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PRGX Global Inc. (NASDAQ:PRGX)

Q2 2013 Earnings Call

July 30, 2013 8:30 am ET

Executives

Romil Bahl – President, Chief Executive Officer

Robert Lee – Chief Financial Officer

Analysts

Alex Paris – Barrington Research

Kevin Liu – B. Riley & Co.

Tim McHugh – William Blair & Co.

Nick Nikitas – Robert W. Baird

Richard Close – Avondale Partners

Operator

Good morning ladies and gentlemen and welcome to PRGX Global’s second quarter 2013 earnings conference call. At this time, all participants are in a listen-only mode. Later we will conduct a question and answer session and instructions will be given at that time. If anyone should require operator assistance during the conference call, please press star then zero on your touchtone telephone. As a reminder, this conference call may be recorded.

I would now like to hand the conference over to Mr. Romil Bahl, President and CEO. Sir, you may begin.

Romil Bahl

Thank you, Said. Good morning, good afternoon and good evening to each of you around the world. Thank you for joining PRGX Global Inc.s’ second quarter 2013 earnings call. We thank you all for the time that you are taking to be with us today. Our Chief Financial Officer, Bob Lee, is with me here in our Atlanta headquarters, and after my introductory comments he will review our financial results for the quarter. I will then update you on our operations and the ongoing execution of our growth strategy. Once we conclude our remarks, we will open the call for your questions.

As you saw in our results released last night, the PRGX team delivered a solid set of results for Q2 2013. Revenue bounced back to over $50 million, which is 11%-plus over Q1 2013. Adjusted EBITDA increased to $7.9 million, which is not only 80% higher than Q1 2013 but is also higher than the same quarter last year. This set of results showcases both the resilience of our business and the effectiveness of our ongoing cost to serve reduction program and overall EBITDA growth story, with adjusted EBITDA margins hitting 15.7% for the quarter.

The highlight of the quarter was clearly our new services segment, which achieved $10 million in revenue for the first time, representing 20% of our revenue mix. Healthcare was the star of the show this quarter with a very nice performance. While some of this was due to deferrals from prior quarters, it also showcases how far our capabilities in this area have come, and this in turn bodes well for the future, especially should we win a contract in the upcoming CMS RAP program re-bid.

On this front and while we have not yet seen the revised RFQ, or Request for Quote, from the Centers of Medicare and Medicaid Services, it could drop at any time. Importantly, it appears that our previously disclosed concerns regarding a long transition phase from the current contract to the new five-year term may be mitigated. In fact, while there are moving parts to the story, there is now a chance that we will continue to audit for much of the year.

Our Americas core business performed well this quarter despite the one client issue we had back in March which negatively impacted both Q1 and Q2. Our EAP region continues to feel the weakness of Europe’s macro-economic issues, but we see signs of improvement. We continue to make structural changes to our European cost structure and hence believe that the second half will be better than the first half of the year for our recovery audit services across the region. So we reiterate that despite the rough start to the year, we believe that for the full year we will be in the same range of profitability as we were last year for our core service globally.

I’ll end my introductory comments by saying we remain encouraged by the opportunities we are starting to create in our profit optimization service area and also with our more recent push into contract compliance. We have a number of large deals in our pipeline, some of which we hope will convert and help bolster our performance this year. I will elaborate on each area of our business after Bob provides details on our financial results on Q2.

Over to you, Bob.

Robert Lee

Thanks you, Romil, and good day to everyone. I will be reviewing our financial results for the three and six months ended June 30, 2013.

Let me note at the outset that certain statements in this conference call may be considered forward-looking statements under the Safe Harbor provisions of the Private Securities Litigation Reform Act. These statements include statements relating to management’s views with respect to future events and financial performance that are based on management’s current expectations and beliefs and are subject to risks, uncertainties and other factors which could cause actual results to differ materially from historical experience, or from future results expressed or implied by such forward-looking statements. For additional information on these factors, please refer to PRGX Global Inc.’s filings with the Securities and Exchange Commission, including but not limited to its reports on Forms 10-K and 10-Q. PRGX undertakes no duty to update or revise any forward-looking statements whether as a result of new information, future events or otherwise.

This presentation also contains references to certain non-GAAP financial measures such as EBIT, EBITDA and adjusted EBITDA, metrics that we use internally to measure our operating performance. A reconciliation between these non-GAAP measures and net earnings, the most directly comparable GAAP measure, is available under the Investor Relations portion of our website at prgx.com.

Now to begin the review of our financial results for the three months ended June 30, 2013. Our revenue was $50.2 million compared to the prior year second quarter revenue of 51.7 million, a decrease of 2.8%. On a constant dollar basis adjusted for changes in foreign currency exchange rates, 2013 second quarter revenue decreased 2.4% compared to the same period in 2012. Second quarter 2013 revenue exceeded first quarter 2013 revenue by 11.3%.

Recovery audit services Americas revenue was $29.4 million compared to the prior year second quarter revenue of 29.6 million, a decrease of 0.7%. On a constant dollar basis adjusted for changes in foreign exchange rates, recovery audit services Americas second quarter revenue was essentially flat compared to the same period in 2012. Recovery audit services Europe Asia Pacific revenue was $10.8 million compared to the prior year second quarter revenue of 13.4 million, a decrease of 19.7%. On a constant dollar basis adjusted for changes in foreign exchange rates, recovery audit services Europe Asia Pacific second quarter revenue decreased by 18.9% compared to the same period in 2012.

New services revenue was $10 million compared to the prior year second quarter revenue of 8.7 million, an increase of 16%. Our new services segment is comprised of our healthcare claims recovery audit business as well as our profit optimization services. The new services segment second quarter 2013 revenue, which was a record high, represented 20% of total revenue compared to 16.8% in Q2 2012. Our cost of revenue was 31.5 million in the second quarter of 2013 compared to 33.3 million in last year’s second quarter, which was 62.8% of revenue in 2013 and 64.5% of revenue for the same quarter in 2012. Margin improvements primarily came from ramped up revenues in healthcare claims recovery audit business and decreases costs to serve in the Americas recovery audit segment.

Total SG&A in the 2013 second quarter was 12.6 million compared to 12.7 million in last year’s second quarter, or approximately 25.2% and 24.6% of revenue in each period respectively. Depreciation expense increased 0.4 million and amortization expense decreased 0.1 million compared to the second quarter of last year.

For the three months ended June 30, 2013, our net earnings were $1.8 million or $0.06 per basic and diluted share, compared to net earnings of $1 million or $0.04 per basic and diluted share for the same period in 2012. Our adjusted EBITDA for the second quarter of 2013 was $7.9 million compared to 7.6 million of adjusted EBITDA in the same period in 2012. Second quarter 2013 adjusted EBITDA excludes a $1.2 million charge related to stock-based compensation, less than $0.1 million for acquisition obligations classified as compensation, $0.6 million of transformation severance and related expenses, and $0.2 million of foreign currency losses on short-term inter-company balances. The comparable adjusted EBITDA for the second quarter of 2012 excludes a $1.2 million charge related to stock-based compensation, $0.1 million for acquisition obligations classified as compensation, $0.3 million of transformation severance and related expenses, $0.3 million related to a wage claim cost, and $0.5 million of foreign currency losses on short-term inter-company balances.

Now to begin the review of our financial results for the six months ended June 30, 2013. Our revenue was $95.3 million for the current year six-month period compared to the prior year six-month revenue of 103.3 million, a decrease of 7.7%. On a constant dollar basis adjusted for changes in foreign currency exchange rates, the first six months of 2013 revenue decreased 7.1% compared to the same period in 2012.

Recovery audit services Americas revenue was $55.6 million compared to the prior year’s revenue of 58.4 million, a decrease of 4.7%. On a constant dollar basis adjusted for changes in foreign exchange rates, recovery audit services Americas revenue decreased 4.2% compared to the first six months of 2012. Recovery audit services Europe Asia Pacific revenue was $21.8 million compared to the prior year’s revenue of 27.7 million, a decrease of 21.4%. On a constant dollar basis adjusted for changes in foreign exchange rates, recovery audit services Europe Asia Pacific revenue for the six months ended June 30, 2013 decreased by 20.2% compared to the same period in 2012.

New services revenues was $17.9 million compared to the prior year revenue of 17.2 million, an increase of 4.1%. The new services segment revenue for the six months ended June 30, 2013 represented 18.8% of total revenue compared to 16.6% in the prior year. For the six months ended June 30, 2013, our cost of revenue was $61.9 million compared to 67.5 million in the prior year, which was 65% of revenue in 2013 and 65.4% of revenue in 2012.

Total SG&A for the six months ended June 30, 2013 was $24.3 million compared to 25.3 million in the prior year, or approximately 25.6% and 24.5% of revenue in each period respectively. Depreciation expense increased $0.9 million and amortization expense decreased $1.2 million compared to the first six months of 2012. The increase in depreciation is primarily due to improvements we made in our IT infrastructure and the depreciation relating to software development projects placed into service in the second half of last year. The decrease in amortization is due to the 2012 period, including greater acquisition-related charges than the 2013 period.

For both the six-month periods ended June 30, 2013 and 2012, our net earnings were $1.3 million or $0.05 per basic and diluted share. The six months ended June 30, 2013 included a $1.2 million credit resulting from the release of a portion of the reserves held for uncertain tax positions. Approximately $0.7 million of this release related to accrued interest on these reserves and is included as a credit to interest expense, and the remainder is reflected as a reduction of income tax expense.

Our adjusted EBITDA for the six months ended June 30, 2013 was $12.2 million compared to 14.4 million of adjusted EBITDA for the same period in 2012. 2013 adjusted EBITDA excludes a $2.5 million charge related to stock-based compensation, $0.1 million for acquisition obligations classified as compensation, $0.6 million of transformation severance and related expenses, and $0.6 million of foreign currency losses on short-term inter-company balances. The comparable adjusted EBITDA for the first six months of 2012 excludes a $2.6 million charge related to stock-based compensation, $0.2 million for acquisition obligations classified as compensation, $0.5 million of transformation severance and related expenses, $0.6 million of wage claim costs, and $0.2 million of foreign currency losses on short-term inter-company balances.

I will now highlight certain 2013 balance sheet and cash flow information. As of June 30, 2013, we had unrestricted cash and cash equivalents of $31.1 million and had no borrowings against our revolving credit facility. Bank debt outstanding was $4.5 million, representing the outstanding balance on a variable rate term loan due in quarterly installments through December 2013, with the final payment being due in January 2014. At June 30, 2013, current assets exceeded current liabilities by $42.6 million.

Net cash used in operating activities for the six months ended June 30, 2013 amounted to $3.1 million compared to the net cash provided by operating activities of 0.9 million in the same period of the prior year. Before working capital changes, cash provided by operating activities amounted to $10.9 million in the first six months of 2013 compared to $11 million in the first six months of 2012. Capital expenditures on property and equipment for the second quarter 2013 amounted to $0.8 million, and for the six months ended June 30, 2013 amounted to $3 million.

Net cash provided by financing activities for the six months ended June 30, 2013 amounted to $0.2 million compared to a $3.8 million net use of cash in the first six months of the prior year. This change is primarily due to the $4.1 million of net proceeds received from the January 2013 exercise of the overallotment option by the underwriters from our follow-on public offering in December of last year.

With that summary of the financial results, I will now turn it back over to Romil.

Romil Bahl

Thank you, Bob. Let’s go right into our core business first. Our Americas team continues to drive our next-generation service delivery model with increased centralization and offshoring of claim categories, including some of the more complex types of auditing. Given the progress we have made by leveraging our shared services centers, including not just our Pune, India offshore center but also our onshore and near-shore centers, we continue to be confident that over the coming years we will drive over half our total recoveries to these lower cost centers, thereby driving our cost to serve lower. At the same time, we continue to drive auditor productivity upwards and our average onsite auditor compensation levels are higher than they have been at any time in the last decade. This really puts an exclamation point on our belief that PRGX has emerged as not only the lowest cost service provider in the recovery audit space but the company with the unmatched ability to attract the very best talent in each of our markets.

I am also pleased to report that the delivery issue we had around a major RA client in Q1 was resolved in Q2. At this same client, we recently won a multi-year contract across their Latin America business as their primary recovery audit provider, so things continue to go well from a relationship perspective. Finally for the Americas, our Canada unit has been coming on strong with the execution of successful audit acceleration at a key client, and our commercial practice is expecting a strong H2 given our recent wins.

As is clear from our results, we continue to struggle in Europe. Our EAP business continues to be negatively impacted by both the macro-economic conditions and ongoing client and vendor delays in process into claims that we have identified. That said, our efforts to rejuvenate our client relationships, develop new business, and drive our next-generation SDM model across our European operations are beginning to pay off, and we are confident that we will have a stronger second half of the year in our EAP region.

Our shared service center in Brno in the Czech Republic is now functional, and we have started the centralization of our central European audits as well as all European commercial clients where we have been able to get the applicable commissions. We have started just like we did in the Americas with the simplest of categories, including duplicates and statements, and as much as possible we are following our global standards as set by our audit and shared services teams in the Americas and India.

We are also launching a second shared service center in northern U.K. to go with our center in Luton. We expect these centers will drive greater standardization and has improved audit results with more recoveries and less paybacks while ensuring better capacity utilization and lowering costs.

Before I transition out of the core business, I would like to provide an update on the expansion of our contract compliance services which increasingly connect our profit recovery and profit optimization services. Historically, our services have focused on recovering overpayments based on analytics, which include matching our clients’ account payable line item data to certain contract pricing provisions. Now we are expanding our addressable market in the contract compliance space by offering a holistic supplier governance and risk mitigation services model. For example, we are performing risk assessments of our client supplier agreements. This allows us to be aligned with our clients’ needs as we are finding more and more companies are launching strategic initiatives to review their supplier base with a specific focus on identifying supplier risks and crafting associated risk mitigation plans. Also, we are reviewing an expanding portfolio of contracts for the purpose of recovering monies. For example, we are reviewing complex licensing agreements on behalf of our clients for the purpose of identifying underpayments of quarterly royalties submitted by the licensees.

Coming back to one of my original points, many of these engagements allow us to seamlessly pull in our profit optimization services due to the need for our clients to review their processes and controls. We continue to invest in our contract compliance services through strategic hires and remain very excited about this growth area.

I am pleased to say that this expansion of our services has led to rapid growth in our pipeline of opportunities. Just since our launch in April, we have signed three clients and have several substantial proposals in process, some of which could be multi-million dollar programs over their lifetime. We also have over a dozen early prospects in our sales funnel. While we do not expect to win all of these opportunities, this rapid pipeline build proves our hypothesis that this expansion is a very natural fit for PRGX.

Our profit optimization services continue to be one of our best growth opportunities and, as mentioned, link very nicely to the contract compliance services expansion, including the fact that these more sophisticated services require more sophisticated analytics. That said and as you are aware, this business includes a combination of shorter term engagements and longer term annuity revenue deals, which are typically analytics heavy.

During the second quarter, we concluded a couple of our larger engagements and so we are in a period of relative weakness as we work to replace those revenue streams. That said, our pipeline in this area has grown about five-fold over the last 12 months, which clearly showcases how much progress we are making in positioning these services at existing clients. As these more discretionary spend engagements are approved by our clients, we believe we will win our fair share and continue to grow PO.

On an earnings call towards the end of last year, I introduced one of our more innovative services, the CIPS Sustainability Index, or CSI. You hence might recall that CSI is our first foray into the data broker or network business model. This service connects buyers with their suppliers via a proprietary online portal, enabling members of the supply chain to share their economic, environmental and social credentials backed by an audit of this information. Following the completion of our strategic alliance agreement with CIPS in December 2012, we launched the UK service during April this year. In the quarter or so of operational activity since then, I am pleased to announce solid progress and continued validation of the growth potential of this business.

First, we already have prominent UK organizations that have agreed to utilize our network, all of which are now live projects. We have made contact with hundreds of their suppliers, some of which are now registered with our online network and are progressing through the subsequent data submission and auditing process. We are focused on delivering a high level of service for these initial buyers and their suppliers and on raising the level of supplier registration compliance.

Our pipeline includes over 50 expressions of interest from midsize to large potential clients across the commercial, retail, and public sectors. These companies represent thousands of new supplier contacts which will start later this year and tens of thousands of potential registrations in future years. It will of course take time to convert supplier engagement to a critical mass of supplier registrations and fully audited data into the network; however, the early adoption rates and pipeline development are encouraging.

Finally, our vision is to develop supplier sustainability data services globally, supported by leading standard setting institutes and enabled by our emerging PRGX online network. To that end, I am pleased to announce the recent extension of our CSI service to Ireland and significant steps forward in progressing an Australia and New Zealand region index and also a North America index being developed in readiness for 2014 launches. I look forward to updating you as this exciting new initiative progresses.

Finally to healthcare. Our healthcare team enjoyed its largest quarterly revenue and EBITDA contribution since the launch of the National Medicare Act Program in 2009. As you are all aware, the program is nearing the end of the term of the current contracts and so we do not believe this level of performance can continue for the remainder of 2013; hence, we expect that our Q3 new services revenue will be lower than Q2’s $10 million contribution. All that said, our performance in healthcare has been very heartening. Our claim selection has stabilized and our process and systems capabilities are improved from even this time last year, and so we have never been more confident about profitably serving this market, even at the low rates required to compete effectively.

We believe that there is a chance that CMS will further extend the transition deadlines that were first communicated in March, and that we will continue to audit under the current contract for longer than we communicated during last quarter’s call. As we wait for the clarifications from CMS, we remain focused on continuously improving our operations and capabilities, on our plans to penetrate the private sector, and on our readiness for the Medicare Part A and B RAP program RFQ. We remain confident that we can win a contract in the new competition, and as incumbent in three of the four current medians that our time to ramp up on the new contract should be amongst the quickest of the current contractors.

In summary, our business is largely back on track. We are managing through our challenges and remain focused on our opportunities. We expect our core business to perform better in the second half of the year. The capabilities fueling our new services continue to gain in maturity, and with the possibility of favorable developments in the CMS RAP program transition comes the possibility that our 2013 financial performance will be better than expected a quarter ago.

That’s the end of my plan update for today. I look forward to answering your questions. I will now turn it back over to Said to help facilitate the Q&A session.

Question and Answer Session

Operator

Thank you sir. [Operator instructions]

Our first question comes from Alex Paris from Barrington Research.

Alex Paris – Barrington Research

Hi guys, good morning.

Romil Bahl

Good morning, Alex.

Alex Paris – Barrington Research

A few questions, many of which you probably don’t know the answer to, but I’ll start with healthcare. I think the general thinking two months ago was that CMS would have a refined or rewritten RFQ out sooner rather than later. When would you expect that new RFQ to be issued?

Romil Bahl

Alex, we continue to expect it drop here in Q3. Some possibility it’s in August, but certainly not much reason for it to slip beyond Q3.

Alex Paris – Barrington Research

Given the fact that the bidders had already submitted their bids to the previous RFQ, one would think that the process once that new refined RFQ lands, would be a quick turnaround. Is that the way you look at it also?

Romil Bahl

Yeah, absolutely. We don’t expect significant reengineering and redesign of the RFQ, and if that’s the case and if the refinements are minimal, we expect a very quick turnaround. I mean, it was a very quick turnaround when it first came out – it was only a few weeks. It could be just one or two weeks this time around, and pending any other pre-award protests we expect a pretty quick decision process as well. One certainly expects post-initial decision protests to happen, but there’s still a chance that we could have an initial decision late in the third quarter, early in the fourth quarter, and certainly comfortably get through protest cycles by December or January and therefore hit February 5 or 6 as 2014 as the first date of the next five years. I think CMS is very focused on that.

Alex Paris – Barrington Research

Okay. To that end, I think given the protest and the delays in the process, there’s already been one extension in terms of initiating new letters to providers. I think that went from May to June, if I’m not mistaken?

Romil Bahl

That’s right, yeah.

Alex Paris – Barrington Research

So as of right now, as of June 30, no new letters are going out? No new claims are being—no more files are being requested, no more claims are being submitted? Is that true?

Romil Bahl

Well, so there’s a difference between requesting additional documentation, what’s often called ADR or additional documentation requests or medical records requests, MRRs, there are no more of those going – you are right – since the end of June. We obviously continue to audit what’s in our pipeline and what’s coming in from the last couple of waves of requests, since the providers have up to 45 days to get us that paperwork.

But your broader point, Alex, is accurate if I’m reading correctly where you’re leaning, which is here we are sitting a full 30 days after that deadline and we’re missing waves, right? So we certainly anticipate being able to do some more as we proceed through the rest of the year.

Alex Paris – Barrington Research

So you just finished saying that new services is going to be less in Q3 than Q2, and that was already my estimate anyway; but is this 30 days that we’re talking about and beyond, is that going to be more impactful on Q4 Medicare-related revenue than Q3?

Romil Bahl

Well, there’s a couple of different dynamics going on. From a straight healthcare perspective, as you know, we had some processing issues and so forth occur in the first quarter and some other—you know, as we start to approach the end of this contract and get more serious about clean-up and so forth, there are some deferrals that helped Q2, right? So even if there had been no change to the waves and so forth, that would have put pressure on Q3 right there. But on top of that, as you point out, the smaller waves, the smaller scope of the waves that were allowed to go, as you recall when the extension of the 30 days happened, we weren’t allowed to submit medical necessity claims, which is 60% of this program’s revenue to date, not just ours but across all the RAPs. So there absolutely has been an impact of what we have been able to do, and that will impact Q3.

And then the final piece in new services of course is PO, which I did mention is in a weaker period. We certainly are working hard to convert our very encouraging pipeline and still upwardly impact Q3, but all of those factors put together explain my comment.

Alex Paris – Barrington Research

Yeah, that makes sense. So we’ll wait and see on that. Obviously there will be more to follow, but in the meantime it looks like the U.S. business is doing much better. You’ve called Q2 the bottom potentially in Europe. What does your acquisition pipeline or appetite look like right now?

Romil Bahl

We remain keenly acquisitive and keenly aware of the cash balance on our books, which is dilutive until we put it to work. There has been a lot of activity these past six months on our M&A pipeline. A couple of those things are sort of—our M&A strategy overall is obviously somewhat dependent on the CMS rebid, and the delays there have not been helpful. But at the same time, we remain committed to trying to close one or two sort of, I’ll call them no-brainer tuck-ins as and when we can.

Alex Paris – Barrington Research

Okay good, that’s helpful. Thank you very much.

Romil Bahl

Thank you, Alex.

Operator

Thank you. Our next question comes from Kevin Liu from B. Riley & Company.

Kevin Liu – B. Riley & Co.

Hi guys. First question here just on the Europe Asia Pac business, there was a comment to the effect that it’s bottoming here in the second quarter. Is that just from a profitability perspective or are you expecting some sequential uptick in the revenue line there as well?

Romil Bahl

Well Kevin, we’re certainly hoping for an uptick on the revenue line. The profitability, to your point, has held up pretty well despite the shrinkage on the top line, and we continue to help that cause with our restructuring activity. Much of that severance item you see on our schedule there is obviously focused in Europe as sort of the brunt of the SBM program moves to Europe for the first time here in 2013, so we certainly continue to do what we know how to do in terms of transforming our service delivery. But our hope is indeed that the top line will get better. Our work in process claims are looking very healthy, sort of too healthy – they need to convert to revenue, and that’s our focus.

Kevin Liu – B. Riley & Co.

And just one more point of clarification there – I think in the script you mentioned that profitability in the back half, or at least for the year potentially, could mirror what you did last year, even on this lower revenue run rate. Just wanted to see if that implied second half would be the same as second half of last year, or if you actually expect to make the same amount of money on an adjusted EBITDA basis for the full year.

Romil Bahl

Yeah, the comment was a full year-type comment, and if you just looked at recovery audit services globally and sort of looked at what our EBITDA dollars were last year, we certainly expect to be very close to that by the time we’re done this year, even if revenue doesn’t quite get back to what revenue was last year just because of the margin improvements we’re driving now on both sides of the pond.

Kevin Liu – B. Riley & Co.

Great. And then turning over to the new services segment, any way to quantify how much of the benefit to Q2 came from the deferrals of the healthcare revenues from Q1?

Romil Bahl

Well, there’s no way to do it without giving you some of the visibility that we’ve resisted doing to date. Bob and I were talking the other day about should we win a contract, and we certainly intend to, it may well be time to sort of start breaking out healthcare. But I’m going to resist answering the question for now, Kevin.

Kevin Liu – B. Riley & Co.

No problem. And then just on the gross margin for new services, obviously at the highest rates we’ve seen. I know part of it isn’t sustainable just from the deferred revenue piece, but what sort of gross margin assumption should we have for new services for the remainder of the year here?

Romil Bahl

Well you know, clearly when a lot of revenue comes in that’s sort of deferred in nature and some of the costs are already accounted for in prior quarters, there’s a bit of an unnatural bump, so I certainly wouldn’t take this quarter’s profitability and project it further. By far, and I’m going to let Bob comment here in a minute on the specifics of your question, I just want to point out that by far the largest driver of new services profitability in the back half of the year is going to be what happens with the transition program from the current contracts, right, because if we’re able to launch a few more waves and keep our team busy for the substantial part of the rest of the year, we will do very well. Otherwise, we’ll probably be carrying a significant sort of team costs until the new contract begins, so really that’s the key driver of profitability for the back half of the year.

Robert Lee

Yeah, I’ll say the same thing. That is it, and by design our new services segment profitability is pretty much mostly related to what’s going on within the healthcare recovery audit segment. Again, that’s by design as we ramp these businesses up, so what happens with the healthcare business will determine entirely the profitability.

Kevin Liu – B. Riley & Co.

Got it. So maybe if I ask it another way – in the past when you’ve had kind of your normalized PO and healthcare run rates, you’ve been running about break-even, maybe a little better on an adjusted EBITDA basis. Is it fair to say, assuming the healthcare business stays relatively stable, that would kind of be your go-forward expectation for the time being?

Romil Bahl

I think that’s true, yeah. I mean, again, if we—

Robert Lee

If we weren’t transitioning healthcare, I think we’d see higher profitability in that sub-segment and the new services segment as a whole.

Kevin Liu – B. Riley & Co.

All right. Thanks for taking my questions.

Operator

Thank you. Again ladies and gentlemen, if you have a question at this time, please press the star then one on your touchtone telephone.

Our next question comes from Tim McHugh from William Blair & Company.

Tim McHugh – William Blair & Co.

Yes, thank you. I guess just one question on the North America revenue. Can you elaborate a little bit more – you talked about commercial picking up here in the second half of the year. What are you seeing there, and how significant of a upward lift are you expecting from that part of the business?

Romil Bahl

So as you know, Tim, commercial has been a nicely growing part of our core business the last few years after we entered it. It still remains small relative to the Americas revenue base, but certainly more significant than the near-zero it was in 2009. The confidence in the second half is related both to a couple of big wins which we hope will turn into revenue in the second half of the year – you know, the data acquisition and orders work is starting, and also based on some delays of audit cycles at a couple of our larger commercial clients that has pushed revenue into the back half of the year.

Tim McHugh – William Blair & Co.

Okay. And what are you seeing competitively on that core business, I guess both within commercial and more broadly? Have you seen any changes out there in the market?

Romil Bahl

I don’t know that there’s been sort of particular changes in the last three months to necessarily talk about, but certainly over the last six and 12 months, we have seen some heightened competitive dynamics. We can sort of guess at some of the reasoning behind that, but certainly the fundamental cause of those dynamics are sort of what PRGX has driven, right? I mean, we have certainly sort of rejuvenated our core business and sort of taken the fight back to the enemy, so to speak, so we are seeing some heightened activity but nothing crazy in the last sort of three months that I could point to.

Tim McHugh – William Blair & Co.

Okay, great. And just the Medicare RAP, just to be clear, at this point—I mean, what are the signs of optimism about the extension for the rest of the year? Is it just the fact that RFQ is not out yet and this deadline has been pushed a few years, or are you actually getting commentary from CMS that gives you confidence it might get—

Romil Bahl

It’s sort of a little bit of both really, Tim. I can’t talk about some of the confidential negotiations ongoing, but it is a little bit of both. Just on the first point and just sort of common sense would suggest, and I think I said this on our last call that we know that our client at CMS is very sensitive to the continuity of the program and the very significant savings the program is driving back into the Medicare trust funds. And so we believe there is already an inherent desire to ensure maximization of the program and the current contract term of five years. The question, I think the big decision is around sort of the transition and the clean-up, right, so should the clean-up and transition happen as a part of that five years, or should it happen sort of after that five years while the next five years providers’ are rocking and rolling on auditing. I think once that decision cleans up, and we clearly have a preference of which way we’d like to see that go, the rest of this becomes pretty easy.

Tim McHugh – William Blair & Co.

And do you have a sense of why the new RFQ is still not out? I guess the expectation was that the protest and the reason for the change was relatively straightforward, and it seems like it’s taking a while to get back out there. I guess you don’t know until you see the full RFQ, but are you expecting more substantial changes to the process, or any sense on that?

Romil Bahl

Yeah, look – if there are more substantial changes, we will be ready for it because even while we’re awaiting the RFQ, we’ve had a couple of sessions to discuss what kinds of dimensions might change and without getting too carried away with the what-if scenarios, just making sure we’re prepared sort of directionally with our thinking based on those changes. But we’re not necessarily expecting significant changes.

We believe the delay of the RFQ has more to do with your earlier question, the last discussion we just had about transition and how to philosophically deal with it, and once that’s clean then the RFQ process becomes very clean because once you say, all right, things are just going to keep going for some period of time on the current five-year term stuff, the new term’s just going to start February 5, then it becomes a very clean and hopefully efficient decision process.

Tim McHugh – William Blair & Co.

Okay, great. Thank you.

Operator

Thank you. Our next question comes from Jeff Mueller from Baird.

Nick Nikitas – Robert W. Baird

This is Nick Nikitas on for Jeff. Just going back to that 3Q European comment for the expected uptick, was that sequential or are we talking year-over-year?

Romil Bahl

I’m sorry – you’re asking if our Q3 projection in EAP is sequential to Q2, or from last year?

Nick Nikitas – Robert W. Baird

Yeah, you mentioned the uptick expected. Is that versus—

Romil Bahl

Yeah, so look, we certainly—our comments are certainly sequentially oriented right now. We’re sitting here on the back of two very weak quarters. I’m not spending a lot of time thinking about the good old days in Q3 last year. If we beat Q3 last year, we’ll take it – trust me. Right now, let’s just get better tomorrow.

Nick Nikitas – Robert W. Baird

Yeah, makes sense. Just wanted to double-check that. And then just looking back at 2Q within that segment, did you see any additional companies within Europe or Asia Pac going into administration? And then on top of that, given the weakness throughout the first half, what kind of gives you confidence that you can see an improvement over the second half of ’13? You mentioned some improvements. Just additional color in general, if you could.

Romil Bahl

Yeah, sure. So first, the good news was no new clients going into administration in Q2, and keep your fingers crossed for us and for our clients that that trend continues. In terms of just color on why we feel better going forward, it sort of breaks out into two or three things. If you’re not losing clients to administration or otherwise, your book of business is pretty solid in this business. Over sort of 12 month-type periods and longer periods, you sort of know what you’re going to find, even though you may not know exactly which quarter the claims are going to come out and get approved by clients or get approved by vendors, and so on and so forth. So the predictability of what we have going forward is solid. Our operations are solid, so in other words what we’re generating kind of on a week-to-week and month-to-month basis, we’re feeling very solid about; and in fact, feeling better about going forward as we continue to do what I was talking about earlier, moving work to more standard, consistent, internal best practice mode, including the use of our shared service centers in Brno, in Luton, hopefully in Manchester soon, and then of course supported by Pune where possible and by our shared service center in Canada, especially with the French-speaking skills for that part of the country.

So a lot more consistency and a lot of stability of the basic sort of audit business that we have going forward, you now couple that with a much larger work in process set of claims than we’ve really ever had since I’ve been here with the business, and over the same time last year, you’re talking somewhere in the 25 to 33% higher in terms of WIP claims right now. So we’re focused, as I said earlier, on converting that work in process claim set to revenue, getting through these difficult and extended negotiations with our vendors. That’s really sort of what we’re factoring in when we talk about our confidence that the second half of the year gets better.

Nick Nikitas – Robert W. Baird

Okay, and then just one last one from me. Looking at the private sector side within the healthcare recovery audit, you talked, I think, about a potential smaller payor hope in the pipeline last quarter. Could you just give an update on the overall business development within that sector, and then talk about maybe the impact of getting a CMS positive RAP decision would have on your role within the private sector.

Romil Bahl

Yeah, so we continue to actually—the smaller private sector payor sort of continues to be out there, continues to be very positive signals. We just haven’t converted to a signed contract. We are starting to ramp each of the three Medicaid wins we have finally with them after many, many delays, and so that will be a small contributor in the back half of the year. And then we have another sort of half dozen or so proposals awaiting decisions out there in terms of what’s out there right now.

We also continue to make progress in terms of being recognizable, invited to more parties, so we talked a little bit on the last quarter’s call about a very large payor that we got into the final rounds of, and that was encouraging and sort of one of those close but not cigar deals, because we didn’t actually win. But we have another one of those coming up, and we’re really going to sharpen our knives as we go after that one, so some continued activity and ramp in healthcare business development, although slow, which leads to the second part of your question.

Will a contract win with the RAP Medicare program help us in our business development needs? I think the answer is absolutely. I cannot tell you sort of how frustrating it has been at times for our healthcare team to have been viewed as some sort of a subcontractor in the RAP program and therefore sort of people not being sure what that means. Does it mean you’re a long-term player? Does it mean you have the breadth of capabilities and all of that sort of thing? I think just the optics alone of being a sort of primary provider will be very helpful as a real call for future business development.

Nick Nikitas – Robert W. Baird

Makes sense. Thanks for taking my questions.

Romil Bahl

Thank you.

Operator

Thank you. Our next question comes from Richard Close from Avondale Partners.

Richard Close – Avondale Partners

Thank you. On the profit optimization side, you had some commentary there. It sounded as though you were saying some of the business was short-term or, I guess maybe more project-based. Can you go over profit optimization for us and really strip out maybe what’s recurring and what is one-time type of revenues or project-based revenues in that business?

Romil Bahl

Yeah, so generically speaking, Richard, the services we offer in this space are sort of either spend optimization oriented, which is both direct and indirect spend, and of course our retail clients call their direct spend, merchandise; data transformation in orientation, which is us taking our core capabilities of cleansing and ETL-ing, if you will, transforming, enriching our data, which we do for our own core business, and taking those capabilities to market for our clients; and then finally sort of a bit of an umbrella of service that we’ve put in a bucket we call profit performance, which can be anything from process improvement-type work to improving liquidity at our clients and improving their cash.

So as you sort of think across that spectrum of services, the latter category is almost all project-based work and falls within that category of can be shorter term, or whether it’s short term or not because that’s somebody’s definition, it comes to a logical end and needs to be resold and people need to be put back to work.

The former two categories can be much longer term, and certainly under the spend umbrella, both our spend tracks tool and our merch tracks tool, when we sell, if you will, those toolkits to our clients, which is really more not selling software but selling reports – quarterly, monthly, weekly updates – those tend to be three-year SAAS-oriented analytics deals with more annuity revenues to it. So that’s sort of the break-up of our services.

Richard Close – Avondale Partners

So when we think of—I think your comment there was the pipeline has grown five-fold in that business, and as we’re modeling this out for years to come now, should we think of the pipeline—or the current pipeline, is it skewed towards the annuity type of business or it is skewed towards the project base?

Romil Bahl

I would have to say that we continue to both execute and recognize revenue, and our pipeline continues to be more in the project-based than in the recurring based businesses. Now obviously that’s something we are working to change, and in fact have changed rather dramatically from about 12 and 18 months ago when we were almost 100% project-based. So we’ve made progress and we’ll continue to make progress, and we’ve love to get to sort of that 50/50 and then better than that over the next 12 to 18 months.

Richard Close – Avondale Partners

Okay. I think you call it the CSI or the data broker network model. What is the market opportunity on that offering? Have you laid that out previously?

Romil Bahl

You know, we haven’t talked about it in a lot of detail. This really is one of these sort of slow-building, network-type models where the average—and it will be supplier funded, right, so the client company, it is the buying companies who are saying, all right, we want this as a service. We want this to help us streamline the 80, 90% of our effort that we spend on 95% of our non-strategic suppliers, take that down significantly so we can spend much more time, maybe 30, 40, 50% of our time on the 5% of truly strategic suppliers. Those sort of client buying companies are driving traffic to this tool, to this portal, and the suppliers are actually paying what is a small per-supplier amount for a year.

The fact is, again, that they will re-sign and be sort of an annuity for—well, forever in theory, and of course as more and more suppliers join, the value proposition for more client companies, buying-side organizations, becomes far more compelling because we can increasingly say to them, hey, 20, 30, and then one day 50, 60, 70% of your suppliers are already on here. It’s a complete no-brainer for you to join this thing.

So it’s a three to five-year build for this to get to significant revenues, and by that I mean 10 to 15% of our revenue base; and yet, good early signs, so something we wanted to talk about.

Richard Close – Avondale Partners

Okay. And just to be sure, that’s all recurring revenue once that gets up and going?

Romil Bahl

Yeah, absolutely. This is the quintessential make money while you sleep model once it’s up and running.

Richard Close – Avondale Partners

Okay, great. Of course I’ll have a couple healthcare questions here as well. So you talked a little bit about confidential negotiations, not going much into that, and I understand the sensitivity around that. As as subcontractor to three regions, in these confidential negotiations are you part of the team in terms of with your prime? You’re sitting the room with them during these confidential negotiations, or are you having separate negotiations with CMS? Just to better understand that process.

Romil Bahl

So look, I’d rather not get into the specifics and details of how all of the negotiations are going on and so forth, but suffice it to say that we feel very good both about the level of information we have and involvement we have, and also our opinions being heard, and really that’s what’s important.

Richard Close – Avondale Partners

Okay. So the people, the providers have 45 days from the end of June, I guess, to get you the records back that you requested up until June 30. How much time, just to be clear, do you have to process the information, the records they come back to you with in that 45-day process? How long do you have to submit the final judgment?

Romil Bahl

So let’s just talk about the current situation specifically. The original deadlines were sort of May end and August 5, which was exactly six months before the original end of the contract term; and then when that moved a month, the claim request deadline moved to the end of June, so about a month, and the initial submission deadline moved from August 5 to September 5. So that’s where we are today, right, so today we’ve got to get these claims in, get them audited, and at least first time submissions or what’s called adjustments by CMS have to be in by sort of September 5, a month and five or six days from now.

Obviously should these extensions happen that we fully expect will happen, both of those deadlines will move back in concert because you do need some time, an extra 30 or 40 days beyond the claim submission or the MRR submission deadline, to actually audit and get those turned around.

Richard Close – Avondale Partners

A final question would be—I guess with the additional document request, those are more complex claims, if I’m correct, and maybe I’m not there; but there’s a lot of automated claims. Does all the timing relate to just the complex or does it include the automated as well?

Romil Bahl

It really is the automated and semi-automated as well, Richard. I mean, it will—yeah. If and when the extensions happen, we should be able to move both automated and sort of semi-automated and complex claims; but again, it remains to be determined what the scope will be, because as I said, the May-end to June-end extension was a partial scope extension. So I would just temper any good news that you hear about these extensions by just making sure you’re digging into what is the scope as well. There is another moving part, just the timeline of extension.

Richard Close – Avondale Partners

I guess my final question would be on the Part A, Part B, there’s been a lot of discussion in and around that in terms of making the rule clear on inpatient, outpatient. Also, there was the notice of proposed rule making on the time, I guess, allotment for the re-bill under Part B. Any thoughts in terms of where we stand on inpatient, outpatient, Part A, Part B re-billing, and medical necessity?

Romil Bahl

Well again, it’s clearly the hot potato du jour, right? It’s probably one of the other factors—not probably, highly likely one of the other factors that has caused delays that have been discussed even on this call, both in terms of the RFQ and in terms of the current contract. So what I would say is we understand the rule today. We understand the intent which is completely logical, which is to say a Part A claim that is a valid Part B claim should be allowed to be re-billed by the provider side. There are chances that there are further modifications to that, which in turn might limit our chances to audit inpatient type, med-nec type claims on any extensions this given year; but I’d rather wait for CMS to give us some guidance before I put more conjecture out there.

Richard Close – Avondale Partners

Okay. Thank you very much for all the answers. I appreciate it.

Romil Bahl

Thank you, Richard, and my apologies to Sam and Greg and others in the pipeline of Q&A ahead of us. We’re obviously well out of time here. I certainly appreciate everybody’s interest and attendance of our call, and we’ll look forward to speaking to you at the next one.

Operator

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

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