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MedAssets, Inc. (NASDAQ:MDAS)

Q3 2008 Earnings Call

November 13, 2008 5:00 pm ET

Executives

Robert Borchert – Vice President of Investor Relations.

John Bardis – Chief Executive Officer

Neil Hunn – Chief Financial Officer

Analysts

Corey Tobin - William Blair

Richard Close – Jefferies & Company

Larry Marsh – Barclays Capital

David Veal – Morgan Stanley

Ross Muken – Deutsche Bank

Charles Rhyee – Oppenheimer

Eric Coldwell – Robert W. Baird

Sean Weiland – Piper Jaffray

Sandy Draper – Raymond James

Operator

Good afternoon. My name is Rachel, and I will be your conference operator today. At this time, I would like to welcome everyone to the MedAssets third quarter 2008 financial results conference call. (Operator Instructions). I would now like to introduce Mr. Robert Borchert, Vice President of Investor Relations.

Robert Borchert

Good afternoon and welcome to the MedAssets conference call to discuss our financial and operating results for the third quarter ended September 30, 2008. With me today are John Bardis, our Chairman, President, and CEO, and Neil Hunn, our Chief Financial Officer. Before we begin, I would like to remind everyone that this conference call will contain forward-looking statements regarding our company’s expected financial and operating performance for 2008 and 2009. The forward-looking statements may be affected by important risk factors that are described in MedAssets filing with Securities Exchange Commission and our earnings press release issued today. Therefore, actual results may differ materially from our forward-looking statements discussed today or in the future. MedAssets assumes no obligation to publicly update any forward-looking statements whether as a result of new information, future events, or otherwise. To the extent that any non-GAAP financial measure is discussed in today’s call, you can find a reconciliation of that measure to the most directly comparable GAAP financial measure in today’s earnings release, which is now posted in the Investor Relations section of our corporate website www.medassests.com. Now, I would like to turn the call over to our CEO, John Bardis.

John Bardis

Thank you, Robert, and good afternoon everyone. It is our pleasure to be speaking with you today about our third quarter results, the market environment, our recent customer successes, the continued strength of our core businesses as well as the integration of the Accuro acquisition. Since our last call, we’ve had a significant number of successes, better than expected third quarter financial results, several large customer wins, and the introduction of three significant solutions.

We posted third quarter net revenue of $76 million, adjusted EBITDA of $25.2 million, and adjusted EPS of $0.15 per share. Specifically, our total net revenue grew 54% over the third quarter of last year and 24% on a sequential basis. Our adjusted EBITDA was up 68% year over year and 32% sequentially. These results were bolstered by excellent execution and organic growth as well as the benefit of our recent acquisitions. In a few minutes, Neil will walk us through the details of our financial and operating performance and will update you on the 2008 financial guidance and outlook for 2009.

Right now, I’d like to take a moment to discuss how I believe the current financial market and economic challenges could affect our customers and our business. Then I will highlight a number of recent successes that underscore why we are confident that MedAssets can continue to deliver solid growth and success in the quarters and years to come.

First of all, healthcare providers and hospitals in particular continue to deal with intense financial pressures. Over the last few months, a number of significant issues have arisen to create even greater cash flow challenges and bad debt risk for these healthcare providers. The disruption in the financial markets has translated into cost of capital and liquidity issues for hospitals. The macroeconomic environment is also forcing higher unemployment rates and adding to the rolls of the uninsured, which will almost certainly lead to lower levels of reimbursement and a greater percentage of uncompensated care.

In addition, aggressive supply cost growth increases forced by rising raw material costs and food production and the manufacture of medical products are symptomatic of a classic stagflation environment in which we are seeing hospitals net revenues increase at a slower rate than supply growth. The federal government’s expected broad rollout of RAC audits will also serve to exacerbate the fundamental financial challenges our hospitals and healthcare provider customer base has, and we believe they will continue to face increasing pressure at this level well into the future.

Importantly, these are the very issues we help to address and solve for our customers. This capital constraint environment is driving customers to MedAssets because the breadth and depth of our technology and services can alleviate these costs and reimbursement pressure and substantially improve the revenue integrity and cash flow in a manner of months. In fact, largely due to our focused cash-based return on investment value proposition, we actually have been experiencing a moderate increase in demand for our solutions. We have specifically built our business to deliver high return on investment solutions that can be funded directly from our customers’ current operating budgets. The vast majority of our technology and service capabilities avoid having to sell in to the headwind of a capital budget, and we are continuing to see acceleration and the number of potential opportunities to sign large transformational deals to help our provider customers close the financial gap between revenue and cost.

Switching gears, we have had a number of important product and service launches over the last month or so as we continue to focus on improving and expanding our suite of solutions. On the frontline of government reimbursement, hospitals are facing RAC audits which are the Medicare recovery audit contractor programs that identify overpayments to hospitals and have the potential to negatively impact their bottom lines.

The RAC program is one of a number of initiatives launched by the center for Medicare and Medicaid Services to identify and recover overpayments to healthcare providers. In mid October, we introduced our Medicare RAC solution that leverages our expertise and medical necessity documentation, clinical appeals recovery, and Medicare reimbursement management to help hospitals address RAC audits. Our comprehensive solution is comprised of three elements to assist providers with the entire RAC audit process.

First is our workflow tool to manage RAC audit timeliness and activities, automate deadline notifications, track activity and audit historical claims to identify vulnerabilities. Second is our consulting service to assess reimbursement risks and third is our RAC appeal in recovery services which help mange and appeal RAC audits and defend the proprietary payments.

With the onset of RAC audits and other CMS initiatives, we expect this to be a large and long-term opportunity. In late October, we announced the release of our newest Alliance decision support solution. Alliance 4.1 combines budgeting, cost accounting, and contract management data to help healthcare providers compare and track utilization patterns and performance indicators against budgets and other established metrics to identify opportunities for sustained margin improvement. We are very excited about the introduction of this highly competitive, intuitive, and adaptable web-based solution for enterprise-wide visibility.

In our spend management segment, we are launching a GPO services program specifically designed to help standalone hospitals and surgery centers fight rising supply chain costs. Our next generation Select program will provide hospitals with lower prices for those supply categories that consume most of their commodity supply expense budget. Select program customers will agree to use MedAssets as their primary group purchasing organization for med search, pharmacy, laboratory, and distribution, and they will commit to purchase a minimum volume share from each contracted supplier. This benefits both the contracted suppliers who will gain market share and the hospitals and surgery centers who on average could save up to 18% on commodity supply expenses.

Moving now on to the integration update. We continue to successfully execute our plan to integrate our Accuro acquisition into MedAssets. On October 1st, we completed the integration of our revenue cycle sales force with regard to our organizational structure, sales territories, and compensation plans, a full three months ahead of schedule. Given this early completion, our sales teams are now 100% focused on winning new business. The integration of all our cooperate administrative, finance, and accounting functions are on track to be completed by year-end. As we previously discussed, the integration of the products and business operations will take several quarters, but is well underway and right on track. We will continue to provide updates on this portion of the integration over the coming quarters.

As it relates to sales and cross selling strategy, we had a number of recent customer wins, renewals, and expansions of service offerings across our business segments that highlight our recent success. During the third quarter, we signed a 5-year GPO agreement with West Tennessee Healthcare, a system with 6 facilities serving communities in 18 counties. As part of this partnership, supply cost savings through our portfolio of 1300 group purchasing contracts is being further enhanced with the implementation of our spend management analytical software tools as well as our medical device cost reduction service. We also extended our longstanding group purchasing relationship with Hawaii Pacific Health through 2014 and added a number of key spend management analytical solutions to drive additional cost savings for this key client.

Within our revenue cycle management segment, we see both increased size and quality of our sales funnel and have signed a number of new product relationships and larger transformational service deals in the past few months. For example, we recently entered into a 3-year transformational revenue cycle agreement with Mountainside Hospital, a 365-bed facility in Montclair, New Jersey, and part of the Merit Health System. Mountainside was already MedAssets’ GPO customer and is now implementing a full spectrum of revenue cycle technology solutions and consulting services which include our patient access management solutions to help manage patient registration and financing through the preadmission and admission processes, our charge integrity solutions to establish protocols for compliant charging and defensible competitive pricing, and our accounts receivable services to improve net cash collections and help meet Mountainside’s fiscal goals to better serve their community.

During the quarter, we also expanded our revenue cycle relationships with a leading provider of long-term and rehabilitation services, Kindred Healthcare, to help them improve their revenue integrity and overall claims processes. Ultimately, the incremental revenue in cash flow and improved efficiencies gained from our engagement can help Kindred reinvest in its facilities, new technology, and existing care programs. These strategic agreements all focus on delivering measurable and sustainable financial improvement to our customers which is the cornerstone of the MedAssets mission.

Our success at delivering a measurable financial return on investment to hospitals in months, not years combined with our high rate of customer attention and robust sales pipeline are key reasons why we remain extremely bullish in our short and longer-term outlook, notwithstanding the broader economic issues facing our country and our industry today. With that, I’d like to turn the call over to Neil Hunn, our Chief Financial Officer.

Neil Hunn

Thank you, John, and good afternoon everyone. As John noted earlier, MedAssets again delivered very solid results in the third quarter that exceeded Wall Street consensus expectation. This afternoon, I will briefly discuss our third quarter financial results, reaffirm and narrow our 2008 guidance, and introduce our financial guidance for 2009. Please bear in mind that any reference to pro forma financial results are made in order to provide a better apple-to-apple comparison and assumes our XactMed and MD-X acquisitions were completed on January 1, 2007, and Accuro as part of our operations at the beginning of 2007 and 2008.

On a segment basis, our revenue cycle management businesses generated net revenue of $45.8 million on a GAAP basis, up almost 88% from the third quarter of 2007. Third quarter 2008 net revenue in our RCM segment increased 11.8% when compared to pro forma revenue of $41 million in the third quarter of 2007. When compared to the third quarter 2007, our RCM segment growth was driven by an increase in recurring subscription and service fee revenue partially offset by a year over year decrease in decision support software revenue. Of particular note, we started to recognize revenue on our largest decision support software project with the Ontario Ministry of Health. This revenue will be recognized through the first quarter of 2010.

Adjusted EBITDA in our RCM segment for the third quarter was $14 million or a 30.6% margin versus adjusted EBIDA of $6.1 million or a 25.2% margin in the third quarter a year ago. This quarter over quarter increase in our third quarter adjusted EBITDA margin in the RCM segment was driven by an increased acceptance of our subscription fee and service offerings, revenue growth from certain customer implementations, the Canadian decision support revenue I mentioned earlier, and the impact of RCM acquisitions.

Our spend management segment reported net revenue of $30.2 million, a 21.3% increase over the third quarter 2007 as we continue to experience solid GPO growth and the strength in our supply chain technology business as well as an increased number of consulting engagements with new and existing customers, including the impact of the transformational supply chain agreement with a large health system that went alive during the second quarter of this year.

Our revenue share obligation or fees we receive from GPO vendors that we share with certain hospital clients was 35.6% of gross administrative fees, up 60 basis points from the same quarter a year ago and up approximately 200 basis points sequentially. The primary reason for the increase in revenue share obligation percentage is timing of contingent revenues recognized in 2008 as compared to 2007. Revenue share obligation for the first nine months of 2008 was 33.4%, which is relatively consistent with the revenue share obligation of 33.0% for the same period last year. Therefore, we anticipate the full year 2008 revenue share obligation percentage to be largely consistent with that of calendar 2007.

Adjusted EBITDA in the spend management segment was $15.2 million or a 50.4% margin as compared to $11.8 million or 47.6% margin in the third quarter of 2007 with the 2008 quarters’ margin expansion driven primarily by operating leverage and lower sales and marketing costs as a percentage of segment net revenue.

Now turning to our consolidated results. Our total net revenue for the quarter was $76 million, an increase of 54.2% as compared to third quarter 2007 which represents a combination of revenue growth from both organic and acquisition sources. Total net revenue in the third quarter 2008 increased 15.4% from total pro forma net revenue of $65.9 million in last year’s third quarter. Our consolidated adjusted EBITDA increased 68.1% in the third quarter 2008 to $25.2 million or a 33.2% margin as compared to a 30.4% adjusted EBITDA margin for the comparable period a year ago. Our margin increase was driven by quarter over quarter increase in adjusted EBITDA margins for each of our segments and a reduction of our corporate cost as a percentage of total net revenue by approximately 80 basis points in the quarter.

On a year to date basis, our pro forma adjusted EBITDA margins have, as predicted, climbed to 31.3%, equal to those for the same period a year ago. Our GAAP net income for the third quarter of 2008 was $3.7 million or earnings of $0.07 per diluted share which included $4.5 million in acquisition-related amortization expense on a tax effective basis. Our adjusted dilute EPS in the third quarter of 2008 was $0.15. We recognized share-based compensation expense of $2.5 million in the third quarter of 2008 which impacted EPS by $0.03 on an after-tax basis resulting in cash earnings per share of $0.18.

Our effective income tax rate for the 9 months ended September 30, 2008, was 40.4%, an increase from 39.5% from the same period a year ago and higher than we anticipated. This increase is attributable to our apportionment of revenues to states with higher income tax rates.

We ended the 2008 nine-month period with strong cash flow from operation of $31.1 million and free cash flow of $18.8 million. Our scheduled revenue share obligations to certain hospital and health system customers are paid primarily in first and third quarters of each calendar year, so we’d anticipate our full year free cash flow to be consistent with our prior communications ranging between 50% and 60% of adjusted EBITDA.

Now turning to our balance sheet. As you will see on our September 30, 2008, balance sheet, we elected to start carrying a cash balance of zero. During September, we instituted this new cash management practice of sweeping our daily cash net receipts to our revolving credit facility in order to decrease our levels of indebtedness on a more expedited basis, thus reducing our interest expense. To the extent we need to fund operations or capital expenditures on any given day, we will temporarily utilize a portion of our $30 million swing line credit facility.

During the quarter, we repaid approximately $19 million of bank debt, and our September 30th balance sheet reflects about $255 million in total bank debt. Our current net leverage is approximately 2.8 times trailing adjusted pro forma EBITDA. We are very comfortable with this level of leverage given our high percentage of recurring revenue and conversion of adjusted EBITDA to free cash flow.

In late September, we locked in our quarterly 90-day LIBOR on our term loan at a rate of 3.76% during its unprecedented rise in the midst of the market’s financial turmoil. The interest rate increase was offset by our lower levels of indebtedness, and we continue to expect our net interest expense will decrease over time as we de-lever our balance sheet. Of note, as a result of the Lehman Brothers’ bankruptcy filing, our total revolver capacity declined by $15 million to $110 million. Despite this, we had approximately $110 million of availability remaining under our revolving credit facility at quarter end, and we did not expect the Lehman filing to impact us further.

Turning to our financial outlook. Given that 85% to 90% of our net revenue is recurring, our contracted revenue metric is our best estimate of future revenues from existing customer contracts. On September 30, 2008, MedAssets rolling 12-month contracted revenue was an estimated $298 million, consisting of $175 million from the RCM segment and $123 million from the spend management segment. This current contracted revenue metric increased approximately 5% on a consolidated basis when compared to this metric a quarter ago.

Today, we are reaffirming and tightening our as reported financial guidance for 2008 based on our current outlook for the balance of the year. Specifically, 2008 guidance consists of consolidated net revenue of $272 to $276 million, RMC net revenue of $149 to $151 million, spend management net revenue of $123 to $125 million, consolidated adjusted EBITDA of $87 to $90 million, full year 2008 adjusted diluted EPS of $0.51 to $0.55, and share-based compensation expense of $0.10 per share yielding cash EPS guidance of $0.61 to $0.65 per diluted share.

For the remainder of 2008, we have a high degree of confidence in our ability to deliver these financial results based on the fact that virtually all of our forecasted revenue in the fourth quarter is currently under contract with the vast majority being fully implemented as we entered the quarter. Second, for the few large clients that were still in the implementation stages at the beginning of the quarter, we have a high level of confidence that these projects will come on line consistent with our expectations, and finally we expect to receive sign off from a spend management customer on a sizeable guarantee during the quarter. Also be mindful that our strong third quarter financial results were benefited in part by timing, and as a result, we are reaffirming our 2008 full year guidance, thus reducing the risk of execution associated with our fourth quarter.

Also given the recurring nature of our revenue and the predictability of our business, we are introducing our 2009 financial guidance which shows accelerating growth based on the underlying strength of our new customer contract and implementation trends. We will enter 2009 with tremendous momentum based on our outlook for the fourth quarter this year and our high degree of visibility for the next few quarters.

Our 2009 annual guidance consists of consolidated net revenue of $346 to $354 million which equates to an as reported GAAP net revenue growth rate of approximately 27% to 30% in 2009 over 2008 or approximately 15% to 17% revenue growth in 2009 as compared to 2008 full year pro forma net revenue of $301 to $305 million, RCM net revenue of $207 to $213 million which represents 16% to 19% growth in this business over 2008 full year pro forma revenues, and spend management net revenue of $137 to $143 million which represents growth of 11% to 15% over 2008.

Given our expectation of achieving our full year 2008 guidance targets, we project our first quarter 2009 revenue cycle management revenue to be roughly equal to that of the fourth quarter of 2008 given the large one time RCM revenue scheduled for this year, then progressing sequentially on a relatively straight line growth basis through the end of the year. Specific to our spend management quarterly 2009 revenue progression, we expect first quarter revenues to be up sequentially from the fourth quarter 2008 by 7% to 9%, then grow 1% to 2% per quarter for the balance of the year with slightly higher fourth quarter growth expectation based on projected new customer wins.

In addition to this, our spend management segment will host our 2009 customer and vendor meeting in the second quarter, increasing revenues by about $3 million beyond the core business revenues outlined above. We expect to deliver consolidated adjusted EBITDA in 2009 between $111 and $117 million. With the natural operating leverage that exists in both our business segments and the cost synergies that we’ve implemented as result of the integration of Accuro, we expect adjusted EBITDA margins to increase in 2009 and be between 32% and 33% with margins being lower in the first half of the year due to our frontloaded staffing plan.

At our first annual stockholders’ meeting, on October 30, 2008, our stockholders approved our new long-term performance incentive plan. This plan clearly aligns the interest of our leadership team and star performers with our stockholders as approximately 40% of the grants will be performance based and vest only if we meet 3-year compounded cash EPS growth targets and each employee remains employed for a period of 4 years from the grant date. Our 2009 EPS guidance reflects this increase in stock compensation expense. Importantly, if the performance-based components of the plan are not achieved, the associated stock compensation expense will be reversed.

We expect our effective income tax rate for full year 2009 to be between 39.5% and 40.5% due to what we previously discussed. Given the impact of our changed capital structure and tax rate, our full-year 2009 adjusted diluted EPS excluding non-cash acquisition related and tangible amortization is expected to be $0.54 to $0.62. In addition, we estimate our non-cash share-cased compensation expense will impact EPS by approximately $0.20 per diluted share in 2009, yielding cash EPS guidance of $0.74 to $0.82 diluted share, or growth of 24% as compared to the midpoint of our 2008 cash EPS guidance. We are forecasting capital expenditures in 2009 to be approximately $20-$25 million, or about $5 to $6 million per quarter, which is consistent with our post-Accuro capital spending run rates. For the reconciling items between adjusted EBITDA and net income for 2008 and 2009 guidance, please refer to our earnings press release.

In summary, we feel very bullish and confident in our 2009 outlook based on our current customers and implementation and late-stage identified bills pipeline. We continue to have an extremely stable financial profile with high recurring revenue, a very high percentage of EBITDA conversion to free cash flow, and a compelling business model that delivers measurable financial improvement for hospitals, health systems, and other healthcare providers across the country. We continue to be very excited about the opportunity to leverage our combined solutions set to drive customer satisfaction and continue to produce value for our customers, employees, and shareholders.

With that, I’d like to thank you for your time this afternoon. At this time, I’d like to now open the call for questions.

Question-and-Answer Session 

Operator 

(Operator Instructions).  Your first question comes from the line of Corey Tobin of William Blair and Company. 

Corey Tobin - William Blair

In the past you’ve talked about a very strong ramp in the RFPs I guess in the pipeline. I think in Q2 we talked about something about a 70% increase in that metric, and then John in your prepared tonight, I think you mentioned that the Maverick solutions was up modestly. I was wondering if you could just reconcile those two data points please. Secondly, if you could comment on the mix between old clients and new clients in the pipeline, that’d be appreciated as well.

John Bardis

First of all, over the earlier part of the year, we actually had a doubling of the pipeline which was a positive surprise for us, and now even in the face of that having doubled in that period of time, we are still seeing actually an increase in demand. So from the new bases, we are actually seeing improved demand versus a pipeline which has virtually doubled in its size. So we view that as positive. If it had stayed flat at a doubling rate, we’d have been pleased with this, but I think given the environment that we’re facing today, Corey, more and more hospitals are getting more nervous and therefore acting more rapidly to seek these kinds of solutions. So I just want to point out that there is no difference. In fact, there is an improvement from where we were.

Corey Tobin - William Blair

Just to salt it down. You are up over double from Q3 of last year?

John Bardis

Our pipeline is, yes.

Corey Tobin - William Blair

And then on the mix please?

John Bardis

Neil, would you take that one because I think you have the…

Neil Hunn

I’d be happy to. The RFPs, it’s been about a month since I checked, but it was still roughly up about 70-75% over a year ago, so the trends have continued, and then relative to the mix in the pipeline between old and new, it is still biased towards new clients versus existing slightly, sort of 60:40. We would anticipate that getting more balanced or maybe flipping the other way during the course of 2009. We just now have a single unified revenue cycle sales team, and working to cross sell across our segments, and so we would expect to see that mix shift a little bit. The final point I would like to point out also is that RFP is only a very small portion of our sales lead process. We have a very consultative sales force that is identified opportunities, talking with CFOs, talking about big deals, and RFPs tend to be focused on single product solutions. So they are both obviously important growth drivers for us, but certainly not the only indicator of the future.

John Bardis

One other point I’d raise there, and that is that actually the pipeline is far more indicative of data that suggests the predictability of growth in sales than clients.

Corey Tobin - William Blair

So the RFP metric was the one that was 70-75%, but the pipeline metric, and to your point, the indicative metric, is up over double from last year.

John Bardis

That’s correct. Again, the RFP is a subset of the pipeline. The pipeline is the comprehensive view of revenue expectation, client growth, and client integration for new products.

Operator

One next question comes from the line of Richard Close from Jefferies & Company.

Richard Close – Jefferies & Company

With respect to the second quarter, was there any type of reclassification of expenses from G&A up into the cost of service line, and if so, can you give us details on that?

Neil Hunn

As we bring Accuro on, they have a different classification scheme between cost, revenue, and the other categories of expenses, and so as we bring them on to our accounting systems, we will see a slight shift in that. The other thing that would maybe drive if you are looking at the change in cost and revenue as a percentage, as we drive our revenue cycle sales, they carry 20-25% cost of revenue whereas our spend management business carries virtually none, and so you will see a mixed issue depending on the growth and the various growth drivers of our two segments.

Richard Close – Jefferies & Company

So, the gross margin we saw in this most recent quarter should be a good metric going forward to use that as a guide?

Neil Hunn

It will be a metric. I would say that we need to look at it again in the fourth quarter because we haven’t fully converted the accounting systems yet. That happens here I think actually starting in November, and we’ll have a much cleaner look in the fourth quarter, but certainly the third quarter is more indicative than the second.

Richard Close – Jefferies & Company

With respect to the interest assumptions in your guidance, if you could just sort of walk us through that?

Neil Hunn

It’s an extremely complex model. It’s got the OID, it’s got this Accuro note that’s due next May or June. It’s got the fees, it’s got change leverage that’s built into it. The punch line of that is that we assume next year that LIBOR is at 3.25% throughout the year, as it’s a 90-day LIBOR. Today, it’s sitting at about 2.2%, and a 3.25% LIBOR rate would yield about an 8.3% average interest rate for next year. That includes all the noncash, spreads, margin, fees, and everything loaded into it.

Richard Close – Jefferies & Company

When we think about the current environment and the opportunities that exist for you guys, obviously the pipeline being up pretty significantly or continuing to be up pretty significantly, have you seen any dramatic change I guess in the month of October in terms of people just not returning phone calls, or maybe if you can comment whether you’ve seen an acceleration of interest based on the current environment over the last month?

John Bardis

I’m actually down in Jacksonville right now with our large integrated delivery network annual meeting along with our vendor meeting, so there’s about 700 people here, and I think about 400 companies. What we’re seeing is an increased demand and request for meeting for our solutions. So, actually it’s growing. However, there are probably some caveats or some information points that are worth about in the marketplace, and one of them is that we are seeing a backup at the door for anybody that’s selling capital. Anything that falls into capital budgets or capital equipment is literally going from complete hold to a slow trickle. There are many institutions here who I spoke to last night where they said literally if there is a capital equipment spend, we have absolutely put that on hold for now. Fortunately for us, we don’t sell capital equipment. We don’t sell into the capital budget. The vast majority of our products come out of current operating expenses, and since they have direct cash on cash return on investment numbers attached to them, we’re seeing increased demand for it. So, we’re kind of seeing two things. One, capital budgets are shrinking, and those who have capital products to sell are not getting support or return calls, and those who are selling higher ROI products that have cash on cash returns attached are getting very good visibility.

Richard Close – Jefferies & Company

On Kindred, maybe if you could talk about what exact products Kindred purchased in the most recent quarter?

Neil Hunn

We try not to speak specifically about which products and any particular customer for confidentiality of the customer, and what we said has been approved by Kindred. It is a services deal. I can tell you that. We are helping them identify cash that’s seeping out of the institution on a contingent basis.

Richard Close – Jefferies & Company

Tenet has talked about rolling out a revenue cycle offering. Do you see them as a competition or are they potentially employing some of your tools in their revenue cycle offering?

John Bardis

The answer, Richard, to that question for both is yes. They are a customer of ours and a very good one. We’ve had a lot of success with them. They are also offering a back office approach, fully integrated turnkey solution, to my understanding to hospital clients, and so we will probably see them in some transformational market opportunities ultimately as competitors, but yes, they will be using a number of our tools because they are central and integrated to their current revenue cycle operations, and you know Tenet has shown in the past a propensity to spin out certain assets that may be more valuable in the eyes of investors than say the hospital assets, and probably the known example of that would have their old BuyPower purchasing organization that become Broadlane.

Operator

Your next question comes from the line of Larry Marsh of Barclays Capital.

Larry Marsh – Barclays Capital

Based on the new compensation program that was approved by shareholders here recently with the alignment toward a 3-year earnings per share goal and being in line for 4 years to get it, if you add that in, it’s obviously a big increase in share compensation expectations for ’09. What kind of increase in comp budgeting does that imply for 2009? How specific are you in terms of those targets, and how exactly would they be adjusted during a year if there was some sort of change in expectation?

Neil Hunn

First, on the cost, if you take the $0.20 per share that we’re sort of expecting for next year, about $0.13 of that is directly related to this new LTIP plan and $0.07 on the existing plans, so hopefully that answers your first question relative to what we’re budgeting from a compensation point of view on the new long-term equity incentive plan. Specific to what the goals are, the plan in terms of aggregate number of shares and the mechanics of the plan and some of the teeth that we have in the plan to make sure that management acts in a diligent way, etc., that’s been approved by the shareholders, what is still in our compensation committee that’ll be presented to our board in December are the exact specifics in terms of the targets on cash EPS, etc. So in the future in proxies, we’ll talk about that, but it is likely to be cash EPS and it is also going to be compounded over a three-year basis, and so that’ll take into account obviously organic growth, it’ll take into account managing our balance sheet, it’ll take into account acquisitions, and so we believe that it gets us tight. The other thing I’d point out is that there are multiple targets in terms of compound cash EPS growth, all of which are stretch oriented, and so this is very much meant to reward the start performers of this company and management only if shareholders do better than currently expected.

Larry Marsh – Barclays Capital

I know it’s been approved by shareholders, but just to play devil’s advocate here, what you’re saying is that your share-based comp expense is expected to more than double in ’09 versus ’08 based on your reported to date. Your revenues with Accuro maybe up 30 some percent, so I understand the alignment, but from an outsider, it feels more like a fixed expense than a variable expense in terms of how you are presenting in your adjusted earnings expectations. Why is that?

Neil Hunn

What we assume in this guidance is that we will be on tract to hit all the performance targets. As I mentioned, about 40% of this plan is only paid if we hit the targets. So to the extent we get to the end of next year and we look out at our models in two years and we assess, for instance, that we aren’t going to hit one of those stretch targets, then at that point in time, accounting requires us to reverse that expense. So we assume it’s not a variable because we assume we hit the plans and our guidance, but to the extent we’re pulling up short, 40% of this expense is variable.

Larry Marsh – Barclays Capital

Your share back comments for the full year of ’08 suggested that they would be consistent with that percentage for ’07. Is that correct?

Neil Hunn

Correct.

Larry Marsh – Barclays Capital

So that would imply a big increase in share back in the fourth quarter?

Neil Hunn

On a percentage basis, I don’t believe that works out to be that way.

Larry Marsh – Barclays Capital

The amortization expense in your guidance, you have another $3 million allocated to cost of goods. That was a couple of million more than I would have thought. Is that consistent with what you have imbedded in this year or is there something different there?

Neil Hunn

Sorry, I just want to make sure I’m clear on the question. I apologize.

Larry Marsh – Barclays Capital

Maybe I should take this offline because it’s not a huge point. You’re allocating about $3.2 million of amortization to cost of revenues and I think $28 million to amortization of intangibles. That’s up a good bit from this past year. I’ll tell you what, let me just take that offline.

Neil Hunn

The short answer is that that is for software that had external facing, and with us putting B4 into production in October, we start amortizing that expense, and that’s why you’re seeing it running through that line. That’s the big change.

Larry Marsh – Barclays Capital

On the cash flow expectations for the full year, based on timing, you’d expect to see a much stronger fourth quarter?

Neil Hunn

Yes. Remember in the first and third quarters, we have $25 to $28 million of payments we make in share backs.

Larry Marsh – Barclays Capital

Two things for John. Your message has been pretty consistent. In an environment when your hospitals are struggling, it creates more opportunities for you. As you said, anything that speaks of CapEx to hospitals has been put on hold. We certainly heard that pretty consistently from a number of vendors this quarter, and your message today is obviously because of what you’ve seen in the marketplace, you haven’t seen any degradation of your opportunities. If anything, you’re seeing more opportunities. When you say that these executives are putting just projects on hold, what are the things they are really concerned about? Is it just their endowments assets being denigrated so much? Are they seeing real changes in admissions, and again how exactly does that allow them to want to accelerate their costs when they are in a period of just kind of being glassy eyed?

John Bardis

I’m not sure I understood the question about accelerating costs. What does that mean?

Larry Marsh – Barclays Capital

Accelerating the conversations that they are having with you around your solutions, I’m sorry.

John Bardis

What I would categorize the environment that is being shared with us by hospital CEOs, CFOs, and operating officers is the following. One, their capital world has changed dramatically. There is virtually no available capital for them to borrow, and only those who have very strong credit ratings are able to even consider it. So all by itself, the liquidity issue is directly affecting their capacity to make capital expenditures. Number two, as far as capital concerned, we have heard anywhere from 25 to the mid 30s in the form of percentage that hospital endowments are off this year, and the expectation is that that decline will continue. So those are larger financial environmental issues as it relates to just general giving and finance markets. The current level of unemployment growth continues to produce people who do not have healthcare benefits or have only partial healthcare benefits, and hospitals have traditionally struggled with private and co-pay and indigent patient co-pays in a good economy. They are now seeing an increase in the number of patients who are responsible for more or all of their own bills, and so bad debt expense continues to actually rise across the board. During the period of the increase in problems in the economy and the financial markets, what we were hearing and continue to hear is that elective surgeries continue to decline, and people who would have gone in for an elective surgery, even ones that might be relatively sizeable, are putting those off, and so the day to day operations of the hospital continue to be fairly centered around the large major surgical cases that have to be done in an environment where their access to capital has declined and their reimbursement and net cash flows continue to decline because of the payer mix issues that they are experiencing due to the changing economy and increasing unemployment. Now, the last very important area that I would point to would be the dramatic and relatively strong increases in cost across the board that hospitals continue to experience for raw materials, medical products, as well as food, and then one additional point to consider on the revenue side, and that is due the decline in the economy and the expense control issues amongst small and medium and large American employers, employers are pushing back on managed care intensively on cost increases. I know for sure we are, and we’re self-insured. We’re managing this very, very close, and so now what we used to see 10 years or 7 to 8 years ago in the form of solid double-digit cost increases paid for by American business and private pay that had cost shifted to it as a result of federal and state programs underfunding their care is not being accepted by the ultimate payer of these services, and that’s the American business infrastructure and enterprise. So hospitals now are seeing the increases in costs and the limitations of access to capital, the limitations of endowment, coupled with very small increased in private pay that they used to depend on to the tune of mid single digits and low teens, etc., to offset the lack of government reimbursement in relationship to relationship to real cost, that’s not longer there, so now we have essentially the engine on the train slowing to a relatively low revenue increase and the caboose of costs coming up behind it at a rate that is two and three times revenue growth. So we’ve got what we would call almost a classic stagflation environment facing many of our US hospitals.

Larry Marsh – Barclays Capital

Obviously that creates the opportunity for us that you talked about, so it sounds like you continue to exploit it. I’ll stop here.

Operator

Your next question comes from the line of David Veal from Morgan Stanley.

David Veal – Morgan Stanley

Neil, the Ministry revenue recognition, was that earlier than you had originally modeled?

Neil Hunn

Yes, by a couple of months.

David Veal – Morgan Stanley

And how much did that help the topline? Can you tell us that?

Neil Hunn

As you know, we try not to talk about revenue from any specific customer.

David Veal – Morgan Stanley

On the bad debt side, the write-offs continue to exceed bad debt expense. In this environment, is that the right approach? I was wondering what’s driving that.

Neil Hunn

Let me start by saying our DSOs again this quarter decreased, and that’s always looking at it on a net basis quarter over quarter. It decreased by a couple of days. Our DSOs are now about 54 days on trailing revenue basis down from 56.5. We’ve hired a director of recovery and collections, and we changed some of our processes. We’re tighter on this, so we actually are doing a better job at collecting. The write-off, and by the way our bad debt to revenue on the year to date basis is about 70 to 75 basis points which is consistent with our expectations for this year and for next year, so we are running exactly where we think we’re going to be because part of the cost of doing business with hospitals is you’re going to have some bad debt. Now, our write-off policy is actually quite aggressive. Once we deem something uncollectible, we write it off. We don’t balloon up our AR reserve. So you’ve seen year to date about a $2.6 million write-off, 1.7 of that was brought to us from the MD-X acquisition that was fully reserved on the opening balance sheet when we bought that company. So it was bad AR when we bought it, and wrote it off over the course of this year. So core MedAssets, truly MedAssets under our stewardship and our ownership, has only about $900,000 in write-off this year, which is substantially less, about 60% of what our bad debt expenses for the year.

Operator

Your next question comes from the line of Ross Muken of Deutsche Bank.

Ross Muken – Deutsche Bank

On the GPO, John, you made a bunch of comments about the capital crunch the hospitals are under. What are you thinking about in terms of spend on the GPO side relative to lower volumes potentially at hospitals. How should we think about the growth next year on a percent basis coming from the existing business plus additional customers?

John Bardis

I would say that the stuff that elective procedures that we’ve seen put on hold this quarter really doesn’t affect us very much at all. In fact, what we’re talking about there is people who might be getting a knee replacement. We don’t, as you know, take fees from medical device manufacturers. So I don’t anticipate any major changes in the growth of the group purchasing business. We continue to gain share, and we continue to expand the portfolio. So the combination of those two things makes us feel very confident about our growth. Having said that, that environment has definitely increased the need for large institutions to get a better handle on their supply cost control, particularly in the medical device arena, so we are now getting more calls and more interactions with large institutions than we even had in the past because these problems are now sticking out of the water at a much higher level of visibility than they were before. Specifically, a medical device consumes 70 or 80% of the entire reimbursement of a case is no longer something that they can tolerate in the face of the macro environment we discussed.

Ross Muken – Deutsche Bank

How should we think of the acquisition strategy going forward? As the capital crunch persists, the venture community and a lot of private companies are feeling it probably more so than you are and clearly there you can see maybe valuations coming to levels that could be opportunities, so how are you think about that versus the existing opportunities versus the continued debt pay down at the aggressive levels you’re doing?

John Bardis

The first order of business here is for us to operate and to do so with a lot of discipline. We do believe that we are uniquely positioned by the good fortune that we had to get public last December, so therefore we are the natural acquirer of certain key assets at certain times should they become available and more importantly makes sense for our strategy. So we’re constantly keeping our eyes open, but because of the access to capital that we have both with equity as well as future debt options, we think that we’re a natural buyer for the right assets, but having said that, our eye right now is squarely focused on integration, execution, and market growth, but we continue to be focused on understanding our available options. We think that the value and the price rather of certain good assets will continue to decline in the private sector.

Operator

Your next question comes from the line of Charles Rhyee of Oppenheimer.

Charles Rhyee – Oppenheimer

Neil, can you give me the rate on your $30 million swing line credit facility?

Neil Hunn

It’s a subset of a revolver, and so it carries a base rate which is either prime which today is about 450 basis points or fed funds plus 50, the maximum of those two, so obviously we are at prime plus a spread on that and the spread is 175 basis points.

Charles Rhyee – Oppenheimer

I missed it when you talked about the revenue progression for the RCM as we think about ’09. Can you just go over the one more time?

Neil Hunn

On the revenue cycle business, we expect that the first quarter of next year will be roughly equal to the fourth quarter of this year because this fourth quarter has a significant amount of one-time revenue. So you’ll see growth in the core business excluding that one-time revenue, and then it’s basically pretty linear sequential growth quarter over quarter over quarter from the first quarter to the end of year.

Charles Rhyee – Oppenheimer

Just to be clear, you said that Q1 is going to be equal to Q4, or is it going to be down from Q4.

Neil Hunn

It should be roughly equal to the fourth quarter and then it grows from there.

Charles Rhyee – Oppenheimer

We talked about obviously the issues facing hospitals today, and one of the other items that people talk about facing hospitals is changing reimbursement environment, but when I think about that and I think about aspects of healthcare, many times a lot of groups are able to lobby effectively to push off changes. Do you see that happening here, particularly with hospitals given the economy? Do you think they have the ability to go back to congress and maybe ask for a delay in certain aspect of Medicare rule changes?

John Bardis

It’s a great question. What I would say is we are getting indications from the new administration that they have a healthcare agenda, and people who had supported them throughout the election have the same agenda, and that is to push the coverage issue, and that coverage issue would be designed to increase the number of who can access Medicare and Medicaid and SCHIP programs. My sense is that those will have to be carefully balanced against those patients today who are unable to or in fact do receive healthcare but fall into the bad debt category, so fundamentally those increase in beneficiaries for those types of programs are probably better than a zero sum game for those who simply cannot pay for the provider. So I actually think that some of this will actually favor the provider because it will be some level of reimbursement against some level of bad debt due to the consumer issue. Having said that, since there has been limited success in making legislative end-roads in the past, it is apparent to us that the regulatory agencies within the federal government have taken it upon themselves to go after costs in relationship to overspending on the budget, and so therefore we’re seeing the RAC audits and soon to be the BAC audits and a number of different programs from federal government to recover dollars, as well as a number of other measures including the OIG investigatory levels of activity to reduce fraud, higher levels of reimbursement, etc. So I think the pressures will continue to be there. I think they’re coming from all sides of government. While government will try to address some of the campaign promises of coverage for more Americans, which in the end should benefit providers because that coverage, even though it might well be below cost, it oftentimes is being applied against a no payment on a bad debt for a consumer who is uninsured.

Operator

Your next question comes from the line of Eric Coldwell of Robert W. Baird.

Eric Coldwell – Robert W. Baird

John, you spent a lot of time tonight talking about one of the challenges for hospitals, namely the increase in raw materials and non-labor supply costs, etc. In fact your largest peer on the GPO side this week put out a press release suggesting that it was putting a freeze in place for all manufacturers and henceforth would not accept prices increases from the supplier base. I’m interested on your thoughts on that.

John Bardis

I think that’s an impressive headliner. I don’t think it mitigates the reality that manufacturers are facing. One can agree or disagree to accept price increases based on those cost increases or not. It still remains to be seen whether or not those cost increases are not applied, and so again I applaud them for taking that action, but again if a company out there has substantial cost increases whether that be a food company, food distributor or what have you, what a group purchasing organization may or may not say or may or may not make rules about regarding this issue, it is yet to be seen as to whether or not it will be effective. I think as a statement and a stance and a policy issue, it makes great sense. It may not have its root in reality for all areas where costs are rising.

Eric Coldwell – Robert W. Baird

My followup question has a strategic longer-term outlook. I think there’s been reference in the past that potentially you would look at spin management controls and other areas of the hospital system. I don’t know if that’s something that’s front and center today, but I’m curious about areas like whether the construction, labor, maintenance solutions and things of that sort, whether that’s a topic that’s currently front and center for management or if it’s something that’s been back-burnered at the moment.

John Bardis

I think where we see the future is associated with the application of clinical labor resources to produce a more efficient and better clinical outcome. Meaning that certainly going forward we have to maximize the efficient application of reimbursement, wherever that reimbursement comes from, the consumer, the federal, state, or private program. We clearly have to then look at the bookend which is the cost of raw materials and supplies to operate that institution, but broadly speaking, we all have to recognize that 50% of the cost of running a hospital is people, and so therefore at the end of the day, it is the clinical and operating interface of the clinical and human resource component that will make or break our long-term ability to apply better medical results for fewer dollars, and so as we go forward, we don’t look at the labor issue by itself. We look at labor as an application point to a better, more six-sigma lean methodology for the clinical interface between clinicians, the utilization or product, and interaction with patients. When that’s done right and we think we understand a few programs that do this quite well, you get a lower cost of care, you get a better outcome, and you get a shorter length of stay. When you get that, the kinds of metrics that you drive to the bottomline are rather impressive, so you can look for us to continue to find and seek solutions in that arena.

Operator

Your next question comes from the line of Sean Weiland of Piper Jaffray.

Sean Weiland – Piper Jaffray

I am just trying to reconcile the ’09 adjusted EBITDA guidance to the ’09 adjusted EPS guidance. The EBITDA is growing a lot faster than the adjusted EPS. Am I missing something there?

Neil Hunn

I think the big difference between adjusted EBITDA and adjusted EPS, if you look at it on a cash EPS basis versus adjusted EBITDA, you’d see cash EPS growing faster, and the reason adjusted is slower is purely because of the $0.13 of stock comp in the new long-term incentive plan.

Sean Weiland – Piper Jaffray

The $0.13 of stock comp then is not in your adjusted EBITDA guidance?

Neil Hunn

I was answering on an EBITDA basis, Sean, not adjusted EBITDA basis. My apologies. I might have to get back to you on that one.

Sean Weiland – Piper Jaffray

Any thoughts or commentary you can give us on the lockup expiration?

Neil Hunn

The only lockup that’s existing is the Welsh Carson lockup. I think it comes up 180 days after close, which I think is at the end of November or the beginning of December. Our expectation is that with Welsh Carson and with all of our larger shareholders that, first they’ve all gotten principally their bases back through either recapped dividends before going public or in Welsh Carson’s case, when we bought the business, they got a big cash chunk, which is an important point because it makes all of the shareholders including Welsh Carson to our understanding more of a time-based seller, not a price-based seller, and so in that regard, whenever something happens, we believe it will be in an organized way. I don’t know when that time is going to be, but I don’t believe that there’s going to be a big impact when the lockup comes off.

Operator

Your last question comes from the line of Sandy Draper of Raymond James.

Sandy Draper – Raymond James

Neil, could you remind me is there any revenue that would be tied to customers if their revenue went down, that if you’re getting a percentage of collections or something like that where if the hospital environment really gets worse that you would actually see a slowdown in revenue? I know most of it is on the service side and a fixed amount, but is there a scenario where you could actually see declining revenue if the customers really started declining?

Neil Hunn

In a really bad situation, on a portion of our business, yes. In our AR services business, we get a percentage of net revenue that we collect, so if net revenues were to decline, so would our revenues in that regard. It is a relatively small percentage of our overall revenue. A lot of our revenue is driven by transactional volume, and so we get X cents per transaction, so when we look at the outlook of what John talked about with the potential increase in coverage, you might see reimbursement shift from commercial to a more government program. The number of transactions will actually probably go up because you are bringing uninsured on to the insured, and so we’d see revenues grow there, and then more compensated care occurring which would drive business on both the transactional side and the percentage of revenue side.

Sandy Draper – Raymond James

Thank you. All the other questions have been answered.

Neil Hunn

Sean, if you’re still on, to your question, adding back stock comp, you add it back to adjusted EBITDA, you don’t add it back to adjusted EPS, and so that’s why there’s a delta. You do add it back to cash EPS, and therefore you see the delta. I think that’s the answer to your question.

John Bardis

Any other questions?

Neil Hunn

Great! John and I would like to thank you for your time this afternoon. We’d also like to as we always do thank our employees for their dedicated service to our customers and we thank our customers for doing business us. John, do you have any final comments?

John Bardis

No. We thank you for your interest in our company. We are looking forward to continuing to provide quality results and keep you apprised on your investment in our company. We continue to be diligent and focused on operations and growth. Thank you for your time, and we look forward to talking to you soon.

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Source: MedAssets, Inc., Q3 2008 Earnings Call Transcript
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