Hanger, Inc.
Q3 2008 Earnings Call Transcript

Published: 28 Oct 2008

[Operator:]

At this time, I would like to welcome everyone to the third quarter earnings conference call. (Operator Instructions). Thank you. Mr. Kirk, you may begin your conference.

[Tom Kirk:]

Thank you, Kathleen, and good morning to all of you and welcome to Hanger Orthopedic Group's discussion of our third quarter results. This is Tom Kirk and I am joined with George McHenry, our CFO; and Ken Abod, our Vice President, Treasurer and Director of Investor Relations. Before starting with our remarks, let me just take a few moments to review with you our declaration on forward-looking statements. During this call, management will make forward-looking statements relating to the company's results of operations. The United States Private Securities Litigation Reform Act of 1995 provides a Safe Harbor for certain forward-looking statements. Statements relating to future results of operations in this document reflect the current views of management. However, various risks, uncertainties and contingencies could cause actual results or performance to differ materially from those expressed in or implied by these statements, including the company's ability to enter into and derive benefits from managed care contracts, the demand for the company's orthotic and prosthetic services and products and the other factors identified in the company's periodic reports on Form 10-K and Form 10-Q filed with the Securities and Exchange Commission under the Securities Exchange Act of 1934. The company disclaims any intent or obligation to update publicly these forward-looking statements whether as a result of new information, future events or otherwise. Now, let's go back to our quarter. Overall, the quarter contained several noteworthy points. As a total entity, our sales grew by about 10% and net income was up over 35% compared with the same quarter last year. This makes the 11th quarter that we have met or exceeded First Call estimates. We continue to see the benefit of the programs that we placed into operation over the last several quarters and the results of our peoples' efforts. Due to these factors, all of our operating units generated substantial improvements compared to the third quarter of 2007. Our balance sheet and liquidity are strong. We have $53 million in cash on hand and $38 million available on a revolving credit facility, which we validated during the quarter. Now, let me turn it over to George, who will review with you our financial results and balance sheet changes in more detail. George?

[George McHenry:]

Thank you, Tom. Good morning, everyone. Q3 was a solid quarter. As Tom mentioned, we exceeded our sales and earnings goals, and our strong cash flow also exceeded our expectations. On top of that, our EPS grew roughly three times our sales growth, so we continue to demonstrate good earnings leverage on our sales growth. Now to my detailed comments. For the quarter, sales increased by $16.4 million or 10.1%. Our patient care centers had another great quarter, reporting same center sales increase of 7.3% or $10.5 million. SPS also had a strong quarter, reporting a $2.9 million or 15.9% increase. The balance of our sales increase was attributable to our acquired entities of $2.8 million. Cost of goods sold as a percentage of sales decreased by three tenths of a point to 49% due to lower material cost. Our labor cost increased by $3.7 million in the current quarter, due principally to the impact of merit increases, an extra day paid during the quarter which was a holiday, so it did not benefit our sales, but cost us about an extra $600,000, $1.3million increase in healthcare cost and the impact of acquisitions. As a percentage of sales, labor costs increased by three tenths of a point to 19.1% of sales, due principally to the extra day and the increased healthcare cost. Material cost, on the other hand, while they increased by $4 million compared to the same quarter last quarter, they decreased by 50 basis points as a percentage of sales. The $16.4 million sales increase accounted for about a $4.9 million increase in material cost and that was offset by $900,000 weight benefit. Our material rate is comparable to last year when you factor in last year's favorable book to physical adjustment that was booked in the fourth quarter last year. SG&A increased by $6.7 million in Q3, principally due to a $1.6 million increase in the accrual compensation for incentive compensation due to our improved performance, a $2.6 million increase in personnel cost, primarily related to healthcare cost and the extra day of wages, which, in this category, accounted for another $400,000 in expense, and $1 million due to acquisitions and $800,000 in merit increases and $700,000 in other costs. Our EBITDA was $24.6 million and increased by $2.1 million or 9.2% compared to the prior year due to the factors I mentioned previously. Our margins decreased by 20 basis points from 13.5% due principally to the additional day in payroll costs. That was 66 versus 65 days which was about $1 million in additional costs and an additional $1.7 million in variable compensation accrual, which together accounted for 150 basis point swing. So we still were improving our margins because we will get some benefit from that extra compensation accrual in the fourth quarter. Through nine months, EBITDA margins are up 40 basis points, which is still at the high end of our goal for the year, to increase our EBITDA margins by 20 to 40 basis points. Interest was $1.3 million less than last year, due principally to the impact of lower variable interest rates. We mentioned at the end of Q2 that we had operated our leverage down below four for the first time in recent memory. Our total leverage as calculated under the Term B now stands at 3.74 times trailing EBITDA, so we are able to reduce it by almost another 0.25 turn since Q2. Income taxes provision for the third quarter was 40% of pre-tax income, which is consistent with prior quarters. Based on that, our EPS was $0.23 compared to $0.18 in the prior, a 27.8% increase. Moving on to the year-to-date results, sales increased by $51 million or 10.9%, comp sales in our patient care centers increased by 6.9% or $28.6 million, SPS outside sales increased by $9.4 million or 21.1% and our acquisitions accounted for the final $12 million in sales increase. Our cost of goods sold as a percentage of sales decreased by three tenths of a point of sales due to decrease in labor costs, which are relatively fixed. Labor costs increased by $8.2 million due to a combination of increased healthcare costs, merit increases and acquisitions. Our material costs were increased by $15.2 million, and that is due entirely to the sales increase as our come rate was identical for both periods. SG&A increased by $19.3 million for the year due to a $2.3 million increase from acquisitions, a $4.5 million increase in the accrual for incentive compensation, $2.2 million due to merit increases, $4 million increase in personnel cost, $2.5 million in healthcare cost, $2.1 million invested in our Linkia and unique growth strategies, and $1.7 million from other costs, principally rent and occupancy. Based on all that, our EBITDA was $68.6 million, an increase by $8.3 million or 13.7% compared to the prior year. Our leverage, as I mentioned before, increased by 40 basis points. Interest was $3.5 million lower than last year, principally due to the impact of lower variable rates, and our income tax provision for the nine months was 40% compared to 41.5% in the prior year. So we have been able to reduce our income tax rate somewhat. Moving on to the balance sheet, AR decreased by $3.3 million since 12/31/07 despite a $51 million increase in sales. Our DSOs decreased to 50 days compared to 56 days a year ago. Bad debt expense was 2.3% compared to 1.9% as for the quarter and our A/R over 120 days, measure of quality of our receivables was 12.5%, which is the lowest it has ever been. So we have good qualities in our receivables. Our inventory increased to $3.4 million to $85.6 million since yearend. That balance makes sense compared to all our other business strengths. CapEx for the second quarter was $4.2 million compared to $4.3 million in the prior year. For the year, we have spent $12 million compared to $13.4 million last year. Cash flow for the quarter was excellent. As I mentioned before, we generated $22.3 million in the quarter compared to $10.1 million last year, an increase of $12.2 million. For the first nine months, cash flow from operations is now at $34.9 million compared to $30.2 million last year. So we have now exceeded last year's number and we have reversed the trend that was caused by the change in our payment of our bonuses. We do expect to generate more cash than we originally predicted for the year. As I mentioned before, the decline in Q2 was due to the frequency of advance payments on practitioners' incentive of compensation since we are at $35 million to $45 million for the year, we expect about $10 million more than our previous projection. Liquidity, to discuss that in late September in response to uncertain credit markets, Hanger drew $20 million on its revolver to approve the availability and to determinate Lehman would fund their share of the commitment. Lehman did not fund so we made it $15.3 million on that draw. After the draw the company had over $53 million in cash on its balance sheet at the end of the quarter at which $42 million was invested in a money market backed by government securities. Company also has $36 million of remaining availability under revolver after factoring out the Lehman commitment. Hanger is also generating positive cash flow from operations. We will consider repaying the draw once some sense of normalcy returns to the credit market. In the meantime, we have adequate cash balances to conduct our operations and execute our growth plans. So, we feel very safe in that regard. Moving onto guidance, the company is confirming its existing guidance for Q4. Full year guidance was not changed but obviously you can just do the math. We did $0.60 through the first nine months and consensus is $0.23 for Q4, so we should come in at about $0.83 for the year. That is all for the financial results. I will turn the call over to Tom Kirk now our CEO.

[Tom Kirk:]

Thanks George. I will take a few minutes and add a little color on our business drivers from an operations perspective. I will go division-by-division. First, let's look at our patient care division, HPO. This business achieved about $10.5 million increase in sales or 7.3% same-center sales growth for the quarter and the performance for the quarter is partially attributable to the rollout of the 2.7% CPIU increase which we received January 1. That impacts about 35% of our business, and this, combined with the rollout of last year's 4.3% increase to our commercial book of business, translates to about 2% of the 7.3% increase. If you remember, we have told you historically and it is still is true today. It takes about three years for a rate increase to work its way to our commercial book of business. The balance or about 5.3% of the 7.3% is attributable to volume which is roughly 75% of the 5.3% in mix at 25%. The programs that impact our volume and mix, in other words, how are we able to achieve those improvements, I will go through and we will discuss briefly. The first is the continued improvement in our Linkia book of business and let me remind you again that HPO or our patient care division is the primary vehicle for the delivery of most of the services under our Linkia contracts which are two forms preferred and exclusive. On an overall basis, the revenue from the Linkia designated contracts was up over 13% for the quarter, that brings us to about 12.8% or almost 13% for the year. The second driver on volume and mix is our continued emphasis on our high performing products such as microprocessor prosthetic hands, knees and feet components. For the quarter the revenue from the delivery from these products was up about 27% compared to the comparable quarter last year. Year-to-date, this figure is running at 31%, so it is a nice addition to our overall product mix. Now the third driver on the volume and mix are our patient evaluation clinics, we call these PECs, and if you recall this is where we bring our patients back in so that we can check the fit and functionality of their devices. These PECs produced approximately $5 million in incremental revenue for the quarter and over $13 million for year-to-date. Good for patient care and good for business. Last, but not least, are our sales and marketing and public relations efforts by our practitioners and those that support the practitioners in identifying opportunities specific to their local businesses and then implement the activities to translate these plans into results and maybe some of you have seen the results of our most recent PR effort in the upper extremity area on the Today's Show where our Vice President of Upper Extremity was working with one of our patients on a brand new high technology articulating hand. The young man had lost his arm in an alligator attack. Let's talk about overall the strength and the solidness of the business. Thus far, we have not seen any evidence that the challenging financial environment is translating into patient care delays; in other words delaying our patients from getting in when they need to have our services. However, we do recognize that if workers lose their jobs, unemployment goes up and do not find another source of benefits before their COBRA expires, we may see some stretching out of the time between their visits. We did have evidence of this many years ago in Rust Belt, America but to-date we have not seen any of that. Normally, we would expect to see some increase in our maintenance procedures as this would start occur. In other words people would be coming in for more repair and maintenance procedures rather than replacement. To date, we have not seen any of that but we certainly are mindful of what is going on out there and watching these trends very closely. As you all know, one of the states that is particularly hard yet these days is Michigan and we are underrepresented in that area. So perhaps that is a good thing. Also, turning our attention to another subject near and dear to our heart is the legislative front. We continue to support the Amputee Coalition on America on educating state legislators on the issues involved with reimbursement caps and how these deprive our patients of quality care and really doing them to lower levels of mobility. Thus far there are 11 states for the past parity and almost 30 more are working on parity legislation where we would expect to see those become more active next year. On the federal level, a bill was introduced into the Senate for national prosthetic parody during this quarter to complement the House version. Now, while it is unlikely that there will be any substantive movement on these bills this year, we hope to see them included in any healthcare reforms when the new Congress commences in 2009. So, we are really trying to lay the groundwork for the installation of those kinds of considerations. As I mentioned during our last call in early July, the Department of Labor Statistics posted that the CPIU increase for 2009 would be 5%. This should be the fee schedule increase that we see next year absent any definitive legislative action to prevent implementation and thus far we know that the folks inside the belt way seemed to be concerned with a lot of other matters and we have not heard any rumors to the effect that there was going to be any blocking kinds of legislation. So as we look into 2009, we are expecting to see that 5% increase. Let's turn our attention to our distribution business called SPS. Their outside sales are up approximately 2.9 million or almost 16% compared to the third quarter of '07. Success in continuing to build sales in SPS's core business is attributable to three major areas. First is the continuing of the leverage of the new location in the Northeast. The new warehouse was open in July of '07 and it continues to be a vital factor in SPS's ability to provide quality service and timely delivery into that Northeast corridor. Second is their superior customer service and training which is really the impetus for them gainings in new large customers during the quarter, and third is the addition of some new standard and high-tech products into their portfolio of products and just during this quarter, we can see evidence of that as they picked up a new line of modular component tree which is already starting to help with their book of business. If you recall, last year at this time, we acquired a company called Surefit. We have been working with Surefit in the integration of them into the Hanger family and we are happy to say that the improvements that we have made in workflow and in manufacturing logistics are paying off. On an overall basis, their sales are up 5% compared to the third quarter of last year and the implementation of the new IT system to make it totally compatible with SPS has been completed. Let's move on to our third unit, Linkia. Linkia continued in its dual mission of one, building its share of the key health company's book of business and two, negotiating a fair price for the services provided by the providers within the Linkia network. This network consists of the Hanger patient care centers and independent providers. Independent provider number has grown from about 300 during our last call to 306 today. As I mentioned, earlier Linkia continues to increase their business as a provider network management as insurance companies recognize the Linkia value and trim their network back. Their book of business is up almost 13%, as I said a little earlier in the call. So it is working. They are providing benefits through their value proposition. On the marketing side, Linkia is continuing their discussions and negotiations with the key national and large regional healthcare management companies, as well as the firms in the workments compensation segment. Last but not least, let's discuss a little bit about Innovative Neurotronics. Innovative Neurotronics had a good quarter by increasing enterprise revenues by almost 50% as compared with Q3 of last year. While the absolute amount of their sales revenue was slightly weaker than the quarters in the first half of the year, which, of course, we remember were so strong due to the wonderful coverage that we had on Good Morning America, nevertheless they continue to win key accounts and continue to establish and build market share and presence in the functional electrical stimulation market. Currently, they are wrapping up their clinical studies at the final three test sites. We still have three of our test sites open, and admissions to those sites will be closed in mid November. Now, we opted to keep the enrollments open just to make certain that we had a sufficiently large enough sample size for our evaluations. Once we have the closure of those sites, we will begin the final analysis of the data and prepare the submissions to CMS, and we expect those submissions to go into CMS in early 2009. We recognize that this is about six to eight weeks later than our plan, but we think the time was well spent to ensure that we have the proper number of fully evaluable patients. It was in our intent to have this wrapped up and begin to do the analysis in early November, and we chose to keep this open so that our sample size would be significant enough so that we would be able to have statistical significance in anything that we sent in. For the patients that are just going into the trials, as I said, we will keep the admissions open till mid November. They will be matriculating through the process and will not be complete until out into 2009, but we do not need all of those patients. We want to continue to study those patients. We know that once we shut those trials down in mid November, we will have had a sufficient number that would be complete to give us the end that we need. So, finally, a few words on acquisitions and our other developmental projects. We continue to pursue strategic acquisitions, and as George had mentioned, overall year-to-date basis, we have accumulated about $12 million in sales. With respect to O&P, we continue to look for those tuck-in candidates that have strategic value to us in the form of location, quality practitioners and/or favorable product service mix. During this past quarter alone, we announced several new additions to the Hanger family and we are happy to have them with us. On the developmental front, we have made some additional progress on our developmental projects and are preparing to complete our pilot studies in Q4 and move them into commercialization in Q1 of next year. So, the next time we speak with you, we will give you more color and transparency into those. Those are going along according to plan. In closing, the results of this quarter demonstrate that our programs continue to generate positive results. However, we certainly recognize that in this environment of volatile commodity and financial conditions, we have to be extra vigilant with respect to generation of revenues and certainly cost management. That concludes our formal remarks. I would like to turn it back over to Kathleen for the Q&A session. Thank you.

[Operator:]

(Operator Instructions). Our first question comes from the line of from Mr. Bryan Sekino of Barclays Capital. Your line is now open.

[Tom Kirk:]

Good morning, Bryan. How are you?

[Bryan Sekino:]

Good. How are you? This is Bryan Sekino on behalf of Adam Feinstein. I know that in Q4 '07 you saw some variable comp increases due to strong cash collections in 2007. With this quarter reporting such strong cash flow, can you provide us an update for your expectations for cash flow and variable comp in Q4?

[George McHenry:]

Well, from a cash flow standpoint, as I mentioned previously, we revised our internal estimates. We originally thought we would generate $30 million to $35 million in cash flow this year and we are going to be more in the $40 million to $45 million range. That is probably conservative. We are ahead of where we were last year in terms of our incentive compensation accruals, and they will not be as heavy as they were last year in the fourth quarter. So we should actually improve our EBITDA margins in fourth quarter over the prior year pretty significantly in fourth quarter. We will have a substantial accrual because it is a good quarter from us from a profitability standpoint. The quarter also will not be influenced by anything like the $4 million inventory book to physical adjustment that we had last year. That was a benefit that also influenced the accrual. So those two things should not happen this year. With where we stand with the accrual this year, we expect to have a more normal accrual in the fourth quarter.

[Bryan Sekino:]

Okay, great. Thanks for the update. Would you also comment on how your plans for CapEx are for the remainder of 2008 given the lack of capital available in the market and just give us an update there, if you can?

[George McHenry:]

Sure. Well, first of all, I would say we are not constrained from a capital standpoint in terms of making the investments that we need to make in this business. That is part of the reason that we did a draw on the revolver just to ensure that point in case things got more volatile in the financial markets. We originally budgeted about $20 million in CapEx for the year or year-to-date spanned through three quarters is a little bit behind where we expect it to be. So we will probably have a little heavier spend in Q4. We do have quite a few projects that are culminating in that quarter. I think we will probably be a little under the $20 million budget that we had. We will probably come in the $18 million, $19 million range.

[Bryan Sekino:]

Okay, great. Thanks a lot.

[Operator:]

Our next question comes from the line of Larry Solow with CJS Securities.

[Tom Kirk:]

Good morning, Larry. How are you today?

[Larry Solow:]

Good. How are you doing?

[Tom Kirk:]

Very good. Thank you.

[Larry Solow:]

Great. Just one quick question. I assume you reaffirmed guidance and said it sounds like you will slightly beat it. I assume that you are $680 million to $690 million on the revenue side, I imagine you probably feel you will beat that too because the high end would only be just about flat year-over-year so I assume that?

[George McHenry:]

Yes. We will probably be revenue-wise in the $695 million to $700 million range.

[Larry Solow:]

Just to touch a little more on the SG&A, can we expect just on a margin basis you running in the low 37% range and you have been accruing for some compensation already, would you expect that to remain there or maybe increase a little bit in Q4 on a margin basis?

[George McHenry:]

On a margin basis, it should be right around where it has been. It might be slightly higher. It might be a point higher.

[Larry Solow:]

Okay. Then just on cost of goods, I see you had some benefit already this quarter, and I imagine it seems like prices have come down even a lot more towards the tail end of the quarter and continue this quarter, if they stay at these levels and stabilize a little bit, can we assume that could be a benefit going out into 2009?

[Tom Kirk:]

Well, I would say the principal area where we saw pressure was in freight. Our transportation costs were definitely up. I do not know if we saw much benefit in Q3 because the decrease in oil prices hadn't really hit.

[Larry Solow:]

Right.

[Tom Kirk:]

We should get some benefit in Q4. Keep in mind, when you look more at our year-to-date com rate, we are practically level with the prior year. It is possible we could be a little bit below 30% in Q4 with the freight costs coming down. Your guess is as good as mine in terms of where oil prices will stay in '09. I mean right now, it looks like things are going to stay fairly level going forward.

[Larry Solow:]

Right. You file early 2009 and would it be fair to say that it is going to be a late '09, maybe 2009 late in the year would be upside and view it as a 2010 event?

[Tom Kirk:]

I think it will be 2010, Larry, before we see a full year effect by filing in early '09.

[Larry Solow:]

Right.

[Tom Kirk:]

The nice thing about where we are for coverage as differentiated from other phases of CMS is that they can entertain our filing whenever it is submitted. So, they will review it and we expect that it should take no longer than about 90 days unless they come back with like a second request. So, if all were to go well and they were to accept our data and health economics study that would support it, it is not going to take us till the end of ' 09. It should be certainly somewhere around Q2. Hopefully, we will have some response back from the end of Q1 and Q2 maybe we could be implementing this so that we can have a full second half of the year.

[Larry Solow:]

Got it. Okay, great. Then just last, just a housekeeping question; I think you said in the high performance products you said $5 million up for the quarter and 13 year-to-date, was that right?

[Tom Kirk:]

No, that was on our patient evaluation.

[Larry Solow:]

Was $5 million for the quarter, 13 year-to-date?

[Tom Kirk:]

That is correct. Yes.

[Larry Solow:]

Do you happen to have the percentages that those equate to?

[Tom Kirk:]

Percentage of overall sales, you mean?

[Larry Solow:]

Not per age of the gain, the gain percentage.

[Tom Kirk:]

They were up slightly compared to Q3 of last year single digits, around 5% to 6% increase.

[Larry Solow:]

For the quarter and then for the year…

[Tom Kirk:]

For the year, it is about 10% increase.

[Larry Solow:]

Got it. Okay, great. Thanks a lot.

[Operator:]

Our next question comes from the line of Mike Petusky.

[Tom Kirk:]

Hi, Mike. How are you today?

[Mike Petusky:]

Good quarter. Couple of questions; one, if you commented on this, I missed it. Did you have any weather impact from the hurricanes? I did not see anything in the release. Did that impact you at all?

[Tom Kirk:]

We did. As a matter of fact, we took a rather severe hit with Ike in the Galveston area specifically our Galveston office still looking for it, trying to rebuild that. On an overall basis, what we have gone through Mike is really charted all through the quarter all the storms and compare them with the last year and just assumed modest rate over last year and when you add them all up, it comes to about a $1.5 million of sales that we did not see in that. We went office by office in those specific offices. So, the two extreme events that happened this time George alluded one was the way the days fell, certainly in terms of the cost that we incurred and did not have comparable revenue and the second was the loss of about $1.5 million of revenue based on our assumptions. It is a good question though.

[Mike Petusky:]

Okay. In terms of the innovative, you said the revenues were down slightly sequentially, do you have those by any chance handy?

[Tom Kirk:]

We saw the revenues, enterprise based revenues of about $3 million in the first quarter, $2.8 million in the second quarter and in this quarter $1.8 million, $1.8 million plus some change. So the $1.8 million is more along the lines where we thought it would be, but we recognized that we had an outstanding benefit early in the year resulting from the Good Morning, America show and some very favorable penetration into a couple of our international markets.

[Mike Petusky:]

Okay. I just want to make sure I understand. You wrap up the clinical somewhere mid November and then you will have that 75 of valuable patients when you wrap those up in addition to the ones you are going to let continue go on but essentially is it 75 patients that you will have fully evaluated?

[Tom Kirk:]

That is correct and actually the number will be a little bit higher when we finish the evaluation and crunching all the numbers. We hope to be more like 85 to 90. We wanted to add a little more into the end just to make sure that we had proper coverage.

[Mike Petusky:]

Then just a final couple bigger picture questions and then I will get back in the queue. You hope to have any new Linkia contracts say between now and the end of calendar '09 and then in terms of any potential new Innovative Neurotronics opportunities between now and the end of '09? Thanks.

[Tom Kirk:]

Certainly in terms of our Linkia book of business, we are making proposals and for example, one company right now, we have revised a proposal three times in an effort to try to get their business. So, we do not offer that speculative prospective view into the Linkia book of business simply because it is pretty difficult to predict exactly what they are going to be able to achieve and history has taught us that lesson very well that the selling time is the lead time and the sell process is pretty lengthy. We have some pretty interested people that are in the final stages of negotiation. So, we would expect that we would have some additional Linkia customers between now and '09. Let me qualify that so we do not actually create an expectation that we can not achieve. We do not see those customers as being huge blockbusters like some of the ones we have. They would be more in the category of what we would call some large regionals that we would be working with. So, it would be incremental and of course the other thing that Linkia does is negotiate favorable prices based on the value that the insurance company se and for example on one of our contracts we have just received a 3.5% increase this past quarter that went into effect. So, that in combination with the additional volume and the favorable price increases is allowing us to go ahead and move forward in terms of building revenue but we also recognize that it is not all gravy out there. There are certain areas, for example, the State of California or the State of Tennessee is taking some measures to reduce their spend on the Medicaid side and to try and pull some of that back down. So, it is a constant battle with them trying to manage with the revenues they have in states who are short of revenues versus our trying to get full value for what we do.

[Mike Petusky:]

Hey Tom, actually let me jump in with a quick follow-up to the point you made. How much of your business is Medicaid related?

[Tom Kirk:]

Medicaid is about 5% to 6% of our overall business.

[Mike Petusky:]

Thanks. Then just that final question, do you hope to have any new high-end products or anything under development in the next year or so?

[Tom Kirk:]

We are talking to some people with some new high-end products on the functional electrical stimulation side. I think it would be premature, Mike, to say that we would have another product and certainly we know even though we like to get late stage products, we know that it does take a while to get them commercial. I alluded to some developmental projects that we have ongoing. Some of these are with other manufacturers that are on the outside that would report into our patient care business. So, we have some of those developmental projects out and we have got some of those projects on test. So, while we do not have a definitive new product for Innovative, we do have other products that we plan to introduce into our patient care business early next year.

[Mike Petusky:]

Perfect. Thanks, Tom.

[Tom Kirk:]

You are welcome.

[George McHenry:]

Thank you.

[Operator:]

Our next question comes from the line of Greg Williams with Sidoti & Company

[Greg Williams:]

Good morning. Thanks for taking my call.

[Tom Kirk:]

Good morning, Greg. How are you?

[Greg Williams:]

Not too bad. Can you talk a little bit about the delay here, specific delay in end markets? Specifically, did you anticipate more enrollees this fall and did not get them so now are you waiting for that or you just felt like you did not have enough? Maybe provide some insight there.

[Tom Kirk:]

We throughout the process and I think we might have mentioned this earlier. We have been constantly battling against defections. When some of the people came into the program and the way the arms are actually worked out, they have got to buy their own units, so they buy it and then let's say the arm is six weeks on the WalkAide and then it is six weeks on an AFO and then six weeks back on the WalkAide, we really expect them to take a $4500 device that they just bought and go back to a current treatment that is not nearly as satisfactory. So, we have had some de infections and throughout the process we have been working very diligently to try and keep our patients into the overall process. So, our original expectation is that we would have completed the trials as I mentioned, as we were saying late summer, we certainly thought by third quarter we would have had them. Our target number was 75. As we started to wind down in the trials, we thought it may be prudent just to ensure that we get the analysis based around the proper end side to let it run for another six or eight weeks and grab up some of the patients just to make sure we are okay. So, it was really the ounce of prevention instead of the pound to cure. Because once you start to do all the analysis and do the calculations, I mean you are there. What is so tricky about this is when you do those evaluations and you see the results, you got to be very careful that those results do not spill back into any of the remaining tests. By that I mean you can bias the outcome in either the way you select the patients or the way you put them into the arms. So we just wanted to let is it go under the normal conditions, grab up a few more people because you do not really get to go back, get a second bite at the apple. We just thought it was prudent just to make sure that statistically we were okay, we had people from the right populations in, in terms of those that were critical immediately after stroke and those that were continuing after their initial recovery. So we wanted to make sure we had the right patient populations into this thing. So it was really, as I said, just to make sure that we could get this analysis done the right way.

[Greg Williams:]

Okay. Thanks for that. It sounds like these folks were six weeks on, did not want to go six weeks off. So from a functional perspective, that is a nice problem to have then?

[Tom Kirk:]

Pardon me, Greg. I missed just for a second.

[Greg Williams:]

I am sorry. Just saying that these folks were on it for six weeks and a lot of them did not want to get off the WalkAide and go on to a brace of some sort.

[Tom Kirk:]

That was one of the issues that we had and then it was a nagging issue throughout the entire test. So everyone that just bought their new WalkAide was forced to give it up at a very short period after they have achieved some benefit. So that side was somewhat underrepresented as you could well imagine. So we did a number of things. We started working more closely with the principal investigators. We started to maintain have them and some of our clinical folks maintain more contact with the patients without biasing the studies just to make sure that they understood the real value that they were creating, not only for themselves but for those that came after them. Of course, in the meantime, we are still continuing to sell these units. So it is not as if the world is standing still. Our targeted sales force which we call RSS is 12. We are down a little bit. We are down two and we are refilling those positions. So we will continue with our sales and marketing effort throughout the period.

[Greg Williams:]

Okay. Tom, you did a great job discussing the economic impact or the macro economy on your volumes and sales going maybe more towards maintenance. Can you maybe see if we face a downturn here, some folks going downstream in terms of product mix, maybe not going for the high end processor devices?

[Tom Kirk:]

That is always a possibility. However, for those that qualify for the high end device, typically they have higher performance levels and higher demands. In some cases, they can not get that level of performance and stability out of some of the lower end devices. That is why there is this stratified level of technology devices out there. So we may see some of that happening more on the orthotic side, but I think people that are prosthetic patients, this is their life. That leg is their mobility. So, I would expect to see less downturn into the lower kinds of products on prosthetics. I would expect to see some stretch out. In other words, on the maintenance side or trying to figure out a way to live with an existing socket by putting additional supplies of socks on when they have had a volume or weight change instead of getting a new one, I think that would be the key on the prosthetics side. Perhaps on the orthotic side, remember, these are lower price point products, so you are not going to save a whole lot in moving from a custom-fabricated device to a custom-fit device. You will save a little, but perhaps on the orthotic side, you may see some downward movement on the product scale.

[Greg Williams:]

Okay, great. Thanks.

[Tom Kirk:]

Thank you.

[Operator:]

(Operator Instructions). Our next question comes from Daniel Owczarski with Avondale Partners.

[Tom Kirk:]

Good morning.

[Daniel Owczarski:]

Good morning and congratulations on the quarter.

[Tom Kirk:]

Thank you, Dan. How are you?

[Daniel Owczarski:]

Good. Tom, you started touching on a topic that I was going to ask a little bit about and that was on the orthotic side. Is that typically a 20% co-pay as well? I was trying to figure out how much of that business is discretionary, thinking that it is more urgent in nature and really would be isolated from economic pressures. Is there any other color that you could help us get our hands around just that piece of the business, how that could be impacted?

[Tom Kirk:]

Sure. That is a great question, Dan. I think we should break our orthotic business perhaps into two pieces. One is the custom where you absolutely have to have the custom-fitted brace or body jacket. Some are congenital and they are in braces for life, others after surgery needs stabilization. So, they really do not have a choice, because in order to do the job, it has to be custom and has to be high end. Furthermore, if it is part of their treatment, the protocols for their improvement in functionality and rehabilitation, they are going to have to have it so they can not delay it and make it discretionary. The second part is probably more of what we would call custom-fit low and off the shelf. Now, probably the first thing to keep in mind is that we are probably underrepresented in that business. A lot of that business tends to be fit either by a doctor, right in the doctor's office, sometimes by a physical therapist. So the off the shelf or low end codes are very small percentage, less than 5%. We went through when Medicare was contemplating at one point, including that end of the orthotic spectrum in competitive bidding, we went through and did an analysis and it was less than 5% of our orthotic business. So that low end, perhaps people may decide that, gee, I can go maybe just over to the med supply store and buy an Ace bandage or buy some other low end type of device and rather than going to see the doctor and then going into the Hanger store if they have got a problem with my elbow or shoulder or knee, they can buy an elastomeric brace and figure out they can just get by with it. That is probably the portion of the population that you are referring to and typically they do not. We see some of them but that is not a big piece of our business. The rest I have to believe is certainly as part of protocol, if they are going to proceed with the procedures that their doctor has outlined for them, they are going to have to come and see us now to the extent that they would opt to delay elective surgery or something and then of course we would not see them until they do get that procedure or that surgery with an implant or replacement. So, there is a number of moving pieces to this and certainly you are right at the end in thinking about some of it may be delayed but it is going to probably be only a fade delay on elective surgeries.

[Daniel Owczarski:]

Very helpful, thank you. Maybe a similar question just when we think about you and how you acquire target new centers. In this environment are the independents finding it more difficult to operate in this economy and does this make it favorable to you when you go out and try to tuck-in?

[Tom Kirk:]

I believe it does. I think these days of uncertainty as George was commenting of seeing some rises in material costs, the volatility on the fuel surcharges that we are seeing, their inability to really have the kinds of volumes that we have so that they can leverage back against the manufacturers and some of the freight companies really hurts them. That volatility is the killer and as George has said also that when this year finishes out, he fully expects and we all agree that probably our cost of materials is going to be almost equivalent to what it was last year which is a great attribute to the practitioners in the field and the way they use and fabricate the devices as well as the SPS and the way they buy. The mom and pops do not that luxury. So, that is number one. Secondly, the insurance companies as if you are not in the Linkia network, we know that their world has gone topsy-turvy here in the last year. So, they are starting to get pretty aggressive around the kinds of discounts that they are seeking and then last but not least you have the states that are in the relentless search like medical in Tennessee trying to figure out how they can save some money. So, all of those factors combined to make it a more favorable market for us to work with the high quality practitioners that are out there. They want to do the clinical work they just got a little bit tired of the uncertainty and volatility in their earnings. So, I think we make them a nice package and they are more than willing to come under the umbrella and we are more than willing to have them.

[Daniel Owczarski:]

Thank you.

[Operator:]

Our last question in queue at this time comes from Henry Ritchotte with Deutsche Bank.

[Tom Kirk:]

Good morning, Henry, how are you today.

[Henry Ritchotte:]

Good morning, Tom and George. Doing just well. Congratulations on your quarter. Really fantastic results. Hey, just two quick questions. One, you mentioned the Rust Belt it is probably 25, 30 years ago now that we saw a weakness out there that you are referencing. How much was it, if there is any anecdotal evidence or memory of how much the weakness was there? Then secondarily just on Linkia with the HMOs topsy-turvy and in terms of their performance, have you renewed all the Linkia contracts and are you seeing pricing that is comparable to last year or some an increase?

[Tom Kirk:]

Okay. Let's take those one at a time. You are right, there was a major shift back in the Rust Belt about 20 years ago when many of support and Tier-1 and Tier-2s to automotive got hit but even more recently if we just go back into the early 2000s, really, we saw some activity again at the 2001-2002 period. It is one of the good things of diversification across the country, because even when we experience some softness in western Pennsylvania and Ohio, and as I mentioned before, we underrepresented in Michigan, those turndowns in those areas or those parts of those areas were maybe in the 5% range. For the most part, people will stretch and do whatever they have to do to try and get the device that they need. So, it was not as if it was catastrophic and the bottom fell out. What we saw was there was a lag because people when they did lose their position, they lost their immediate benefits but then they went out to COBRA and then they started looking for other companies to find employment. So, we saw probably in some of those pockets maybe a 5% turndown which on our overall basis was less than a percent. So, there is always that presence of revenue deterioration that can occur. Secondly with the HMO turnaround, they have been negotiating very aggressively particularly with the mom and pops. What we have seen though is because and I go back to using probably this word too much the value proposition of Linkia that saves them administrative costs and gives them what we call clinical simplicity in that we measure customer satisfaction and quality and ensure certification, Linkia has been able to increase prices, not off the charts but in commensurate with the value they are delivering. So while we know that it is a tough environment that we fundamentally seeing that the Linkia deal really works out, it is a win-win for both sides. So we have seen Linkia is renewing the contracts and they are coming up continuously. Some of the ones that were signed last year have provision in them for three-year terms and increases each year and then at the end of that they are going to link back and take the then current Medicare fee schedule. So, we will capture those benefits. So, we think that of all the folks that are out there in the profession, Hanger is perhaps best suited to whether these kinds of storms just due to the diversity of our locations and the value that we can bring through the Linkia provider network and we really want to be partners with these HMO companies to make sure that what we are bringing enables them to go out and sell to the employers of the US because after all, they have to market those services and satisfy the employees is what it is all about. So, we try to encourage our people to keep a good focus on patient care and customer satisfaction and we know that is going to pay off for us.

[Henry Ritchotte:]

Thanks so much.

[Tom Kirk:]

You are welcome. Thank you, Henry.

[Operator:]

At this time there are no further questions in queue.

[Tom Kirk:]

Thank you very much Katherine. I want to thank everybody for joining us. We certainly know that there is some good hard work to be done out there over the fourth quarter. We will be back with you in February to report our year-end results and since we will not be talking with you, I just want to wish all of you very safe and happy holiday season. Thank you.

[Operator:]

This concludes you conference. At this time, you may disconnect your lines. Thank you for using the conferencing services.