, we’re assuming about half that in terms of what would come in and it spread out over the year and it’s heavily weighted in the second half before it can actually impacts our residence. On the switch of lives, which will continue and will continue into other years, but we’re exiting 2013 with somewhere on order of 70%, 75% of the lives in Medicaid managed care already. This is also after what we identified as a $11 million lives out of the base of 55 million to 60 million lives that have been transferring over and the most of those lives are done now through 2013 although they will still be some going through in 2014 as well. So, we’ve take – we’re seeing that trend reversing, or lessening, I shouldn’t say reversing, it’s lessening and the impact is much smaller then of course as we do our bottom-up planning, we’re looking at it count by count and all the up selling and cross selling that we can do particularly with program integrity, although, I know you’re not referring program integrity, but for us in that government state we are that’s allowing us to expand revenues with our state Medicaid claims where we’re seeing the negative growth. So, overall we are seeing that marketplace leveling off that’s why we have a 0% to 2% number in that and included in that is program integrity as well.

[Bret Jones:]

And any sense for the underlying Medicaid expenditure growth you’ve embedded in guidance, excluding reform.

[Walter Hosp:]

Yes, it’s modest, its – underlying growth would be in that 4%, 5% range.

[Bret Jones:]

Okay. Within PI, you’re expecting 20%, 25% growth. Can you talk about how much of that is coming from Medicaid, from the Medicaid RAC program?

[Walter Hosp:]

It’s not a large amount, is what we said last quarter and reiterates some of that is that we’ve had 30 contracts. We’ve done a lot this year in terms of getting fully implemented on the contractual commitments and we’ve been working with the program that’s in its infancy, in terms of trying to get results out of that. Results have been very varied across the board. We have large state, New York and New Jersey they’ve got an early support of the program quite substantially and they are doing quite well. We had many others state in other parts of the country that have not been supporting the program as much as we’ve like and their issues around that. So, what we said is in 2014 expect us to trim the portfolio and optimized a bit more. We have targeted contracts, they were going to just increase the yield out a bit and is good, some of that were going to because these are not a multiyear contracts, they are rather short-term. So, we have opportunities to renegotiate. Some will be focusing on price increases and some quite frankly we simply won’t rebid on. So we expect to see that number decrease and we’re still committed to it, it’s still a good part of our long-term strategy, but we’re going to be more selective in 2014.

[Bret Jones:]

Any chance you’d break out the Medicaid RAC contribution in 2013?

[Walter Hosp:]

No, it’s really, it’s not that material to be able to breakout there on that. But and again we’re folding that into our new presentation of the different markets and we’ll continue our just two broad buckets of products there. But you would see that in the state gov and its part of that derivative 2% growth.

[Bret Jones:]

Okay. And then just lastly I’m sorry..

[Bill Lucia:]

I mean most of our program integrity growth will come from the commercial market which is really the entirety of Medicaid Managed Care plans that are under contract. We know their data, we’re up selling to them. Medicare Advantage plans that have a very similar need and then through commercial plans and that’s where you’ll see most of the growth in our program integrity product line this fiscal year.

[Bret Jones:]

Alright. And then just lastly I just want to hit on the HDI commercial. Did I hear correctly that’s stripped out and put into the traditional commercial bucket? And is that reflective of – or does that include primarily Medicare RAC Audits for Medicare Advantage plans?

[Bill Lucia:]

It’s – it is true. We’re capturing that under our commercial bucket. It’s really a combination of audits, complex audits that are very similar to the RAC audits for Medicare as well as general data mining and pharmacy audits for Medicare Advantage plans, commercial plans, Medicaid Advantage care plans. So it’s really a full gamut of program integrity solution, very similar to what HMS was bringing to the market as well. We’ll see the synergy of combining the know-how in operations on those areas this year and that’s where we think will also see expansion in both revenue and margins.

[Bret Jones:]

Is any of that were subject to the pause in the Medicare RAC program for the Medicare Advantage plans?

[Bill Lucia:]

No. It’s really very different. Medicare Advantage, the Medicare Advantage plans do, CMS requires that they have auditors, independent auditors. And they really – while they may follow some of the Medicare policy in terms of following what Medicare implements in policy, they really are administering their own benefit and they work with higher auditors and follow their own leads. And we have not really seen any reduction or pause in the audits for those Medicare Advantage plans.

[Bret Jones:]

Thank you.

[Operator:]

Our next question comes from the line of Frank Sparacino from First Analysis. Please proceed with your question.

[Frank Sparacino:]

Hi guys. Well so real quick maybe can you give us a sense on where you stand today from a resource standpoint as it relates to Medicare RAC and maybe when you talk about some of the furloughs coming up I mean what do you expect headcount to be. I’m trying to get a sense of when you look at that business in isolation where the margins are?

[Walter Hosp:]

Well the – there are limited opportunities but there are opportunities to manage the cost block with the decrease in revenues under the contract, right. Of course we’re doing all sorts of load analysis of what we need and trying to do the right things by the people as well in terms of as Bill said earlier transitioning over to the growing commercial side of the business and where possible on the Medicaid RAC side. Having said that, we have also said in prior quarters is that we need to maintain the infrastructure business and have it in place. So that would include all the corporate expenses, the IT infrastructure etcetera that needs to be in place to process the existing contract through June to work on the procurements and to be in place for the new contracts and get them implemented as well. So the real cost area we have is with the folks that we have doing the reviews. We use the word furloughs because we fully anticipate than coming back and yes we’re talking about in excess of over 100 personnel that can be flexed if you would during this. But I don’t want you to think that there are other huge blocks of cost that we can cut on a temporary basis. It’s just – it would cut into our ability to provide capabilities under these contracts and ROIs on the full year and long-term view.

[Frank Sparacino:]

Great. And maybe lastly just in terms of the 2014 guidance and some of the factors you talked about earlier with Bret. Given the issues we saw earlier around the transition to 5010. Are you concerned around the transition of ICD-10 and have you factored anything in the model in terms of delayed disruptions associated with that?

[Bill Lucia:]

This is Bill, let me answer that. We’re concerned about anytime there is a major transactional change or change in standards. And ICD-10 is a big change and while we’re a little bit heartened that CMS would not move the implementation date because we heard generally and the industry is, many providers will not be ready. We’re – help – surely helping payors already, but because our claim volume is retrospective it always falls a couple of months after the impact, we don’t really see impact in 2014, if there are major delays in ICD-10. We have a very active remediation plan, we’ve got people working today with carriers on clients - with our clients and making sure that we’re going through testing with them. We’re also testing with carriers who would be recipients of claims from us on behalf of Medicaid. We expect that testing to continue and we’re prepared to continue that through the implementation date. So we think we have a good plan for it but like any major change in the industry there could be some disruption.

[Frank Sparacino:]

Thank you guys.

[Operator:]

Our final question comes from the line of Charlie Strauzer [CJS Securities]. Your line is now open. Please go ahead.

[Charlie Strauzer:]

Hi, good morning. Just to ship back on to the RAC re-procurement and the RFQs. If you look at the – now that they’ve changed it where you could win potentially two regions, have they put any requirements in there potentially use subcontractors and if not would you consider using subcontractors if you want two regions?

[Bill Lucia:]

I don’t believe they put any requirement that you must use subcontractors. I don’t remember the actual details of it, but we of course would consider subcontractors that they would benefit our ability to identify overpayment. And but we as a company don’t need to use subcontractors and able to get the contracts up and running if we were to win two regions. We’ve got – we’ll have the staff, the infrastructure everything else on board. So..

[Charlie Strauzer:]

Got it. And then Bill if you could talk about the – is there any change or major change that you’ve seen and of course the number of bidders on these RFQs?

[Bill Lucia:]

Well the number of bidders is not public. So CMS doesn’t have a public opening. Some of our states do that and you’ll note what the bidders are. We’ve no evidence to that, that’s confidential at this point.

[Charlie Strauzer:]

I guess – I’m sorry go ahead.

[Walter Hosp:]

Well I just add we’ve commented in the past that this is under GSA schedule. It’s a very different procurement than the first time around five years ago. There are list of vendors on there, the additional requirements that are put in. We’ve always said we don’t know what as Bill has reiterated, what the final number of vendors will be on that, but our estimate was that there were potentially five bidders. And we recently just heard that one of those has decided to back out and made that public. So but there’s still could be five or more there, but from our analysis maybe the field is narrowed.

[Charlie Strauzer:]

So I guess it all changes in the RFQs, there’s been no change to that would basically make under potential bidders eligible I guess is another way to ask the question that you’ve seen at least?

[Walter Hosp:]

That would have been on the GSA schedule already. So it wouldn’t expand the pool of them or have made anybody who is bidding on this now be more qualified than the group that we were talking about in the past.

[Charlie Strauzer:]

And just to clarify on the piece that you’re processing in terms of the 420 day potential versus 120 days. If that protest is not in your favor and 420 days is “the kind of the timeframe you’re looking at for recovery” What can you do as a company to kind of offset that?

[Walter Hosp:]

It’s obviously extending a payment terms out roughly 300 days for subset of revenues. And we have been considering that in our discussions of what the contract might be. We feel that the language around the program itself calls for reimbursement of RACs on a more timely basis, so that’s why ourselves and others are protesting that. Should they get it in place it would involve us financing those receivables, we certainly have the wherewithal to do that. Clearly as I mentioned before with our cash balances and available revolvers we could certainly finance one or even two contracts where necessary it’s clearly not our preference but we could do that. And again this all has to factor into what the final contract would be and that includes pricing around that.

[Charlie Strauzer:]

Got it. And then lastly Bill or Walter, you’re having absolute drop the date when all of this could potentially be resolving in kind of worse case scenario of this dragging on through multiple protests. Is there an absolute drop that you have kind of out there?

[Bill Lucia:]

I mean it’s I wish I could look in the crystal ball and tell you that this is when this will all be resolved. But if we follow the GAO’s published schedule each protest is a protest, multiple protest but the protest against each of the procurements or I think for other procurements. It runs through the end of May approximately the end of May. A decision could be made earlier. That decision could engender another round of protest. That decision could engender negotiations with the current bidders. It could require the RFQs to be reissued. There is that there is so much variability when you get into this kind of a process, it will be really hard to say what the drop that date is. But we’d all like I believe both CMS and the contractors is that we get resolution as early as possible and that we move on to awards, contract negotiations and start business up again. But the earliest that could happen in the third quarter of this year, I don’t see it happening any faster quite frankly but it could drag out further.

[Charlie Strauzer:]

Understood. Thank you very much.

[Operator:]

I would now like to turn the call over to Bill Lucia for closing remarks. Sir, please go ahead.

[Bill Lucia:]

Well I’d like to thank you all for joining our call today. It is much appreciated and we look forward to speaking with you and reporting on our 2014 first quarter results. Thank you.

[Operator:]

Ladies and gentlemen, thank you for participating in today’s conference. This does conclude today’s program. You may all disconnect. Everyone have a wonderful day.