Tivity Health, Inc.
Q3 2013 Earnings Call Transcript

Published: 25 Oct 2013

[Operator:]

Please stand by, we're about to begin.

[Chip Wochomurka:]

Good afternoon, and welcome to Healthways' Third Quarter 2013 Conference Call. Today's call is being recorded and will be available for replay beginning today and through November 2 by dialing [phone]. The replay passcode is 6885653. The replay may also be accessed for the next 12 months on the company's website. To the extent any non-GAAP financial measures discussed in today's call, you will also find a reconciliation of that measure to the most directly comparable financial measure calculated according to GAAP in today's news release, which is also posted on the company's website. This conference call may contain forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995, including statements, among others, regarding Healthways' expected quarterly and annual operating and financial performance for 2013, 2014 and beyond. For this purpose, any statements made during this call that are not statements of historical fact may be deemed to be forward-looking statements. Without limiting the foregoing, the words believes, anticipates, plans, expects and similar expressions are intended to identify forward-looking statements. You're hereby cautioned that these statements may be affected by the important factors, among others, set forth in Healthways' filings with the Securities and Exchange Commission and in today's news release. And consequently, actual operations and results may differ materially from the results discussed in the forward-looking statements. The company undertakes no obligation to update publicly any forward-looking statements, whether as a result of new information, future events or otherwise. At this time, for opening remarks, I'd like to turn the conference over to the company's President and Chief Executive Officer, Mr. Ben Leedle. Please go ahead, sir.

[Ben R. Leedle:]

Good afternoon, everyone. Thank you for being with us today for our third quarter 2013 conference call. I'm here today with Healthways' CFO, Alfred Lumsdaine. We'll both make some remarks about our results for the third quarter, as well as our outlook and guidance. Following those remarks, we'll open the floor for your questions. I'll begin with the assumption that you've all read the news release we issued an hour ago, which details our third quarter results, our guidance and our outlook. Rather than repeat that information in-depth, I want to make some relatively brief comments so we'll have more time for questions. First, I'll reiterate that the primary reason for the reduction in our guidance for 2013 is from a much lower number of risk lives than anticipated from certain health system contracts. Our previous expectations reflected the momentum we experienced in signing 6 health system contracts and building an active pipeline of new potential health system customers, but did not incorporate the impact of an industry slowdown. For the market in general, we believe, and others in the industry will confirm this, that the energy has dissipated as the magnitude in complexity of the transition from ACO contracting between payers and providers to full ACO implementation and operation has become more apparent. As we see with a number of our health system partners, progress is still being made, but the pace is slow. As a result, the yield of lives available for our Population Health Management services in support of certain health system customers is lagging. We continue to believe the market will reach a forward tipping point, and this transition will reaccelerate in time. As our changing guidance reconfirms for us, however, we do not control the timing of this transition, and we will no longer forecast its pace in the formation of our guidance. Second, in addition to growing our health systems market, importantly, we have grown and strengthened our business in all our core markets this year, including health plans, large employers and our fitness business. Our continuing contract announcements are clear indications that we are adding to and expanding a strong operating contract base in all our core markets for which we are retaining clients, retaining revenue, both at benchmark levels for Healthways. As a contract service business, these are the positive factors that, combined, will drive future growth. In 2013, we expect to recover all of the 2012 revenue source from what we defined in the news release as the 2 terminated contracts, and we expect to expand revenue and margins from this phase in 2014. Third, because of the reduced slope of the ramp for certain health system contracts, we have configured advanced and leveraged key components of our well-being improvement capabilities that afford health systems, physicians and health plans to deliver a subset of population health services, which concurrently afford them immediate revenues and near-term cost savings under either a fee-for-service or value-based reimbursement method. As our news release discussed in detail, our exclusive agreement in July to license and operate Dr. Dean Ornish's Lifestyle Management Programs has received a great reception and, in a short period, more than doubled our number of committed health system relationships with market-leading organizations. In addition, we just announced 2 new Blue Zones projects, one of which is for Fort Worth, Texas, with our first health systems partner Texas Health Resources, and the other in Hawaii with our long-term health plan partner, HMSA. This week, we also announced an exclusive agreement to provide Dave Ramsey's CORE Financial Wellness program as an integrated component of the Healthways Well-Being Improvement Solution. Beyond the benefit this service provide our customers in terms of outcomes and member satisfaction, the services are focused on the types of longitudinal costs and quality outcomes that are essential for value-based performance and, thus, represent further progress in the transition. For the past 60 days, we've been engaged in deep discussions with 2 very large current customers, exploring and developing unique business structures and relationships for well-being improvement service expansion. Until very recently, we had direct line of sight to expected fourth quarter contribution from one of these customers that would've made up the difference in our earnings shortfall inherent in our guidance reduction. We learned in the last few days that the initial stage of that expansion opportunity may now be more limited on the front end, although it remains a very large business development that would afford significant expansion with execution. Our expectations were that we could've secured this agreement this month and, thus, would've either met or exceeded our previous earnings guidance for 2013. Instead, we will continue negotiations, expect to sign at least one of these 2 prospective expansions within the fourth quarter. As a consequence, most of the financial contribution from either of these 2 potential client expansions has been removed from our revised 2013 financial guidance. As a final point, our discussion today of the slowdown in the movement to value-based reimbursement should not be interpreted as any lessening of both the need for value-based total Population Health Management or the opportunity that it represents. In the release, I discussed the importance of our 2 recent announcements related to Renaissance Health Network and CareFirst BlueCross BlueShield of Maryland and D.C. These are innovative leaders in their markets, who understand both the beneficial and imperative nature of longitudinal value-based health management, and have made clear strategic decisions to embrace the opportunities and the challenges of providing a solution to their customers. The market leadership and long-term success each has already achieved brings even more weight to their strategic decisions to deepen their relationships with Healthways. In closing, we do not disregard the short-term disappointment that our revised financial outlook for 2013 creates for our colleagues and stockholders. Our path to profitable growth has not been smooth since the fourth quarter of 2010 ,when we began to outline for you the opportunities we saw in the emerging transition to value-based reimbursement. However, it is undeniable that Healthways has made tremendous progress since that time and that our market positioning today is stronger than ever with regard to the long-term growth opportunity that this transformational change in the healthcare industry represents. We believe the momentum of this progress has continued to increase as evidenced by the breadth and depth of the contracts we are signing and which you will see us continue to announce in the months ahead. The business that this momentum is producing, combined with our proven ability to implement and operate our solutions successfully, supports our confidence in achieving our long-term growth objectives. Thank you for your interest in Healthways. And now, I'm going to ask Alfred, our CFO [Technical Difficulty] third quarter results and guidance in a little more detail.

[Alfred Lumsdaine:]

Thanks, Ben. Good afternoon, everyone. Third quarter revenue of $167 million was equal to the third quarter of 2012. Excluding the impact of the 2 terminated contracts, our revenues increased 14% on a comparable quarter basis. On a sequential quarter basis, revenue increased by $4 million or approximately 3%. We did return to profitability during the third quarter as earnings per diluted share totaled $0.05. EBITDA margins increased sequentially for the third quarter by 250 basis points to 11.4%. As Ben just discussed, our overall financial performance for the third quarter was clearly below our expectations. Our revenue growth did not progress at the pace we've previously expected, primarily within our existing health system contracts. As Ben mentioned, the pace at which our health system partners develop and finalize arrangements to take on fully attributed commercial populations with financial risk for managed care organizations was much slower than we anticipated. In addition, we saw membership numbers that were lower than our expectations across several of our commercial health plan customers. None of which were individually material, but which aggregated to a modest impact to our previous expectations. For the quarter, we generated $12 million in cash flow from operations, which now totals $51 million year-to-date. Our capital expenditures for the quarter were $13 million and now total $33 million year-to-date. Our leverage ratio, calculated under our credit agreement, increased to 4.2x as of September 30. We expect the leverage ratio will decline to under 4x at December 31 and to continue to decline throughout 2014. So now let's turn to financial guidance for the fourth quarter. As you saw in today's release, we've provided revenue guidance for the fourth quarter in a range of $171 million to $181 million. This guidance range for the fourth quarter implies a full year revenue guidance range of $665 million to $675 million. The sequential quarterly revenue increase of approximately 2% to 8%, represented by the fourth quarter revenue range, is well below our previous expectations, again, driven primarily from the slower-than-expected revenue ramp within several of our health system contracts, as well as the slightly lower-than-expected membership across a number of our commercial health plan customers. With regard to guidance for earnings per diluted share for the fourth quarter, we expect to perform within a range of a breakeven to $0.06. This guidance range for the fourth quarter implies a full year loss per share range of $0.04 to $0.10. As we move into the fourth quarter, we'll begin to incur our normal increase in costs, preparing for new contract implementations that go live on January 1, 2014. And as a result, even with the expected sequential quarter increase in revenue, our EBITDA margins for the fourth quarter are expected to be somewhat lower than the third quarter. Based on our guidance provision today, we now expect the EBITDA margins for the full year to be in a range of 9% to 9.5%. From a cash flow standpoint, we continue to expect operating cash flows for the full year to be in a range of $70 million to $80 million, and capital expenditures to total approximately $45 million. Before I move to the financial guidance for 2014, let me add a comment about our revised guidance for 2013. As we've progressed through the months of August and September and now into October, there were certainly some data points coming from our customers about the slower-than-expected pace of ramping revenue within several of our health system contracts, as well as the somewhat lower-than-expected membership across several commercial health plan customers. Obviously, these data points came at various times throughout this period and provided varying degrees of clarity. At the same time, as Ben mentioned, we're working on a couple of very large, new business opportunities, either one of which could have offset most or all of the slower health system expansion. It's only been within the last several days that these business development opportunities have been dispositioned in a way where we have better visibility to the fourth quarter and, therefore, leads us to our revised guidance for the year. So turning to our initial financial guidance for 2014. Based upon our current visibility, we're providing our initial expectation for 2014 revenue in a range of $725 million to $760 million. There are 3 elements that drive our growth projected for 2014. The first factor is retention. As we indicated in our earnings release, we've renewed 2 of the 3 largest contracts up for renewal in 2013, and we expect to finalize our renewal of the third contract very soon. As with any contract services business, we'll never retain 100% of revenue from each and every contract, and our current expectation is a revenue retention factor from 2013 to 2014 in a range of 92% to 93%. This level of revenue retention is consistent with our expectations coming into the year and substantially better than the past several years. The second factor is ramping revenues under existing contracts. We've previously expected our current book of business to provide organic growth of at least $85 million in 2014 over 2013. Given the slower-than-expected ramp that we're experiencing on some of our existing contracts, which we've talked about, primarily with our health system customers, we are now projecting that this organic or same-store growth will be in a range of $50 million to $55 million. It should be noted that we've taken a much more conservative approach to quantifying the revenue ramp under these contracts for 2014, and we are not including any expectation for revenues from our customers for attributed populations, except for those that are already signed and already scheduled to go live. Finally, even though we've already had a successful year generating business with new customers in each of our markets, the bottom end of our 2014 range includes no new business for 2014 that has not been committed to as of today. As noted in today's release, we continue to expect EBITDA margins to expand year-over-year in 2014 and beyond. We'll communicate our expected EBITDA range for 2014 in connection with our full year guidance in February. So just a few final comments. We continue to have strong confidence that we are returning to growth in revenues and earnings. In fact, excluding the 2 terminated contracts, each of our markets saw revenue growth in 2013. We've learned that there can be fits and starts with regard to the pace of deployment of our services as we move into the full implementation of health care reform and the associated move to a value-based reimbursement system for health care in this country. At the same time, we continue to sign new business in each of our markets and have a historically strong pipeline. In addition, we've continued to expand our well-being value proposition, as evidenced with the recent addition of the Ornish's Lifestyle Management Program and the Dave Ramsey's CORE Financial Wellness Program. We believe that the revisions we've made to our guidance today are largely an expression of timing, driven by market forces, and not a diminishment of the growth potential for Healthways. With that, operator, we'll go to Q&A.

[Operator:]

[Operator Instructions] We'll take our first question from Tom Carroll with Stifel, Nicolaus.

[Thomas A. Carroll:]

So question in a little more detail about the -- well, the first of the 2 items that you are referring to in terms of lowering your numbers here. And just from your second paragraph on the press release, you highlight lower number of risk lives related to your health system business. Does this mean you're seeing less business because health system utilization remains low related to the economy, or are you referring to this business from health systems really as large employers and these health systems as large employers are not generating the kind of revenues that you thought?

[Ben R. Leedle:]

Tom, this is Ben. Thanks for your question. The simple answer is neither. When we're talking about these risk lives, we're talking about attributed lives that are funded into our services where we have contracted with a health system. And you've seen us announced 6 of those types of partnerships, the Texas Health Resources, Beacon, Carondelet, others, where they are entered into an agreement with a commercial payer for accountable care organization arrangements and that they're taking on value-based payment models. Now there may be combinations of fee-for-service, plus bonus for quality and cost targets. They could be actual gain-sharing arrangements that they have. They go all the way to capitation, in some instances. It is -- and I know you've seen it as well. We follow the data in the industry. And the one data set we think is exceptional to look at is, over the last 18 months, about 495, I think, of these types of ACO arrangements have been created between payers and health systems in the U.S. And so the pace of those contract signings -- contract signings are happening. The commitments for those health plan live, the MCO live to be put into these models have been built up, and they've been built up with -- to different degrees with our customers. The challenge, and I noted it in my prepared remarks, but maybe I wasn't as clear as I'd hoped, getting a contract done is one thing, creating the data interface between that health system and the health plan to receive claims data, eligibility data and data that confirms attribution to their own and integrated primary care physicians and then linking that back into ASO groups that might be partially afforded participation in these. They're complex models. The minute you go past a payer thing, I'd like to do a collaborative deal with the health system to be able to create these agreements, here's 25,000 or 40,000 lives. In fact, I think the data today is, on average, across these, roughly 500 ACOs. There are about 40,000 lives for each one of those. The depth is the source of the risk lives that we're talking about. So our progression with our health system clients around, say, their own employee and workforce, for diabetes services line, as you saw in the agreement for the Ornish's cardiovascular services, for even things such as community transformation effort by Blue Zones, all moving forward. This specific ramp we're referring to are those lives that will come through attribution from payers, even Medicare Advantage or commercial, that the integrated system is then going to manage under something other than a straight fee-for-service arrangement. It is there where we are taking our capabilities. And you might have seen a release, we commented on it, again, today on our release, about Well-Being Direct platform that we've integrated at the physician level in order to support a Population Health Management approach. So the challenge to these agreements hasn't been that there aren't commitments and contracts in place between the health system and the payer for lives and that those lives under those multiple contracts don't accumulate to the potential that we thought about. It's the actual real-time throughput for the pace with which those lives are actually entering into the primary care delivery system that is supported by us and using our services. Does that help?

[Thomas A. Carroll:]

Yes, that's much clearer. I was just looking for a clarification on that in terms of how you've characterized in the press release, again all that. So I guess just 2 things and I'll hop off. I guess how are you changing the way you're forecasting that -- those potential lives kind of into becoming more of a benefit for Healthways?

[Ben R. Leedle:]

Yes.

[Thomas A. Carroll:]

And then secondly, Alfred, I understand you're -- you guys are holding off in guidance till February, but we've had a -- we've heard a relatively consistent confident story from you guys going into second half that's now been pushed out a little bit. I wonder if you could maybe give us a little bit more clarity on what your EBITDA margin expectations are for 2014 and, certainly, a wide range would be helpful, and it would be certainly more helpful than not hearing anything till February.

[Ben R. Leedle:]

Yes. So let me take the first part of that, Tom, and then -- and I'll have Alfred address the margin piece. In terms of how we look at then forecasting lives going forward, instead of providing those in as the health system signs the agreement with the MCO, those would essentially wait to enter our forecast now, and this may seem ultra-conservative, but we don't know any other way to do it, given that we haven't found an accurate way to predict the timing and the throughput on this, is that we're going to not include them in the forecast, unless we actually have them under management. It's that simple. So the forward view which you're going to ask Alfred about from a margin standpoint assumes that in the normal flow, we would have looked at our contract with the health system that would've said they just signed a accountable care Organization deal with a commercial payer. It's for 20,000 or 50,000 lives. Those 20,000, 50,000 lives don't go into our forecast as they would per -- just because all the agreement mechanisms in place. They are going to our forecast once we have the data and can begin to deliver our services in support of their primary care network.

[Alfred Lumsdaine:]

So, Tom, as far as the EBITDA margins expectations for 2014, I won't be able to provide any more specific range today. At the same time, I think last year was the only time we've provided any form of EBITDA margin range this early. At the same time, I think the underlying dynamics that we've been talking about as it relates to it and EBITDA margin progression are entirely intact. Clearly, we're going to be starting from a lower revenue point than we had expected, but our progression upward and our expectation, their matched to a revenue increase is really unchanged. So we continue to view progressive margin expansion over the next several years, so -- which is very consistent to everything we've said. And I think we would continue, again, for that computation to be entirely intact.

[Operator:]

We'll take our next question from Ryan Daniels with William Blair.

[Ryan Daniels:]

I guess the first one in regards to the revenue downtick in your guidance of the year. Can you talk about the weighting between the 2 reasons you discussed, meaning the lower lives on the risk-based contract with providers and then the turnover in your existing health plan customers?

[Ben R. Leedle:]

Yes. If you just compare those 2 things in proportion to one another, and of course, Ryan, there's always lots of much smaller things because of the 2 predominant variances, the lives under management is probably 25% to 75% out of -- if you just take those 2 things in isolation.

[Ryan Daniels:]

Okay. And for the 25% hit then with the health plan customers, I mean, I guess I'm surprised to see that midyear. Is that just them reducing health care benefits? I mean, is it then losing share to other payers? I wouldn't think that takes place midyear, given that open enrollments kind of during the start of the year. So what drove that deviation?

[Ben R. Leedle:]

Yes, that's a good question. And of course, again, it is the significantly smaller of the 2 things that we're citing here. We've looked for a discernible pattern, Ryan. We can't find it. If you look underneath each of them, there's a different -- some maybe -- one is the case of, really, health care reform and the movement of ASO lives into PCMH models. Other cases, it's a single, large employer leaving midyear. Again, each of the individual changes were immaterial, but it has aggregated to a number that was, at least, consequential in the big scheme of this conversation.

[Ryan Daniels:]

Okay. And then help me out a little bit to you. You've talked about -- it sounds like 2 large business development opportunities that if they came to fruition into the call here would've given you a little bit more cushion in regards to the guidance this year. How should we think about those? Sounds like they're removed from '13 altogether. So correct me if I'm wrong, number one. And number two, how do we think about that as we contemplate your forward guidance for '14? Have you pulled those out altogether, or is that kind of in there if we look towards the higher end towards that $760 million number that -- as it come in back to the pipeline?

[Alfred Lumsdaine:]

Good question, yes. And as far as their effect, '13 first, in terms of '13, obviously, we still have a very wide range, particularly as it relates to revenue now, given the fact that we are sitting here in late October and given that we don't want to put out a number and be wrong. We've substantially all -- the opportunity has been removed. But I couldn't say that it's been entirely removed, that you're talking about the entire range of our guidance. So -- but clearly, at the bottom of the range, there are no revenues for this year for either of these opportunities. At the same time, and I think this came across in Ben's comments, we're very optimistic about both of the opportunities, and so it clearly is inside of our range for next year. We do have a modest amount of revenue expectation, but that's an entire pipeline being handicapped. And that's really the entire contribution, if you will, or the entire results of our revenue range for next year. I think I said at the bottom end, we've not assumed anything that's not committed for today. And we've also said we're assuming no ramp, unless we know that we have a signed -- there's a signed deal for attributed lives and a start date in hand. And so really, the entire breadth of our range for next year is potential new business. But clearly, there a component of the pipeline that has been -- probable lives and is contributing to the -- and that's really creating the range for 2014.

[Ryan Daniels:]

Okay. And, Ben, did you say those were existing customers that they were thinking about expanding? I didn't quite catch all of it -- all of that.

[Ben R. Leedle:]

Yes, you're a good listener. Those are our already large current customers asking and working with us in pretty unique ways to leverage our well-being improvement services. They're expansions of relationships that already exist. This is a different scenario then. It's a prospect that we've never done business with before. These are clients that are 3-plus years experience with.

[Ryan Daniels:]

And did you mention that -- and this would be my last question, that the scope for one has kind of permanently been reduced, that maybe they went through their diligence and decided we don't want to move in this direction so they reduced it permanently, or is it really just more delays and implementation timing with you?

[Ben R. Leedle:]

More form of structure of how risk and reward gets balanced inside of the equation at the rollout and startup of the effort. Ultimately, the economics, as I mentioned, afford significant expansion with our execution. So as we would roll it out in a phased manner, successful phases lead itself to as big or bigger than what we were originally looking at.

[Ryan Daniels:]

Okay, got it. All right.

[Ben R. Leedle:]

The right size of the opportunity is as big or bigger in the form in which we're working on it now. The near-term front end of it is different.

[Operator:]

We'll take our next question from Sean Wieland with Piper Jaffray.

[Sean W. Wieland:]

Sorry, joining a little bit late here. So apologize if I ask questions that have already been addressed. But what is your thought around -- what can you tell us in terms of the visibility that you have on your new revenue range in terms of where backlog stands, maybe relative to year-over-year? What happened to the $80 million or so worth of signed contracts that you had for going into next year? Anything you could do to hang your hat on visibility would be helpful.

[Ben R. Leedle:]

Sure, Sean. This is Ben. On the backlog question, I'll address that. I'll let Alfred address the $80 million. He did, earlier script, but it's worth repeating. So as of 9/30, the backlog was $28.3 million. If you go back in time, that backlog was fairly low as you would expect it to be at the end of the second -- or first or second quarters of '13, those -- respectively. June 30 were $2.7 million. On 3/31, it was $2.5 million. And then as compared to what we would expect to seasonally see things that are in implementation but not have gone live, the 12/31/12 backlog was $39 million. So that takes you back through the last year. Last year, at 9/30/12, the backlog was at $32.7 million, so relatively comparable backlog related to where we are in the season of throughput on new business.

[Sean W. Wieland:]

Okay. So excluding the 2 terminated contracts in this quarter, your revenue would've grown at 14.2%. And if I'm doing the math correctly, at the midpoint of your guidance, you're looking at about 10% growth for next year. So why would we be seeing. [Technical Difficulty]

[Ben R. Leedle:]

Sean, are you there?

[Operator:]

[Operator Instructions] We'll go next to Josh Raskin.

[Alfred Lumsdaine:]

if I could interject that -- because Sean did asked question that I want to go ahead and answer, and that was around the visibility as it relates to the $85 million in expected ramping revenues, which would represent, in essence, same-store growth from '13' to '14. In my prepared comments, I mentioned that based on the slower attribution of lives into our health system customers, we now have -- are scoping that number for 2014 in the $50 million to $55 million range. In addition, I mentioned that at the low end of our 2014 guidance, we have no -- it includes only business that has been committed to today. So our visibility to the bottom of our guidance for 2014 is -- I would say, is excellent. And in our entire range, we've not included any attributed lives for our health system customers, unless those has been contracted and are scheduled to go live.

[Operator:]

In just one moment, sir, we do have Sean queuing back up.

[Sean W. Wieland:]

And I'm here. I don't know what happened there. So my question was 14% growth on a pro forma basis this quarter. I think it's the midpoint. The growth is like 10% for next year. So what would be causing a deceleration in the business?

[Ben R. Leedle:]

Yes. I think the midpoint is just shy of 11% next year. I think it's a function of what Alfred outlined in terms of the approach that we've taken to -- at least, our preliminary view from where we sit today. There's still a significant new business to still finish work on for this year. And the view that we've taken on what we think is the opportunity, our risk lives in the health systems business, we've really, really flattened down any kind of expectations. And you may missed part of the call that asked how we're forecasting differently. Sean, as it relates specifically to those ACO lives is there'll be a -- put into our forecast when we receive the data to go live on them, rather than the contract between the health system and the payer that commits to, in particular start date and flow, which, quite frankly, has been hard for those constituents in this equation in order to make happen in a timely way. It's that simple.

[Operator:]

And we'll go next to Josh Raskin with Barclays.

[Joshua R. Raskin:]

First question, just what percentage of your total revenues comes from commercial health plans?

[Ben R. Leedle:]

It -- for 2012, it was probably in the 40% range. It'll be a little bit lower this year, as you can imagine, with the 2 commercial health plan contracts have terminated and the growth in the other aspects of our business. You -- probably about 1/3 of our business this year.

[Joshua R. Raskin:]

I guess if it's 1/3 of sort of that $670 million, that's about $220 million. That means the 15 -- and you guys said 25% of the decline was health plans of the $50 million reduction in revenues. That's $15 million, looks like 7% of the overall book. It seems like a big number to me. So I'm just curious, maybe my math is wrong, that could be the issue, but are you seeing something in that magnitude in terms of membership losses on the health plans?

[Alfred Lumsdaine:]

No. It -- I won't necessarily say your math is wrong. I didn't do it in my head. But there's other pluses and minuses throughout of any forecasts, Josh. We've only quantified the 2 material items. By far, the biggest one of which is the attributed lives at our health system customers. But it is -- we wouldn't have talked about it if it wasn't meaningful. And again, we can't see a consistent pattern or anything systemic in the issue. But again, it was meaningful and worth mentioning.

[Joshua R. Raskin:]

But you did mention -- I just want to make sure that my number is right then. So it's 1/3 of the total book and 25% of the reduction in revenues was due to health plan membership losses, is that right?

[Ben R. Leedle:]

Probably a little smaller than the total, and I think you may be still working off of our original guidance range not the revised guidance. But again, that, notwithstanding, if you just look at the 2 items that we mentioned, the slower ramp and these -- and the lives in our commercial health plan, then it's about 1/4 of that total.

[Joshua R. Raskin:]

And then just till I understand the health system -- and I apologize. I know you guys gave a great answer for Tom's question. But just so I understand where Healthways comes in and where you guys get to see on some Population Health Management contract. My understanding is the -- an ACO will be created between some sort of payer and system. You guys will be providing a service for the management, the health and population management for that health system. And then are you paid some sort of a percentage of savings, or are you getting sort of a fee per member, PMPM, from the health system for those lives that they take at risk?

[Ben R. Leedle:]

That's great question, Josh. Think of us as mirroring the structure that the health system is under. So if they're on a modified fee for service or they may get some primary care PMPM, plus targets for quality and targets for cost savings as an upside or up and downside risk-sharing arrangements, we would flow similarly. We'd get a portion of PMPM, and the rest would come from our alignment and performing to the targets that, that health system and their physician groups have, all the way to 100% of our portion of the share at target performance. If they're under a global cap, they're with the Medicare Advantage plan. So it's a mix of fee methods for us that are aligned to the structure for which that health system has entered into the function of their contract with the payer.

[Joshua R. Raskin:]

Okay. And this doesn't sound like there's been any issue around the hitting of these targets to get those reimbursement. There's more of a -- just the lives haven't shown up yet, is that fair?

[Ben R. Leedle:]

Yes. And in a lot of ways, we'd love the opportunity to be enhanced, to show those outcomes. A lot of these have not -- I mean, literally, I think, if you go look at the people who are tracking us, and everybody might have their own favorite source, we follow the Leavitt Partners data set on this, and if you look at what's happening, you can argue whatever you want for the relative slowdown. But about 20% to 25% of these arrangements nationwide are in full capitation. The rest are either some type of fee-for-service with upside opportunity only, somewhat upside, downside risk kind of at the end of the year. And out of that, it's probably 40% that are simply just upside opportunities. And then a few, the smallest percentage of all that, maybe 10%, is then kind of bundled payment arrangement. So you're seeing all those different business models come in. The -- obviously, challenges, there's 3 major challenges that have emerged post the health system payers contracting. The first and foremost is no data or bad data, and what data is provided struggles both from the standpoint, not just of accuracy, but also timely. And you understand our model and these models is a data-driven, analytics-driven identification, stratification, prioritization, predictive logic in order to apply the resources to the right cohorts within those physician panel populations. The second issue, obviously, is it requires a lot different tools than what have traditionally been available. From that standpoint, we think we represent market-leading capabilities, and that's why we've been hired by these health systems. And then third, which is not going to shock anybody, the cultural change required among the physician, even though they are owned and integrated into these health systems, it still get quite a bit of pushback just because of the degree of change that's being asked in terms of the reengineering of workflows and the redefining of the role of the primary care physician as it relates to these models. So without strong physician buy-in enabling them see how that mind shift occurs, it's -- everything is just slower than expected. And so the yield of lives that have gone live is much lower than what we have projected, that you could get to and quantify very easily by understanding what's been contracted for at the payer health system level. So these -- we didn't make up these numbers about what was likely to be yield across our health system relationships, which is the throughput around some of the implementation issues to operationalize these between the payer and the health system and then the movement within the physician practices for everybody pulling the same direction to reengineer these care models. It shouldn't surprise any. It's taking longer, and it's complex. And despite that, we did not handicap that factor enough in our equation, and you've heard how we'll address that going forward.

[Joshua R. Raskin:]

Just -- and then I'm calculating the debt to trailing 12 EBITDA, a little over 4x. And I guess depending on what happens to the fourth quarter, maybe to be up or down a little bit. Can you just remind us what the covenants are on your credit agreements?

[Alfred Lumsdaine:]

Sure, yes. I think in my prepared comments, Josh, we've been calculating 4.2x at September 30. And our expectation would be below 4x to end the year and continue to decline every quarter next year, according to our current expectation. So -- and as far as the covenants, we're at a 5x covenant. It steps down to 4.75x at 12/31.

[Joshua R. Raskin:]

So you have plan, okay. And then -- I'm sorry, just last question, just a clarification on the EBITDA margins. As you said progression into '14, does that mean 1Q '14 is higher than 4Q '13 and then 2Q will be up, 3Q, 4Q, or just '14 will be higher than '13 in total?

[Alfred Lumsdaine:]

'14 will be meaningfully higher than '13. We do have some dynamics in terms to their seasonality to the business. There's new starts and that sort of things. So -- but '14 would -- certainly, our expectations are intact. It will be meaningfully higher than '13. And likely, at each quarter in '14, higher than the comp quarter in '13.

[Joshua R. Raskin:]

So 1Q not necessarily above 4Q of...

[Alfred Lumsdaine:]

Not necessarily in that same form of progression track, because of seasonality, the costs and revenues.

[Operator:]

So we'll take our next question from Brooks O'Neil with Dougherty & Company.

[Brooks G. O'Neil:]

I have a couple questions. So could you guys give us an update on you how you're doing relative to your expectations for earning performance-based fees. I think earlier in the year, it was a pretty aggressive expectation that you'd be earning meaningful amounts of performance-based fees this year. So help us get an update on where you stand on that.

[Ben R. Leedle:]

Sure. Well, in terms of performance-based fees, we're essentially on track to our expectations through the first 9 months. That's certainly not a driver in terms of the components of the guidance revision.

[Brooks G. O'Neil:]

Okay, good. And then I'm just curious, obviously, you did the financing in the third quarter and there are some imputed interest costs. I'm sure there was some fees included in your interest expense. Could you help us to -- just to understand how much was -- of your interest expense was cash interest expense incurred in the quarter versus imputed or fee-based charges?

[Alfred Lumsdaine:]

Sure. Well, in terms of -- there certainly were some costs. Some of the costs actually had to flow through our SG&A line, Brooks, and not interest expense as it related to the financing, and we had some fees for some of the cost of doing the convert. And that was actually one of the reasons that you will have noticed that our SG&A took -- ticked up in the quarter. In terms of the noncash component of our interest expense, I think it's about $0.5 million a month. You can think so for the quarter about -- since the deal was right at the start of the quarter, $1.5 million. I'm thinking you can actually see it on our cash flow statement.

[Brooks G. O'Neil:]

Okay, good. And just speaking of the statements, it looked to me like there was a pretty big jump in other long-term liabilities and pretty big drawdown in your accounts receivable. Can you just tell us what's going on in those 2 items?

[Alfred Lumsdaine:]

Sure. In terms of the other, that's actually related to the financing. We've got these hedges associated with the convertible bond deal. And they're mark to market, and they exist on both sides of the balance sheet. I think, in total, maybe $44 million at the end of the quarter. I think at issuance, that was about $35 million. But it's the embedded derivative that -- in terms of how you account for a convertible bond issuance that creates that dynamic on our balance sheet. And I'm sorry, Brooks, what's the second part of your question?

[Brooks G. O'Neil:]

I'm just curious, the AR was down quite a bit.

[Alfred Lumsdaine:]

Right, right. Yes, we -- we've had it real good, and it's one of the reasons that I hit on in my prepared remarks. We're on track even with the revised guidance for our cash flow from operations for the year. We've seen better-than-expected performance in our collections, frankly. It's been a real focus area for us, and I think we've got our DSOs down substantially under 50 days, which has historically been -- gosh, several years ago, we used to target 60 days, and I'm thinking we're operating in the mid-40s now. So we would expect, with focus, that can continue.

[Brooks G. O'Neil:]

Great. And then just -- I guess switching back to this broader issue of what's happening in the market, what is right now. I just -- those of us who have been around for more than a decade and we remember back in the '90s when there was a lot of noise about making capitation payments, and in fact, a lot of movement towards making capitation pavements. And I think most of it, if I remember, was a complete disaster from the perspective of hospitals and physician groups' ability to actually manage that risk. I think Ben said at the Stifel conference that only 4% of actual payments out there, at the time he must've made those comments, were value-based payments. Is the issue right now that the health plans just aren't paying the hospitals and the doctor groups on any kind of real performance-based fee schedules right now? And what is it that really gives you confidence that they're really going to move to that kind of a payment methodology in 2014?

[Ben R. Leedle:]

I think, first, what I would say is that there are some differences from the prior timeframe in the '90s that you talked about and now. Much of that -- obviously, the difference is technology that's able to be delivered inside of these models. And I do think, second time around, of similar notions that everybody learned from the last time. I do believe that the commercial payers, Medicare Advantage plans, who may have been doing this longer than the commercial plans, in the more recent timeframe will get the data connectivity and work the data flows and work the kinks out of all of this. I just believe it's one of those things that went fast, incredibly fast, at the contracting pace and now has to go slow in order to go fast again on the operating side of things. And what I mean by that is, these are processes and some deep change that have to get factored into this because there's humans involved. And you have a natural tension for all the different stakeholders in this equation to worry and be concerned about if I go too fast, what am I doing to my current day economic model versus being prepared for my future economic model. And that's a matter of mix. And I think what drives this is increasing mix of value-based payment, and we are seeing that happen and progress. It's just slower than I think what anybody would have expected, and part of that is just digestion of what people went and tapered over the last year and working through the front end of how to get this done. I would point to our relationship with Renaissance Health Network, Brooks. It's just outside of Philadelphia. And we engage in that relationship as a function of our M&A activity, acquiring Ascentia Health management, that had the basis of -- the first preliminary basis of a integrated Population Health Management platform and care coordination model. And they have had incredible success, not only in Medicare and, now, as the first pioneer ACO and one of the top-performing Medicare ACOs amongst many that have struggled. They have done very well. And they also have over 100,000 commercial lives, and they've built that up and their processes over the last decade. So when you find special parts of Population Health Management that's been going on in different forms at the physician integrated level for some time, their ability to ramp and take in and move fast is very different than the very first time that a group of physicians that used to be independent, but now sold their practices to health system, is going to move from 100% essentially fee-for-service over to these value-based model. That change, that work is going to come off differently than the one I described at Renaissance Health Network, and we see both the promise and the value that gets created when this model is able to be operationalized. And that's what gives us the full confidence that if you're going to address cost containment, improving healthy populations, you can't just stay in the state that we've all been in and expect a different result. You've got to create change. That change is hard for all parties involved. And so I do think this is a marketplace slowing down to get it right so that they can go fast, and then it will go fast again. We're not going to sit and predict where that re-acceleration inflection point is. We just are confident that it's out in front of us, and it's not 5 and 10 years away. It's nearer to us than that.

[Brooks G. O'Neil:]

That's great. Can you just say -- would you estimate that there's been any substantial movement from the 4% value-based payments that you estimated a couple -- a month or so ago, or is that still a reasonable guesstimate?

[Ben R. Leedle:]

Let me just type -- let me just make sure. These agreements are put in place and so statistics, statistics. If you look at all of the adjudicated payments, the data set that we had from our -- the research firm said roughly 4% or 5% of all adjudicated payments were done under a strict definition of value-based pay. If you broaden that to include modified fee-for-service, I can give you these statistics, Brooks, just as of today. The preponderance is still fee-for-service during the year and then reconciliations around different target metrics of cost and quality kind of at the end of the year. That if you took all the ACOs, and this won't add up to 100% because these ACOs have multiple contracts, but the analysis of 495 ACOs that are out there now, 57% of the commercial ACOs have up and -- upside and downside risk on top of a fee-for-service schedule. And the upside-downside risk is kind of calculated at the end of the year, either in a bonus only, so 40% of those are upside only. The rest have both up and downside risk. Some of these arrangements, Brooks, are for very narrow things. Somebody may put a bundle around a coronary artery bypass episode that links all the different costs into it and bundle those payment arrangements and afford those type of deals to be cut. So there'd be kind of a fixed fee around a broad episodic care component. And then only 23% have capitation arrangement, and there's, by far, more of that in the Medicare Advantage space, by far, that in the commercial. So we're still at the front end of how that mix is working itself through. And we think solving for the cultural change and the physician pushback in terms of getting these implemented, even when they're an owned and integrated part of organizations, that they'll change more rapidly to the degree that the risk models become more aggressive. And where they have been more aggressive, you'd -- you hear less about a reticent behavior physicians to change and go with the flow. They are flowing to where the money is and where they're rewarded for producing outcomes under that capitated arrangement. Those are the things that give us belief that this has all started. And while it seems small on the number that I gave you of 4% or 5% in the context of all types of payments, that inside these ACOs, there is -- their mechanisms truly are going to push, I think, the behavior set towards this Population Health Management model more and more as you go out in time.

[Operator:]

And we'll take our next question from Shawn Bevec with Deutsche Bank.

[Shawn Bevec:]

Are you guys generating revenues from all 6 current health system partners today? And is your health system segment profitable today, or do you need these increased lives that you've been talking about to achieve profitability there?

[Alfred Lumsdaine:]

No. it's yes to both questions. We are profitable, and we are generating revenue from all 6. It's clearly not at the levels in -- I would say, probably in all cases that we might have expected at the start of the year.

[Shawn Bevec:]

And when -- so what can you guys do from your point of view to try to accelerate adoption of these value-based payment models among the existing health system customers?

[Ben R. Leedle:]

We can certainly continue to produce the outcomes with our services. I think your -- the question is -- I would answer your question maybe a little bit differently than you might expect. We can configure our well-being improvement capability to address unique type of opportunities where there is clearer fee-for-service reimbursement today. And that for whosever paying for that fee-for-service reimbursement, there are near-term savings that create a significant return for paying for that service. And we highlighted the example of just how much the market responds to solutions that can be configured with that. Because what it -- what we think of it is for the buyer of our services like this is kind of no remorse strategy. They can take this service, put it in and aggressively drive it, knowing that it's going to -- as a health system produce revenue for them, as physicians produce revenue for them, even as health plans, during these months, produce revenue for them while it also create savings. Now you might be revenue as a health system on the front end, and over time, this same service is going to be the reason why you can manage lives under capitation. And the example that we showed and put a table in the press release was around the Dean Ornish program, which had very strong science improvement outcomes, over 36 years, to be able to address cardiovascular disease. It also has shown effective with type 2 diabetes, even early-stage prostate cancer, all of which, as you know, are high-cost, high-utilization factors that are going to be targeted in any of these kind of models. And here's a way that they can work with us to collaborate to deliver these program. Medicare, CMS pays for this and then -- and so it affords them a revenue and profit center for themselves with this initiative. We can share in that. And the commercial payers, who have agreed to reimburse with that program, accrue the savings that come from driving it. So everybody involved is looking for how do you get the people with the appropriate indications that can benefit from that program, how do you drive as many people into that program as possible. And those are the types of depths that I think are highly sought out in the marketplace today, and we're afforded the ability to deliver on, not just Ornish, but other models that have the same type of inherent characteristics that afford everybody to go faster in building and creating the infrastructure and competencies to manage risks over time.

[Shawn Bevec:]

Okay. And then just real quickly, turning to your EBITDA guidance for the remainder of this year. That 9% and 9.5%, if my math is correct, implies 9% to 11% EBITDA margin in 4Q. Given that revenue is expected to step up sequentially, why should we be seeing EBITDA margins step down in the fourth quarter?

[Alfred Lumsdaine:]

I think I mentioned in our -- in my prepared comments, we always have, in fourth quarter, start-up costs as it related to -- as it relates to January 1 implementations, and that always puts a little pressure as it compares to Q3. That's a very normal pattern for us.

[Operator:]

We have a follow-up question from Sean Wieland with Piper Jaffray.

[Sean W. Wieland:]

Can you talk a little bit about maybe your pipeline of population health deals assess how you see your competitiveness in that market, and specifically, who are you competing with? Have you lost any deals there?

[Ben R. Leedle:]

It's not in our key process, so it's harder for us to track what -- if something hasn't happened yet until we would see either an announcement or be told that we're not -- they're not interested or they disengage with us, that somehow we've lost an opportunity. We do know that the lists of challenges -- one of those challenges, that's identified and as I highlight to converting on the speed of these ACOs that has been brought out from people following it and doing the research, is the analytic tools for helping target and focus disproportionate resources where there's return opportunity on outcomes. And so we do see an increasing frequency of companies like Avalon in the marketplace, Sean, that are responding and using their relationships to, for themselves, business development opportunities. I think there is also -- and you probably see in some of the same press releases we do, the big platform technology platform companies in this space, the Epic, the Cerner, McKesson, are all looking to wrap population health services around their positions around the data and the technology. That's a growing source of alternative form of competition. I wouldn't say that they do what we do, but as competition in the sense that they may be an alternative option or a pathway for someone to go down. In terms of straight-up competition for us, particularly with physician, enterprises and integrated health systems, are the big large national NCOs, United, Aetna, Cigna. And there's a subset of Optum, Active Health continue not just on the large self-insured employer front, which we've been pretty clear over time who we're competing with there as well, but these also for -- vying for the opportunity to be the trusted partner that helps support these health systems as they navigate through this deep market transition.

[Operator:]

And we have follow-up question from Tom Carroll with Stifel, Nicholas.

[Thomas A. Carroll:]

Yes. Just one -- sorry, I'm just looking at my notes here. Remind me again of the kind of 2 to 3 contracts you mentioned that you didn't get done, certainly for this call or for the remainder of the year, that are perhaps haircutting your revenue view a bit more than what we expected? What was that again? Would you mind us going over that one more time?

[Ben R. Leedle:]

Yes. I talked about 2 very large, current customers who, intensely, over the past 60 days or so, we have been exploring and developing different business structures for well-being improvement sort of this expansion with them. And my comments were -- that until very recently, we had direct line of sight to expected fourth quarter contribution from one of those customers with an expansion, that would've made up the difference in the earnings shortfall and in our guidance reduction. And I commented that we did learn in the last few days, that's how recent this is, that the initial stage of that expansion opportunity might take -- may take a different form on the front end that would limit its contribution in '13, but still remain a very large business development that affords significant expansion in phases with our execution out in '14 and beyond. And we commented that because that one and the other one are still in deep negotiations and we haven't secured either one, we thought we would -- as I mentioned, secure one of them this month, that we've just taken their potential impact on 2013 out, and that was the information that we had shared.

[Thomas A. Carroll:]

So you -- I mean, are you being conservative in taking them out, or these -- is this something that could come back this year?

[Ben R. Leedle:]

There's a potential that either one of those could hit in the year. And as my comments said, we expect to sign at least one of these during the fourth quarter. The time in the fourth quarter and the final form of that structure would create maybe a small possibility for contribution. But the way that we've approached this is, if it does, then okay, that's nice. We're not trying to set definitive expectations with you in that '13 guidance that we put out today, that somehow we're counting on those things to be able to deliver on the economics we've shared.

[Thomas A. Carroll:]

So are these health plan customers?

[Ben R. Leedle:]

I'm really not at liberty to say. I can tell you that these are 2 very different industry category players.

[Thomas A. Carroll:]

So in terms of just order of magnitude of redoing the -- or whatever process you're going through now, I mean, is the potential that perhaps the contribution from these gets cut in half, or is this something where you're just kind of working through final contract details and you expect the size of the contracts to stay roughly the same, but that they don't contribute this year and carry into next?

[Ben R. Leedle:]

It's the latter description. We're going through the details and, obviously, upon success of that, would announce it in the fourth quarter, but would likely have smaller and minimal impact in the fourth quarter but hold and retain a very large economic potential for our company in '14 and beyond.

[Operator:]

And Mr. Leedle, that is our final question today. I'll turn the call back over to you for any closing remarks.

[Ben R. Leedle:]

Thanks, everybody, for being on the call. I appreciate your questions and comments. Alfred and I and Chip Wochomurka are here. We would love to be able to take any further questions or calls while we're available this evening and look forward to talking with you.

[Operator:]

And ladies and gentlemen, this does conclude today's conference. We appreciate your participation.