Virtual Radiologic Corporation Q2 2008 Earnings Call Transcript

Virtual Radiologic Corporation (VRAD)

Q2 2008 Earnings Call

October 27, 2008 4:30 am ET

Executives

Mollie O'Brien - Director of IR and PR

Sean Casey - Founder and CEO

Rob Kill - President and COO

Len Purkis - CFO

Analysts

Brooks O'Neil - Dougherty & Company

Colleen Lang - Merrill Lynch

Kristina Blaschek - William Blair

Shelley Gnall - Goldman Sachs

Presentation

Operator

Good day and welcome to the Virtual Radiologic's third quarter 2008 earnings conference call. (Operator Instructions).

At this time, I would like to turn the conference over to your host, Ms. Mollie O'Brien, Director of Investor Relations. Please go ahead, ma'am.

Mollie O'Brien

Thank you.

Before we begin, I'd like to let everyone know that during today's conference call, we'll be making certain forward-looking statements about management's expectations that are not limited to historical facts. These forward-looking statements are based upon current beliefs, assumptions and expectations regarding future events, and involve risks and uncertainties that could cause actual results to differ materially. For examples of such risks and uncertainties, please see our annual report on Form 10-K as well as our other filings with the Securities and Exchange Commission. Any forward-looking statements speak only of today and we do not intend to update forward-looking statements to reflect facts, assumptions, circumstances or events which have changed after the statements were made.

We will also be discussing some non-GAAP financial information on today's call, such as adjusted net income and adjusted EBITDA. For a reconciliation of each non-GAAP measure we discuss today to its most comparable GAAP measure, please visit the Investor Relations portion of our website, ir.virtualrad.com, and click on Events and Presentations.

And with that, I'd like to turn the call over to Sean Casey, Co-Founder and Chief Executive Officer of Virtual Radiologic.

Sean Casey

Good afternoon, everyone. Today, we'd like to discuss our third quarter 2008 financial results and provide some market commentary. We'll then open up the call to your questions.

Joining me on today's call are Rob Kill, Virtual Radiologic's President and Chief Operating Officer; and Len Purkis, our Chief Financial Officer. We also have our Chief Technology Officer, Rick Jennings, on hand for Q&A.

We delivered strong quarterly financial results in a competitive market and an uncertain economic environment. During the third quarter, we generated record revenue of $29 million, up 21% from the third quarter of 2007 and saw a 27% gain in total volume.

In the first nine months of 2008, our radiologists interpreted more than 1.6 million studies, keeping us on track to read in excess of 2 million studies in fiscal year 2008.

Adjusted EBITDA margin was a healthy 22.5%, consistent with the same period last year.

In today's turbulent times, we are fortunate as a company to have no direct exposure to credit markets. We are self-financing and our balance sheet is strong with $35 million in cash and short-term investments and no debt.

During the quarter, while we delivered strong growth, our volumes were not as high as previously forecasted, particularly in September. This was the result of a reduction in procedure counts at our customer facilities, which impacted the number of studies they sent to us.

Recent industry surveys suggest hospital admissions fell to a six-year low in August, and more specifically, emergency department visits, which are a significant source of our imaging volume, were down 5% in September.

Furthermore, weak economic conditions, in general, have led consumers to delay or forego certain medical procedures, which again means decreased utilization. We do not believe the drop in customer procedure counts in September represents a long-term trend in our business, but is rather more of a reaction to the current economic environment.

Interestingly, as more people delay needed medical care, including some preventative services, medical conditions could become worse and lead to rising emergency room admissions down the road. We do believe procedure counts will return to historical levels, although in this economic environment, it is difficult to predict with certainty when.

We also believe supply/demand in balance of radiologists will only continue to worsen overtime, which in turn creates continued demand for our services. So as we look forward, we remain confident in the fundamentals supporting the growth of our core business.

We also have new opportunities to ensure growth in the long-term. One of those opportunities is our software as a service business. We have signed three customers to-date, all of whom will go live by the end of the year.

Last quarter we announced an agreement with the Department of Radiology of Massachusetts General Hospital. Today, we are very pleased to announce that we have signed a contract with the Mayo Clinic for a pilot project that has the potential to expand to a system-wide opportunity.

Although the software as a service model is well-established in other industries, it is a relatively new concept within healthcare, especially radiology. These marquee key clients provide a very encouraging foundation for building this part of our business over the next three to five years.

Furthermore, if the capital market crisis continues, we believe this subscription-based model may be increasingly appealing when compared to traditional software models that often involve heavy upfront capital costs.

In summary, we had strong growth in the third quarter. In fact, we have had year-over-year growth every quarter since inception. We are confident that the fundamentals underlying the teleradiology market remain strong and believe that with our US-based distributed operating model and management discipline, we are in a position of strength to profitably expand our business as we look into 2009 and beyond.

I'd now like to turn the call over to Rob Kill, our President and Chief Operating Officer.

Rob Kill

Thanks, Sean. I'd like to start by addressing the trends we're seeing in customer counts, volume and pricing. Since the third quarter of 2007, we've added 144 net new customers and 191 net new facilities, finishing the third quarter of 2008 with 601 customers serving 978 medical facilities or 15% of US hospitals.

Our customer retention rate measured from June 30, 2008 to September 30, 2008 remained exceptionally high at 97%.

During the third quarter, total study volume increased 27% over the third quarter of 2007, and on a sequential basis, total volume increased 12% when compared to the second quarter of 2008.

Year-over-year same-site volume growth was 1%. If you exclude the impact of the two large customers who in-sourced the portion of their final studies, as discussed on last quarter's call, same-site volume growth was 4.1%.

Preliminary read volume increased by 28% over prior year and final read volume increased by 22%. On a sequential basis, our finals volume was up 17%, representing the strongest sequential growth in the last five quarters.

During the third quarter, we had 185 facilities sending us finals compared to 130 during the same period last year. More importantly, almost 50% of the revenue generated from new clients (inaudible) so far in 2008 comes from final studies.

Clearly, we continue to successfully penetrate and grow our finals business. We believe the finals market represents the largest growth opportunity for our business as we move forward, and we remain very pleased with our continued progress here.

Let's move on to pricing next. Our average study price declined 5% when compared to the third quarter of 2007. However, as expected, we did see a deceleration in the pricing decline trends in the third quarter in comparison to the first six months of 2008 as the average study price remained stable sequentially.

The average study price in the third quarter was $47.85, which compares to $47.88 in the second quarter of this year. This was a result of the strong growth in finals discussed just a moment ago, especially in the CT modality.

As a reminder, we received an approximate 30% pricing premium from our customers for CT final studies when compared to CT prelim studies, as they require more time and a more detailed report from our radiologist. We still expect full year price declines to be within the 5% to 7% range we previously provided.

At the end of the third quarter, we had 147 radiologists under contract, with 134 of those actively reading.

As a reminder, in teleradiology once a radiologist is hired, it typically takes six to nine months to license and credential them before they actually begin reading for us. This is because a teleradiologist needs to be licensed in approximately 15 states and credentialed at an average of 125 facilities.

This is much different than a traditional private practice radiologist, who typically works in only one state and at a relatively few number of local facilities, and will begin reading shortly after their hire date.

Because of this six to nine month timeframe, we made hiring decisions in the first quarter of this year based on our demand forecast at that time.

The drop in procedure counts at our customer facilities in September has led to a temporary situation in which our radiologist capacity exceeds our customer demand. As a result, we will incur higher than expected diagnostic compensation costs as a percent of revenue for the remainder of the year.

We are adjusting our business to adapt to current market conditions. Going forward, we're taking actions to align radiologist staffing levels and SG&A costs with our revised growth expectations. We have adjusted our radiologist hiring plans accordingly, and we have taken a new volume forecast into account when establishing start dates for already contracted radiologists.

As a result of our cost management efforts, we are expecting a reduction in SG&A as a percentage of revenue during the fourth quarter over the comparable prior year period.

Most importantly, with our exceptionally high customer retention rates, the best way to correct the short-term imbalance is to win new customers. We are very excited about the sales results achieved in the third quarter. We measure our sales results in terms of daily studies that will be sent to us by a client once they begin transmitting studies to be read by our radiologists.

In terms of new studies signed, June, July, August and September were the four best individual months ever in the history of the company. These are now studies in our backlog that will go live during the fourth quarter of 2008 and first quarter of 2009.

It can take anywhere from 90 to 120 days for a client to go live once they sign with us as we need to set up the IT connections with the hospital and our radiologists need to be credentialed at those same facilities in order for us to read those studies.

As these studies go live, they will take up the excess radiologist capacity, and we will return to lower diagnostic compensation costs as a percent of revenue.

I'd like to conclude by saying that we have a very healthy business with high customer retention rates, record commitments from new customers and continued double-digit growth in volumes and revenue. I am confident that we will align our radiologist capacity and our cost structure with current expected volume levels to deliver future growth and profitability.

Even though we are in the midst of uncertain economic times, the bottomline is that overall imaging demand is growing at a significantly faster rate than the supply of radiologists. And as the leader in quality of patient care and service excellence in the teleradiology industry, we expect continued strong growth going forward.

I'd now like to turn the call over to our Chief Financial Officer, Len Purkis, who will go through the results in more detail.

Len Purkis

Thanks, Rob. Revenue at $29 million is up 21% on the third quarter of '07 and up 12% sequentially. For the nine months to September 30, '08, revenue totaled $78.3 million, up 24% on the same period in 2007.

Professional services, excluding stock-based compensation of $13.3 million, is up 22% on third quarter '07 and up 11% on the second quarter of '08. There are 134 reading radiologists, up from 106 same period last year and up from 124 last quarter.

SG&A, excluding stock-based compensation at $9.2 million, is up 22% from third quarter '07 and up 3% from second quarter of '08. As a percentage of revenue, third quarter '08 is at 31.6%, flat with third quarter of '07 and down from 34.4% in the second quarter of '08.

The resulting adjusted EBITDA for the third quarter of '08 is $6.5 million, which is up 16% on same quarter last year and up 30% on second quarter of '08, and represents 22.5% of revenue.

We did receive the benefit of a research and development tax credit in the third quarter of '08, which lowered our effective tax rate from 43% to 34%. The credit relates to the tax year 2007 and was filed with our 2008 tax return in September.

We continue to generate cash from reinvestments into the growth of the business. In the third quarter of '08, we had cash inflows of $3.5 million and generated an additional $1.9 million from auction exercise tax benefits.

We had capital expenditures of $1.1 million and purchase shares in the amount of $1.9 million. The net result was an increase in cash and short-term investments of $2.4 million.

At the end of the third quarter of '08, we had cash and short-term investments of $34.8 million and we have no debt.

Since the end of the third quarter of '08, we have successfully completed the $8 million share repurchase program announced earlier this year. In total, we purchased 944,760 shares at an average price of $8.44 per share.

The shares repurchased in the third quarter of '08 did not impact the adjusted EPS calculation and the full quarter impact on the fourth quarter '08 EPS is probably going to round to less than $0.01.

We have now formed a captive insurance company we announced on September the 29th of '08. Established as a wholly-owned subsidiary, the captive provides a way for us to have more predictability with regards to our medical malpractice claims. In a competitive market, this is an advantage that comes with scale and is a financial effort opportunity smaller companies don't have.

Since 2006, we have almost doubled our reading radiologists and have seen volumes grow from 1 million reads in 2006 to over 2 million in 2008. Because of our growth and the fact that we have enough loss history now to enable an actuarial assessment of our future liabilities, we will be recording a loss reserve based on that actuarial assessment.

We decided to form a captive because, firstly, it provides more control over our loss experience and normality to our P&L charges, secondly, the potential for accelerated tax benefits, and thirdly, it ensures the availability of medical malpractice coverage over the long-term.

To establish the appropriate level of initial funding, the charge to the fourth quarter '08 results will be $1.5 million to $1.7 million or $0.05 to $0.06 EPS. This is less than the original estimated range of $2.7 million to $3 million and is a result of further review by all parties involved in establishing the actuarial reserves and the accounting treatment for them.

To be clear, we are not entering the insurance business. We are maintaining a medical malpractice insurance policy with our present insurance company, which means that any settlement amount above our retention, which is similar to a deductible, will be paid by the insurance company.

The establishment of the captive was a sound business and financial decision we made for the long-term health of the company.

There are no changes to the updated guidance we provided September the 29th, which was revenue of $102 million to $104 million, adjusted EBITDA of $17.5 million to $19.2 million and adjusted EPS of $0.46 to $0.52. To establish the appropriate level of initial funding for the captive insurance company, we expect the adjusted EPS of $0.46 to $0.52 to be reduced by $0.05 to $0.06.

With that, operator, I'll open up the line to questions.

Question-and-Answer Session

Operator

(Operator Instructions). And we'll take our first question from Brooks O'Neil with Dougherty & Company.

Brooks O'Neil - Dougherty & Company

Good afternoon. I have a couple of questions. In light of the very strong third quarter results, I'm curious if you could give us any update on what may or may not have changed relative to your perspective when you provided the pre-release, towards the end of September?

Specifically, it sounds like things deteriorated in September. Can you help us with any update for October about how the trends might have continued?

Rob Kill

Hi, Brooks, it's Rob.

Brooks O'Neil - Dougherty & Company

Hi, Rob.

Rob Kill

How are you?

Brooks O'Neil - Dougherty & Company

Fine. Thank you.

Rob Kill

Good. You are right. July and August for us were as forecast. In September, while we still saw growth of 25% in volumes over prior year, we did see a decline in those volume levels versus our expectations. And there is no doubt that the current economic situation impacted procedure counts at some of our customer facilities.

We don't see this drop in procedure counts as a long-term trend. At the same time, I don't think any of us can predict with any kind of certainty when these trends might change. And we've taken, what I would call a prudently cautious view based on what we saw in September, we're comfortable with our full year guidance based on what we're seeing in October.

Brooks O'Neil - Dougherty & Company

Obviously, we analysts probably got the progression wrong. But we're looking at a pretty soft fourth quarter if you're going to hit the guidance you've provided before?

Len Purkis

Yes. We were prudently conservative again. We're in October, we don't see what happened in September continuing at the same rate. So when we put the annual guidance together, we stated at the 102 and 104 level we were prudently cautious.

Brooks O'Neil - Dougherty & Company

Can you give us a quick sense of what the short-term investment is on the balance sheet?

Len Purkis

It is $7 million that we have in CDs. About 90% of our cash is either in CDs or in money market funds and we have 10% just for regular operating cash.

Brooks O'Neil - Dougherty & Company

One more question. About same-site growth of 1%, can you give us any feel for sort of how that trended through the quarter and what you've seen in October on that statistic?

Rob Kill

Brooks, this is Rob. Obviously, we saw the more significant impact in September. Obviously, if you exclude the impact of those two large clients, it was over 4%. As I said before, in terms of guidance for the rest of the year, we expect we'll be able to achieve that guidance and that assumes some mid single digits growth rates in same-site volume for the full year.

Brooks O'Neil - Dougherty & Company

Okay. Thank you very much.

Rob Kill

Sure.

Operator

And we'll move on to our next question from Tom Gallucci with Merrill Lynch.

Colleen Lang - Merrill Lynch

Colleen Lang on for Tom. Is the tax rate supposed to be the normal 43% next quarter?

Len Purkis

It's probably going to go down to 40% in the fourth quarter. The tax credit that we got for 2007 did get rolled over into 2008 by Congress. But the amount, because it's a rolling average, is going to be much less of an impact. So fourth quarter we're looking at 40% tax rate.

Colleen Lang - Merrill Lynch

Okay. Can you give us an update on use of cash? Since you completed the buyback, would you want to do another program or is M&A activity in the future for you guys?

Len Purkis

Well, right now we're feeling pretty good that we have a healthy balance sheet with $35 million worth of cash. We feel that we are self-financing in a quarter after spending the $1.9 million on the share repurchase. But with no debt and a healthy balance sheet and $35 million in cash in this economic environment, we think that's the right place to be right now.

Colleen Lang - Merrill Lynch

Going to software as a service, what percentage revenues do you think this will be in three to five years, like, how do you see this growing?

Sean Casey

This is Sean. It is such a new business line that it is difficult to give an exact forecast to that. We believe it will be meaningful in three to five years and that would be double-digit percentages of revenue and perhaps an even higher percentage of our EBITDA.

So we are making very good progress on this, but it's going to take awhile for it to be material.

Colleen Lang - Merrill Lynch

Do you have cash flow for the quarter, cash flow from operations?

Len Purkis

Yes, it was in the script. We had cash inflows of $3.5 million.

Colleen Lang - Merrill Lynch

Okay.

Len Purkis

We had another $1.9 million from option exercise tax benefits and we had CapEx of $1.1 million and purchase shares of $1.9 million. So net result was an increase in cash of $2.4 million.

Colleen Lang - Merrill Lynch

Okay, great. Thank you.

Sean Casey

Thank you.

Operator

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

Kristina Blaschek - William Blair

Good afternoon. It's Kristina Blaschek for Ryan today. Going back to same-store growth, can you give us a little bit more detail on same-store revenue growth or price compression?

Rob Kill

Hi, Kristina, it's Rob. In terms of price compression, I think on a year-over-year basis the decline was 5%, of that approximately 20% of it is related to mix. So the true price decline is somewhere around 4%.

Kristina Blaschek - William Blair

Okay.

Rob Kill

Sequentially though, it was flat to prior quarter as we were able to increase our growth in the finals business.

Kristina Blaschek - William Blair

Great, thanks. Since we're on pricing, given the challenging economic times right now, are you seeing more of your competitors compete on price right now? Going forward, you'd indicated annual price declines still between the 5% and 7% decrease, do you see that more of a true pricing pressure or more a mix shift?

Rob Kill

Well, certainly we are in a competitive market, but we haven't seen any indications of what I might term increased irrationality on the part of competitors.

Kristina Blaschek - William Blair

Sure.

Rob Kill

We do continue to exercise pricing discipline. And in many cases we receive a premium price for our services just due to our reputation in the marketplace and as well as our ability to provide subspecialty expertise that many of our smaller competitors can't provide.

We're seeing greater demand for final interpretations and they tend to be less price sensitive and many of our competitors can't provide finals like we can too because of some of the unique requirements, especially around billing with CMS.

As for pricing assumptions, we expect the full year average decline to be in the 5% to 7% range and we'll provide a bit more guidance in the Q4 earnings call for 2009.

Kristina Blaschek - William Blair

Okay. A last question on the Diagna acquisition. I know you mentioned before on previous quarters that you had the opportunity for upselling. Previously, Diagna had indicated that they couldn't do final or specialty reads. Are those radiologists able to provide those services now or is that still going to be an opportunity for later quarters?

Rob Kill

It's still an opportunity for us and our radiologists can provide it. We've converted three clients to-date, one of them being one of the largest Diagna clients. In addition, we are actively working on some other conversions to finals.

Kristina Blaschek - William Blair

Great. Thank you.

Sean Casey

You're welcome.

Operator

And we'll move on to our next question from Shelley Gnall with Goldman Sachs.

Shelley Gnall - Goldman Sachs

Hi, thanks. A question on the implied guidance for the fourth quarter. If I understand correctly, for the first three quarters of the year, it looks like you've brought in revenues of about $78.3 million. If I take that guidance range of $102 million to $104 million, that looks like we're getting between 23.7 to 25.7 implied revenues for the fourth quarter. So what that looks like it implies is 3% to 12% revenue growth in the fourth quarter.

So can you talk about what assumptions are included in that growth rate? We've talked about the 1 percent same-site growth. We've talked about 5% to 7% pricing declines. Can you talk about new business wins and retention rates assumed in that guidance range?

Len Purkis

Well, let me take it first, Shelley. We've been very conservative about putting out the 102 to the 104. What we've built into that is price declines in the fourth quarter that would get you to be 5% to 7% still retained on an annualized rate.

But we also have the traditional fourth quarter drop off in volumes, which have happened every year. That drop-off in volume that we've assumed there could be anywhere from 8% to 15% so we've been pretty cautious in taking a look at what happened in September, seeing the trend in October, which is more positive, but being very cautious about what could still happen during October.

Rob Kill

Shelley, it's Rob. You asked about new customers or new business. We don't need to sign any new contracts to meet the guidance. In fact, most deals that get signed now going forward will likely go live in the first quarter of 2009. We do need to bring live a percentage of the studies from the backlog that already exist, but achieving our new business forecast won't be an issue because we have a very healthy backlog.

Shelley Gnall - Goldman Sachs

Rob, you had mentioned that retention so far is 97%. Is a continuation of this similar retention rate assumed in the fourth quarter?

Rob Kill

It is.

Shelley Gnall - Goldman Sachs

I should say for full year because you didn't give fourth quarter.

Rob Kill

There will be continuing high customer retention rates.

Shelley Gnall - Goldman Sachs

Does that 97% take into account the business that was taken in-house by those two customers last quarter? How do we view that relative to the 97%?

Rob Kill

Great question, Shelley. That actually shows up in the same-site volume growth because both those customers still remain customers, send us final studies today, but it impacts the same-site volume growth. So they are retained customers, but with lesser volume.

Shelley Gnall - Goldman Sachs

Was that a volume retention rate that you've given us, the 97%, or truly a customer retention rate?

Rob Kill

It's both. Customer retention rate is 97%. Volume retention rate would also be 97%.

Shelley Gnall - Goldman Sachs

Okay, alright. I appreciate that. Now, a question on another comment you made, Rob. I don't know if I caught this. Was SG&A going to be down either sequentially or year-over-year into the fourth quarter, or at least were the expectations down if trend continued. I'm assuming that that would be before the charge for the captive insurance product?

Rob Kill

Yes.

Shelley Gnall - Goldman Sachs

Okay. And was that sequentially or year-over-year, your expectation?

Rob Kill

Year-over-year.

Shelley Gnall - Goldman Sachs

One broader question. As we think about one of your competitors, EMS, MCare has recently made an acquisition of a tele-radiology provider. Sean, I was wondering if you could comment on how that changes the competitive landscape if at all?

Sean Casey

Sure. I was just corrected that EMS historically has not been our competitor. So yes, Templeton Radiology, the acquired entity, has been a competitor of ours in the past. But, quite frankly, we really haven't seen them in competitive situations all that often. They have a different business model from ours as far as we can tell. And back several years ago, we encountered them as perhaps our third most prominent competitor. But we haven't seen too much of them in competitive situations in the past several years. So we will watch it, but we don't anticipate a major change in the competitive dynamic.

Shelley Gnall - Goldman Sachs

Okay. Appreciate it. Thanks very much.

Sean Casey

Thanks.

Operator

This concludes today's Virtual Radiologic conference call. Thank you for joining and have a wonderful day.

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