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Athena Health Inc (NASDAQ:ATHN)

Q3 2009 Earnings Call

October 30, 2009; 08:00 am ET

Executives

Jonathan Bush - Chief Executive Officer, President & Chairman

Carl Byers - Senior Vice President, Chief Financial Officer & Treasurer

Jennifer Heizer - Senior Manager, Investor Realtions

Analysts

Constantine Davides - JMP Securities

Glenn Garmont - Thinkequity

Richard Close - Jefferies

Anthony Vendetti - Maxim Group

Sandy Draper - Raymond James

Bret Jones - Brean Murray

Michael Cherny - Deutsche Bank

Sean Wieland - Piper Jaffray

Jeremy - William Blair & Company

David Bayer - Cantor Fitzgerald

Dave - Leerink Swann

Doug Simpson - Morgan Stanley

Newton Juhng - BB&T Capital Markets

Leo Carpio - Caris & Company

Charles Rhyee - Oppenheimer & Co

Eric Coldwell - Robert W. Baird

Charles Brady - Citi

Gene Mannheimer - Auriga

Frank Sparacino - First Analysis Corp

Operator

Welcome everyone to the athenahealth third quarter 2009 conference call. As a reminder, today’s call is being recorded. At this time, I would like to turn the call over to Jennifer Heizer, Senior Manager of Investor Relations for athenahealth. Please go ahead, Ms. Heizer.

Jennifer Heizer

Good morning and thank you for joining us. With me on the call today is Jonathan Bush our Chairman and CEO; and Carl Byers, our Chief Financial Officer.

Certain statements contained in this conference call may be considered forward-looking as defined by the Private Securities Litigation Reform Act of 1995. In particular, any statements we make about our expectations for future financial and operational performance or company growth the timing of future events or the benefits of our service offerings.

Forward-looking statements may often be identified with words such as we expect, we anticipate, upcoming or similar indications of future expectations. These statements involve various risks and uncertainties that could cause our actual results to differ materially from those expressed in such forward-looking statements and these include the risks and uncertainties under the heading Risk Factors in our most recent annual report on Form 10-K and other periodic reports filed with the SEC, which are available on our website at www.investors.athenahealth.com and on the SEC’s website.

Investors are cautioned not to place undue reliance on such forward-looking statements, as there is no assurance that the matters contained in such statements will occur. The forward-looking statements we make on today’s call are based on our beliefs and expectations as of today, October 30th, 2009 only. We do not undertake any obligation to revise or update such forward-looking statements.

Finally, please note that on today’s call we will refer to certain non-GAAP financial measures in which we exclude certain non-cash or non-recurring items such as stock based compensation from our non-GAAP financial results. We believe that in order to properly understand our short-term and long-term financial trends, investors may wish to consider the impact of these items as a supplement to financial performance measures determined in accordance with GAAP.

Please refer to yesterday’s press release announcing our third quarter 2009 results available on our website for reconciliation of those non-GAAP performance measures to our GAAP financial results.

With that, I will now turn the call over to Jonathan Bush, who will discuss the highlights of the quarter. Jonathan?

Jonathan Bush

Thank you, Jennifer, good morning everyone. I’m pleased to report that athenahealth performed very well in Q3 of ‘09. I will start our reviewing on the results during that period and then provide additional commentary about product and sales efforts before turning it over to Carl.

In the third quarter, we generated record revenue of $48.7 million, growth of 37% over Q3 of ‘08. We also expanded our profitability to record levels with adjusted gross margin reaching 61% in the third quarter, that’s up 2 points over Q3 of ‘08 and approaching our 2011 target range. Achieving this level of profitability ahead of schedule is the result of exceptional work by our technology and operations teams to increase automation and thereby reduce variable cost.

Adjusted operating income increased by 61% over Q3 of last year, that’s nearly double the rate of our revenue growth. Because we are now applying a full tax rate adjusted net income for only grew 4% of our last year to $0.14 per diluted share.

Our Q3 results were also in terms of our underlying drivers of the long-term success. So our employee engagement remained high at 4.0 out of 5 using the framework I have described in the prior calls. When we think about our cultures the most important thing we have for retaining key talent and so this engagement level is a key strategic asset.

Second, client days in accounts receivable improved to a record 39.3 days during Q3 that’s an improvement in 16% or 7.5 days year-over-year. Our business model is designed to get smarter and more effective as we grow and this results show that it is still working.

Third, client satisfaction was strong at 86.4 in the quarter; this is 4 points better than the same sample sets last sampling in Q1. Our client operations overhaul will be working very well and the metrics we used to evaluate this area are improving accordingly.

Having covered the results I want to spend a few minutes updating you on product development and sales efforts. First, on the product front, we completed our acquisition of Anodyne Health Partners earlier this month. Anodyne’s business intelligence services used by leading physician organizations to better understand the revenues cycle operations. By improving visibility in the legacy software systems, and assessing financial and operational performance, Anodyne gives us an ideal form to educate decision makers.

About the benefits of our core service; anodyne’s client base represents more than 14,000 providers and it is expanding rapidly, given its low cost, easy install and high value. It is a perfect example of the kind of “light offering” that we are seeking in order to expand market share.

At anodyne’s medical group’s now, our clients offer us a compelling cross sell opportunities. As Mike Funk, Anodyne’s President put, ‘it’s like stepping up to bat already knowing what the pitch would be’ in fact Danbury Office of Physician Services, the 250 provider organization recently we signed on the collective, used Anodyne as a key resource in determining the value that we would have.

Carl will discuss the financial impact of the acquisition and its integration. Secondly, we completed the roll out of the new user experience to our entire client base, this was significant and we mentioned in the last call, because it involved changing the core work flow of all of our clients.

All of our clients now use the same five stage encounter, which better aligns GAAP with specific tasks, enables our rules engine to fire throughout patient workflow and improves our ability to monitor and optimize performance overtime. The success of this rollout is a testament to the power of uniting all clients on one web native application.

Whenever we release new functionality to our growing base of clients, we are sort of conducting the largest simultaneous technology implementation in healthcare IT, or immediate 100% adoption disability to keep pace with change in an industry characterized by evolving standards continues to differentiate athenahealth.

Third, we have moved to virtual implementations for all small practices on athenahealth Clinicals, this is an important first step in improving the scalability of our implementation function, a project which will take the bulk of 2010 to complete, and what’s more, this improvement enabled us to make adoptions that much easier by allowed us to cut cost with clinical implementation for small practices by over 50%, it used to be 6,500 hours and now it’s as low as $3000 for a solo physician. This is an important step for the ultimate goal of bringing the cost of joining this network to zero.

Finally, before we get to sales, I’m ecstatic to announce that on October 21, athenahealth was notified that we all received our first patent, it’s called practice, management and billing automation system, and it’s for the athena net rules engine. We’ve often highlighted our ability to reverse engineer, quantify and drive payer intelligence in the client work flow as a source of key competitive advantage. This differentiation is always been value to us, but it’s always been defended by superior execution, starting on November 10, when the patent issues we will also have a strong legal basis for defending this advantage.

In sales, increasing physician awareness of athenahealth and of software enabled services in general remains our biggest opportunity for growth. To adjust this, we took a significant step. We offered the industry’s most meaningful guarantee for high-tech dollars. We sent out a clear message we are not in the business of selling software that has passed the test, we are in the business of getting physicians paid, this is a start contrast to every other guarantee that we’ve heard about and is early evidence that the market is responding favorably.

This guarantee is one of many steps that we’re taking to drive awareness. We are pursuing relevant industry certifications, sharing our insights our insight on healthcare and with key policymakers. We are contacting all known regional extension centers to educate them about our network. We are continuing to collaborate with channel partners like, PSS World Medical.

During the third quarter, we launched the bulk of a broad multi channel awareness campaign covering print publications so rather, regional flier campaigns, PR and a host of different advertising placements. Such initiatives drove leading activity to an all time high in September, with total responses and lead up significantly over last year.

These efforts to expand awareness are leading to a new business in all three of our market segments, in that regard I’m pleased to announce within the third quarter we signed regional health, a 100 medical provider network to collector AN Clinical. Lead Providers make up the largest physician networking in South Dakota and are among the first to take advantage of our new federal stimulus guarantee program. And in athena we expect to become routine over time, they are leading a software based EMR that they have only had for three years to do so.

Regional Health children’s last quarter was a deal involving both collector and clinical right up front. On the Q2 call I said that we would share information about overall tax rate. We reviewed the data and found that a year ago; just 10% of deals were both collector and clincials up front.

Today, clinicals, the tax rate has increased to more than 30%, because both small and large top practices profit from adoption of athenaClinicals will represent a future for EHR adoption, that it now depends on hospital or government subsidy for success. This is a fact which both our physician client and hospital clients find reassuring.

In terms of our sales force, we added five carrying reps in Q3, bringing the total sales force, including cross sell to 48. This is 37% more than we had in Q3 of 2008. Our plan of course is to continue adding to all aspects of our growth infrastructure as fast as awareness and demand it will allow.

Before I hand it over to Carl, let me offer some perspective on athenahealth in the context of the broader direction of industry. At athenahealth we aim to build a national infrastructure that can help make healthcare work as it should. Our role in that is using the internet to combine software, knowledge and work so that systemic improvement of healthcare delivery is a profitable thing for doctors.

Therefore unlike others who focus primarily on the temporary boost that the high-tech provide, athenahealth is focused on the long term economics of modernizing physician practice. Product development at Athena is always focused on making us the best in the world at getting doctors paid for doing the right thing.

2009, marks the first time that we have felt this statement to be true with athenaClinicals. Furthermore, we believe it is only true at athenaClinicals and in the calls ahead we will begin the process of proving that point as we already have with the revenue cycle. With these strikes in place our strategy is clear, expand awareness, develop new channels of growth, make implementation more efficient and affordable, and expand our sales.

Carl, will now walk you through our financial, after which we will be happy to take your questions.

Carl Byers

Thank you, Jonathan. In the third quarter we achieved significant year-over-year revenue growth of 37%, this was our 39 consecutive quarter of revenue growth and we look forward next quarter to celebrating our 40, 10 straight years of sequential quarterly revenue growth, a trend we believe we will continue far into the future.

This revenue result was supported by expansion within our client base and improvements in client performance, including low client base they are as Jonathan mentioned. In the third quarter of 2009, we selected and recorded receipt of $1.2 billion of our client’s cash, up 31% from Q3 of 2008 and up 1% from Q2 of this year.

Collections follow a seasonal pattern of this lowest sequential growth was in line with our expectations. Year-over-year, collections per physician were up 5.9%, the highest rate of annual growth in that metric in two years and business services revenue per position was also up strongly at 11.2% year-over-year.

This quarter marks the anniversary of the go live Per MinuteClinic, whose active beginning in the latter part of Q3 of 2008. Per quarter while, firming the industry have reported lower physician office activity we have maintained that our data show relatively steady activity. It remains the case that year-over-year same store analysis shows no significant change, and the revenue result per physician in the third quarter is a helpful sign that a shift from flat activity to elevated activity might return.

There was certainly a lot of focus nationally on the full this year as well and AthenaNet represents one of the best real time sources for data on this diagnosis. Notably, on a same-store basis in the third quarter the diagnosis of flu was up 27 times over the same period last year.

Also of note flu diagnoses best store in October already exceed the number of diagnoses made during the entire third quarter. Certainly these data suggests much higher activity regarding the flu which probably relates both to the rate of incidents and patient behavior. We will continue to monitor this information and share any relevant observations over time.

In addition to revenue performance for existing clients, our revenue growth was also driven by growth in the size of our client base. The number of physicians actively using our services increased by 1244 sequentially, to 14,835 in the third quarter of 2009. Total providers which include physicians and non-physicians providers increased by 1,777 in the quarter to 22,100. This was our second strongest quarter ever for provider ads.

While this metric can be lumpy quarter to quarter our growth drivers indicate a very strong trajectory, which gives us confidence in our growth commitments. Notable go-lives in Q3 included university hospitals in Ohio and target within 31 sites across Minnesota and Maryland. I’m also pleased to report that Caritas Christi went live in Mass on October 1st as originally projected.

Total providers on athenaClinicals increased by 227 in the quarter to 1270, of this total 780 were physicians. This was our largest quarter for physician go-lives on athenaClinicals with a 156 ads in the quarter. This equates to a clinicals adoption rate of 5.3% in terms of total physicians up from 3.3% in Q3 of 2008 and up from 4.6% in Q2 of 2009.

The athenaClinicals adoption rate among providers was nearly 6% in the quarter. We are confident in our ability to maintain, if not accelerate, expansion of our client base as we go to market with new strategies like the anodyne light BI platform in our high-tech act guarantee program. We’re also confident in our scalability as evidenced by the additional progress we made on automation in the third quarter.

Our adjusted gross margin reached 61% up two points over the last year, and at the threshold of our 2011 target range. One key variable margin driver is automation as illustrated by our electronic remittance advice rate or ERA rate. This measures the degree to which we have automated the processing of information about payments.

Our ERA rate came in at a record 64.2% in Q3, up on almost 12 points from 52.3% in Q3 of 2008, and up nearly 6 points sequentially from 58.5% in Q2. While we continue to invest in growth and innovation, our adjusted EBITDA and adjusted operating income expanded year-over-year at a much faster pace than revenue did.

Our adjusted EBITDA margin was 19.4% in the third quarter an increase of 210 basis points over Q3 of 2008. Adjusted operating income was 15.1% of revenue in the quarter, up 220 basis points over Q3 of 2008.

While our adjusted net income now includes the impact of a full tax rate. It increased by 4% year-over-year with adjusted net income for diluted share of $0.14 which was flat compared to Q3 of ‘08. As we mentioned within our earnings release, we expect that for the balance of 2009, our growth and margin momentum is likely to drive meaningful year-over-year bottom line progress.

Turning to the balance sheet, the company’s cash and investments remain liquid and secured. We ended the quarter with cash, cash equivalents in short term investments of $104.6 million, up from $78.5 million from over a year ago.

Our debt in the period increased to $12.1 million, so cash minus debt was $92.5 million, up from $70 million in Q3 of last year and up from $84.8 million in Q2 of this year. This cash balance will be drawn down in Q4 by the Anodyne Health acquisition which closed on October 16 and triggered a cash payment of $30 million of which $7.7 million went into escrow related to earn out targets.

Now, I would like to address a few accounting points in regard to our guarantee program and the financial impact of the Anodyne acquisition. When we launched the guarantee program we indicated these service warranties would likely result in an immediate liability for the company at the time each physician signs up. After a further review because of our high level of readiness to fulfill these commitments, we believe the probability of an actual financial consequence to the company to be currently very low.

As a result, we have not booked anything to-date related to the program even though a significant number of warranties were issued in the third quarter. We will monitor the likelihood of an obligation and we will account for that when and if we determine that it is appropriate. In doing so, we will continue to consult with outside experts and/or audit firm to ensure that any obligation is handled appropriately should it arise.

Turning to Anodyne I would like to provide some additional detail around how the acquisition of this business will impact our financials during 2009 and beyond. At the time of the announcement we do expect transaction related cost of about $0.03 per diluted share during 2009, and in Q3 we had about $650,000 of such expense or approximately $0.02 per diluted share.

During the fourth quarter the remainder of these costs are likely to hit and we will also see the beginning of amortized purchase intangibles related to the Anodyne acquisition that begin to impact our GAAP results. This amortization will be approximately one penny per quarter.

While we do not provide specific short term earnings guidance we do expect that this amortization expense in combination with other investments in this business that we plan to make during 2010 will have a mildly diluted impact or a bottom line next year and we’ll turn accretive in 2011.

We will continue to exclude transaction related cost in amortization of purchased intangibles from our non-GAAP adjusted financials. And we will update you on our progress ramping up Anodyne’s business over time.

Even with these investments in mind we maintain our confidence in our 2011 target model and we’ll provide more details on progression towards those goals during our second annual investor summit, which is scheduled for December 3rd at our headquarters here in Watertown, Massachusetts.

With that, we would be happy to take your questions.

Question-And-Answer Session

Operator

(Operator Instructions) Your first question comes from Constantine Davides - JMP Securities.

Constantine Davides - JMP Securities

Just wondering on the enterprise agreements you have signed and disclosed, I’m just wondering what’s out there that you haven’t announced, it sounds like Christi is coming on board or came on board October 1. What’s out there that’s been announced that hasn’t come on board and what’s the expectation around timing of those GoLive?

Carl Byers

Constantine, this is Carl. I can address that. With our announcement this morning of the regional health’s deal there are a few important deals that are lined up that really provide anchors in each quarter for doc ads going forward.

So the fourth quarter as I just mentioned, Caritas Christi went live, all of Caritas Christi went live on October 1. Cook Children’s is slated for the first quarter of next year, and we do not have specific GoLive dates yet for Danbury or Regional, but given the typical timeframe for that type of account, you would expect them on average to be going live in the second quarter.

So I think what these deals do is give some significant visibility on doc ads in terms of providing a foundation for each quarter to support the type of doc ads that are needed to bring about growth commitments that we’ve made and that we expect of ourselves.

Constantine Davides - JMP Securities

Okay, and then it looks like pretty strong progress on the clinicals front. Can you just give us a sense for maybe what a realistic expectation is for Clinicals across, so maybe in 2010 and Jonathan are you seeing any indication that Clinicals light offering is starting to translate into full clinical sales at this point?

Jonathan Bush

Constantine, do you mean the Anodyne offering, because that’s not clinical.

Constantine Davides - JMP Securities

I mean I am sorry, the five stage workflow that you have lit up for your clients?

Jonathan Bush

I see. So I don’t know whether it’s the government guarantee or just the government noise or if it was the five stage visit or if it was the factor that our own sales force has gotten out of their cautious toe in the water stage which they are always in before they kind of really start to stand behind something we do.

Anyway, it’s one of those things because it’s happening in a lot of volume and we are up against our capacity with implementation. So, we will be investing heavily in making the implementation process more scalable in order to be able to grow even more there.

Carl Byers

Constantine, this is Carl. One other point to add there is, I was talking about these anchor deals driving provider as going forward. It’s notable that two of the four deals that I mentioned are both athenaCollector and athenaClinicals.

So, in addition to what Jonathan is talking about which is really expanded confidence and interest levels both on the supply and the demand side for clinicals throughout the market segments we reserve those larger clients also provide a significant foundation, and some of our existing clients also given their shifts toward clinical strategy also provide tremendous opportunity to drive that number.

Operator

Your next question comes from Glenn Garmont - Thinkequity.

Glenn Garmont - Thinkequity

Just two quick questions; first Jonathan, on the virtual implementation that you talked about on the clinical side and the dramatic reduction in the associated cost for the doctor. I am wondering from the docs perspective can you give a little more detail on what that implementation looks like or what it is about the process that’s changed and then, secondarily, the five sales ads in the quarter, are they focused, are they going to be focusing on sort of the enterprise segment or what specific market segment are they going to be focused on? Thanks.

Jonathan Bush

Let me get the first part and then you might have to turn me up again on the second part of your question. The implementation of Clinicals is now happening in small overlap through five and sometimes ten doc groups, where you have your implementation specialist on the phone here at headquarters, and there is set of kind of screens that look a lot like an elaborate sort of TurboTax application on the web.

Each screen asks you a bunch of questions and ask you to watch a bunch of videos, and you move through the setup of the practice. That replaces the person going up there with a roller bag and setting up shop at Marriott courtyard and they are doing it on the ground.

The same is now becoming true of Clinicals, and again it’s happening exactly the same way that of the same developers are sort of getting the band bag together, getting the white toast of the chicken and starting to do the overhaul, the re-factoring of the application and of the training videos and of everything necessary to make it happen that way and we are starting with solo practices and we’ll start creeping up through the entire implementation process.

The overall idea behind all of this is that software should be dead and we still have to look a little bit like software, but as we refine this network and get it smarter and get it to know more about you before you start, there is less setting up of it and tuning of it that you need to do. Now, what was your second part of your question.

Glenn Garmont - Thinkequity

Yes, that’s helpful, and I was just asking about you mentioned that you added five sales reps in the quarter, I was just curious specifically what market segments they are going to be targeting?

Carl Byers

Glenn, this is Carl. I can give you some of those details. In the group practice segment we went from to 17 to 18 going from Q2 to Q3, in the small practice segment we went from 17 to 20. Enterprise stayed even at five and the cross sell team went from 4 to 5.

Operator

Your next question comes from Richard Close - Jefferies.

Richard Close - Jefferies

If you could just go over that tax rate data that you gave and explain that a little bit more?

Jonathan Bush

Well, I will start at the high level and try not to use any numbers which confuse me sometimes, Richard. A third of everything we sold on collector in this last quarter, included, they said, ‘look, I want Clinicals too.’ So the contract included both services.

If you went back a year, only 10% of it, and if you look back two years, none, so that’s the basic trend line, and we certainly believe that by the end of next year it would be rare that somebody is signing up with both, and then we’ve got this idea that we’re kind of cooking away on called athenaOne where you could get collector clinicals and athenaCommunicator all in one fully wrapped thing for a fraction of the cost on implementation of getting each one sold separately, kind of like the maple syrup at Costco.

Richard Close - Jefferies

So the ones, their buying collector, they are not just looking at Clinicals they are actually signing on for Clinicals, are they being implemented at the same time?

Jonathan Bush

That’s the second wave of it and that is earlier in its maturity, but yes, it is starting to happen as well. It is not the case that 30% of all Collector GoLive now have the Clinicals going live at the same time.

We are still doing a lot of them in two waves. So you go live on Collector get used to it and then we flip up Clinicals, but part of the refactoring with the implementation will be to make it so that a 100% of those implementations that people buy both, they get both at the same time. That’s a work in progress, and we can do it but it’s not a natural stroke quite yet.

Richard Close - Jefferies

And then Carl, if you could go over the guarantee a little bit, in a little bit more detail talking about you haven’t had to book any of the expense yet associated with the potential liability, just over that for us, and should, on a go forward basis, that we not to expect you guys to book the expense or?

Carl Byers

I would be happy to address that Richard. When we announced this program we were very sensitive to the fact that unlike other people turning around the word guarantee, that we were willing to stand behind our service commitments to our clients with something that is meaningful. So it’s sort of a meaningful use guarantee. And so, we wanted to be very careful about that. We consulted with literally a member of the emerging issues task force who wrote the book called Revenue Recognition that everyone reads.

Jonathan Bush

It’s a great read by the way.

Carl Byers

It’s a very light thing provided you read, and so that was the basis for our thinking about this and it’s an ongoing discussion both with experts and our audit firm to talk about it. But if you go back to that announcement, you will remember that we basically were telling folks that of course we’re not going to actually end up showing out money here, because we’re so ready and our network is designed, our software programming is designed to make sure we can fulfill these types of requests.

We’ve had [CCHED], we’ve had NPI, we’ve had HIPAA, we’ll take on ICD-10 when it comes, and so we’re really good at meeting whatever requirements are needed, our ability to immediately adopt new software as needed as stands alone in the industry. Every time we do an implementation of athenaNet it becomes a new largest simultaneous implementation of software ever in our space.

So, we feel very confident in our ability to fulfill it, and so, I think the accounting question I raised is, if you don’t really think you have an obligation that will be fulfilled, should you really be putting that on your balance sheet, and so, really it’s a matter of monitoring both our readiness and the requirements as they evolve, and if at some point we think there is a significant probability of an obligation, we’ll account for it at that time, but until that time essentially if our readiness exceeds the expected requirements then there shouldn’t be any to account for that in the significant way on the balance sheet.

Richard Close - Jefferies

Okay, and just one final question on the acquisition. I guess some people may think that you had to go out and buy these guys just to be successful or more competitive in the enterprise market, how would you respond to such an accusation?

Carl Byers

Well, it’s not the most damning accusation in the history of accusations, but because more growth is always good, right? I think what this represents is the first of a set of initiatives that we would call light initiatives. Ways to take a low cost, high value product to get awareness up and to start a conversation with physicians who can be enticed into our core services.

As Jonathan mentioned, in the case of Danbury, they literally used this tool, because they happen to have it, to assess the potential on athenaNet. And so, we’ve seen real examples of it in action.

Jonathan Bush

Anybody who is going to accuse us of being insecure about the fact that most doctors have never heard of us is spot on.

We’re frantically insecure about the fact that 88% of doctors have never heard of us, and if we can buy a company that has thousands and thousands of doctors, and certainly haven’t heard of us, and if the cost of that business relationship is a fraction of the cost of acquiring a Collector account, we are all about it, we absolutely will do it. So we would never view ourselves as in such a weak position that we need to do kind of a rollup of billing services that would be some sort of being standing on a cliff, I would be so depressed if we ever did that.

I think that Buying is a little portal type BI tool and other little portals that lots of doctors use, and at least they know the name of the portal. That’s a huge obstacle for us and if we can buy away into that thing and have a neat enhancement in this case, a real unique enhancement to our reporting, athenaNet does incredible reporting as long as you want a report on athenaNet, but if you want to report on legacy systems that you also have we just don’t play there, whereas Anodyne has got a team of incredible black belts down in Georgia that can go in with [Miners Lamps] and connect One System they are to athenaNet.

They are at present an integrated dashboard of the two, that’s just incredible stuff that we don’t have and it would take us 5-10 years to build to their caliber. So we get both, but we certainly are guilty of wooing about getting awareness level up as we said in pretty much every script have read to you guys.

Operator

Your next question comes from Anthony Vendetti - Maxim Group.

Anthony Vendetti - Maxim Group

Just to focus a little more on Anodyne. I know the deal closed the 16 of this month, so it might be a little early to say how the cross selling is going, but I’m sure you were putting into plate some procedures to go ahead and do that or practices to do that. How are you going to go about doing that? What are you going to do to try to sign those particular 14,000 physicians up, and how long do you think that will take?

Jonathan Bush

Well, my goal is to have met all of them by 2010, and in other words there are 90 accounts that are Anodyne accounts, 14,000 or 15,000 docs represent it. We have been in there and had a conversation with all 90 of them. We’ve got very conservative cross sell, hopes rose sales in our earn out and our sort of core expectations, but obviously we are dying to be pleasantly surprised there.

Similarly, on the growth of Anodyne itself, Michael Funk is a selling machine there, incredibly good at marketing. Just a little anecdote for you, at the last AMGA meetings, we set up these elaborate cocktail parties, really beautiful and marketed way in advance, and we would get eleven prospects, and people would come and we would even see customers of ours coming down the hall, and they go, ‘oh hey here is the customer coming for old home week to hang out with you Athena people,’ and they say, ‘Oh hi. Yes, can you tell me how to get to the Anodyne meeting,’ and Anodyne would be down the hall with next to no fanciness in hundreds of people.

So, CFOs and Executive staff of these large clinics just love this thing, and we are a little scary and heavy to be considering. So, I think they are very good at what they do and we expect for them to continue to grow as fast or faster than us on their base of 14,000 docs, and then of course we will hopefully start to learn more about how many of them can then step up to Collector.

Anthony Vendetti - Maxim Group

Are they going to be kept in terms of the BI that you are getting from Anodyne, are you going to try to incorporate that into Collector or is it really going to be sold as an add on?

Jonathan Bush

Well, they have a lot of really neat functionality and user experience that we may add to Collector. But certainly the core BI tool and the full service that they wrap around it, they are very much a software enabled service. This isn’t like Cognos where somebody shows up and implements it and that’s you buy the license.

This is an ongoing software enabled service where an analyst that knows your practice well follows you using the Anodyne tool, just perfect match with our model, and those guys are great kind of a lead force for our sales guys. So does that answer your question.

Anthony Vendetti - Maxim Group

Yes, just lastly on the stimulus dollars. Obviously, there is some practices that are still waiting, I know you mentioned steady, I think you mentioned steady demand, maybe even seeing accelerating demand, but are there still some practices that you are seeing that are saying ‘hey, I still want to slowdown here, and wait until meaningful use comes in,’ or are they saying ‘at this point I’m comfortable with the guarantee you have and if I’m contemplating a purchase.’ I’m not going to be slowed down by waiting for the meaningful use at this point?

Jonathan Bush

Well obviously, there may be twice as much demand for us waiting in the wings that we don’t know about, but we are certainly seeing enough demand, we are not feeling like we need to explain a debit in demand and use hijack or not hijack to do that. Now, we are a small group sales force and as big as it will be next year and the year after, and so, we can really just take the look from that giant audience of 185,000 and 200,000 different medical practices that are in our small group segment.

That being said, I should mention in the group practice segment particularly specialties that include primary care, a lot of them are looking to the hospital to buy them out and guarantee their salaries going into this period. Its wave three of something I was going to say I’ve never seen it before, it’s something I have seen twice before.

Once with the PBMs and then again with the sort of PBM clinicization of the hospitals where they all put together MSOs in the mid ‘90s, and then each time they got to this huge roll up and they thought it would be different and then had a huge breakup, and we are now entering the roll up phase of that again, this time the enabler is at the CIO, the hospital buys a great huge copy of some EMR, and says don’t worry doctor we’ll guarantee your base and we’ll eat the cost of this huge EMR installation, because I think I know how this ends.

It has made for a great improvement in our enterprise, I mean our enterprise groups keeps growing frantically, I mean just huge, and I think that a lot of that is because hospitals are finding themselves in a position where they may have to buy up lots and lots of doctors and then deal with that. But in the group practice segment, particularly primary care, we are seeing a freezing, it’s not so much about waiting for the hi-tech act, it’s sort of waiting to see whether the hospitals are going to guarantee their salary or whether they’re going to buy them one or whether the hospital is going to just buy them out completely.

Luckily, inside of our group segment, the sales force can just move to the smaller hospitals that are doing the buying, and there is plenty for them to do, but there is that going on just for you own sort of database.

Operator

Your next question comes from Sandy Draper - Raymond James.

Sandy Draper - Raymond James

First, a question for Carl. Thinking about modeling the adoption of Clinicals, because that’s picking up, when I think about it is, and basically if you take an average percent, 6% weight for Collector and you add 2%, is it reasonable to think about sort of just an incremental 25% to 30% growth and revenue for practice for each of those that’s adopting Clinicals, and is that one way to think about it or would that be way off if I’m going in that direction?

Jonathan Bush

Well, we tend to think of it in more like a 50% increase. There are some variances around that obviously. There are definitely some situations where we’ve gotten much more than 50% for the Clinical’s piece, but there are also some where we have been less, but in general our thinking is roughly 50%.

Sandy Draper - Raymond James

Then just two quick financial follow ups on the increased amortization from Anodyne, will that go from D&A or is that up in direct operating costs?

Carl Byers

It’s just intangibles when they amortized have to hit direct, and so that’s where they would go, and as we have indicated we would back those out of our pro forma numbers.

Sandy Draper - Raymond James

Then the final question is, you’ve seen just generally D&A growing sort of moderately each quarter. Is that a trend that we would expect to continue at some point, does that level out relative to what your CapEx expenses are or what do you think sort of the general trend we should be thinking about for D&A?

Carl Byers

Well, if you tie back to our original kind of target model from the IPO, we talked about CapEx in the 5% or 6% of revenue range. We’ve been below that even just in this third quarter was 4.5%.

So, we don’t really see a significant shift overall in our thinking about that, that being said the sequential increase relates in part to our clinical development work, because it’s in the building mode that is still capitalized and amortized, and so that’s one of the reasons for that sequential up tick.

That being said, if you keep an eye on our CapEx and capital software development, it gives you an indicator of where things should settle and it’s not out of range from what we have talked about.

Operator

Your next question comes from Bret Jones - Brean Murray.

Bret Jones - Brean Murray

When we talk about, when you guys were talking about the virtual implementations for Clinicals, I was wondering if you could give a sense of when you expect the virtual implementations to catch up to their collector side and if you can kind of talk about the commentary Jonathan made about ramping up cost significantly to boost your capacity on EMR side, since you are bumping up against your capacity now?

Jonathan Bush

Well, we certainly have ramped up the implementation for us dramatically. It’s inside of the improvements that we’re making elsewhere in the company, so we don’t, unlike the overhaul of client services that we spoke to you about last year we don’t think we need to tell you guys to give us some room in our gross margin progression to get the work done.

There is a huge amount of technical work that will go into it. A lot of our dev capacity, development capacity will go into it and the goal is to have a fully refractored implementation process completed by the end of 2010. It’s a very ambitious set of projects that we’ve got in mind for it, but we think we can get them all done by then and we really need to.

Bret Jones - Brean Murray

So you feel in vision having to add capacity and actually having to come off of your 2011 targets then because of the EMR demand?

Jonathan Bush

No, no.

Bret Jones - Brean Murray

In terms of the ERA rate and why such a dramatic ramp there, I guess what are the limiting factors, are they within the physician office side, on the payer side or is it more automation on year end that really drives where that rate can go and how quickly?

Carl Byers

This is Carl. I’ll start and Jonathan maybe can expand on it in terms of the operating strategy. But ERA has been an area of focus for us, because it has a tremendous cash yield by eliminating variable cost, and that’s a number that we have pushed up as a company by expanding the number of payers who are connected to and then secondly increasing what we call the yield which is the percentage of our docs were properly signed up and transacting through that channel.

As you have indicated, that rate has improved substantially, go back to Q1 of ‘07, we had 28.5% ERA, Q3 of this year 64.2%, and it continues to ramp. So it has had a tremendous impact on our level of automation which helps not just our cost, but also our cycle times in terms of payments, some of the quality measures we look at, and so, it’s been a tremendous boon for us financially and in other ways.

In terms of what the natural limit of that, in the past we’ve said that when you get above say 75% to 80%, maybe you can increase the rate from there, but you would be looking at really small payers where maybe it doesn’t pay to do so. So, that’s kind of the feeling we are shooting toward.

Bret Jones - Brean Murray

With the jump in ERA in this quarter, should we expect the DAR to really be impacted next quarter?

Carl Byers

Well, the DAR has continued to decline and we had our first quarter ever in Q3 with the average days in AR below 40, which is a tremendous result. Keeping in mind that our client base includes large urban hospitals and orthopods who are billing the lawyers because of motor vehicle accidents, and so the average halls of specialties we serve, actually the median DAR is below that number.

So, what the company really does is on track with its mission of being the best in the world of getting doctors paid, that number also can continue to fall, but it’s not driven just by ERA, it’s driven by a much larger set of factors.

Jonathan Bush

Yes, actually the largest driver of DAR improvement during this past year was the overhaul of the claim services area where we were able to get aggressive with the 18 accounts that has the hardest time staffing themselves and running themselves, only 18 accounts affected several of the total company days in AR, and there is a lot of those kinds of projects in addition to the automation and the intelligence factor.

Carl Byers

This is Carl. One of the data point I want to get out there because lot of people tracked us is what we call the first tax resolution rate, and in the third quarter it was 92.5%, so that’s the percentage of claims resolved on the first attempt. That was up sequentially about 20 basis points, and year-over-year up about a 140 basis points. So that was a very nice result to see, and obviously if you are resolving things in the first attempt, you are not just cutting cycle time on resolution and payment, you are also eliminating the variable cost associated with fighting a denial.

Bret Jones - Brean Murray

Then the last question, when you talked about, Carl I think you mentioned Cook should go live in Q1, should that also be EMR as well as Collector?

Carl Byers

In terms of, it is in the EMR deal along with Collector. In terms of with specific logistics of what goes live first, I think there might be a slight gap between Collector and Clinicals, but not too big of a gap.

Operator

Your next question comes from Michael Cherny - Deutsche Bank.

Michael Cherny - Deutsche Bank

I actually have one kind of quick housekeeping one. Well, no one on this call I think wants to see Carl leave, is there any update just kind of to see transition process, especially ahead of the Investor’s Summit in December?

Jonathan Bush

Yes, I don’t want to see it either, but anyway it is what it is, something about Chile. We have now started to meet candidates that I can get excited about, and I would say within the next month we’ll probably know what we are going to do. So, I think we are on track to have it all ready for you by the investor summit on December 3rd, I just don’t want to count any chickens quite yet.

Operator

Your next question comes from Sean Wieland - Piper Jaffray.

Sean Wieland - Piper Jaffray

When does a doc count light up and what do you need to do to make that happen?

Jonathan Bush

We both just pointed at each other. I think that it’s lit up. I think the only problem with doc count it’s lumpy, right. So especially when you have such a large percentage of our growth shifting from group practice to enterprise as a result of the factors I described earlier on this call, you end up with people that have one, will have a 10 month implementation and they will have a 12, and the other will have an 8 until you have it.

I think back in Q3 of ‘08 we had a massively skewing provider add month where it was just enormous, and if you would have drawn that line we’d be growing at 80% a year or it would have been 40% a year, and then it had to come back into the trough, and so, actually I don’t really know whether it’s going to light up any difference than it already does. If you pull your lens back, fine, you will see that revenue is on Collector and provider is on Collector, are kind of rolling on already 30% a year.

Carl Byers

Sean, this is Carl. Just to add to that, I think what we’ve always said is, we know how to grow the company in a linear fashion, and so we know how to go get the lease that lead to the deals, that lead to the docs, that lead to the growth and I think we’ve shown a track record of doing that and we feel very comfortable with our ability to continue doing that given all of the drivers we see.

We occasionally see glimpses of the non-linear growth that we all would love to see as well. And our efforts related to virtual implementation to the product design of moving toward athenaOne over time to the light initiatives that we’ve discussed.

Those, we think all hey in the day. The doctors say, ‘Well, of course I am not going to shell out 50 grand out of my checking account for software,’ and no one does that anymore. You go to the cloud and you get your work done. So, Athena couldn’t be better positioned. If that base is coming for anybody, it’s coming for Athena and we’re all building our architecture and our business to make that happen.

That being said, if you pan back and look at our favorite financial news paychecks, they just spent 30 years transforming the industry from do it yourself payroll to where they are today, and if you discounted from today back to where they were way back then, they were undervalued way back then, and so, even accelerated linear growth leads to a tremendous investment return, but we sure would love to see the non-linear as well.

Operator

Your next question comes from Corey Tobin - William Blair & Company.

Jeremy - William Blair & Company

I guess to follow on Sean’s question, I know the growth in the incremental number of doctors, more of a second derivative metric in terms of the growth rate of your business. I’m just trying to get a sense for what you believe in terms of that number you need to generate kind of to meet your growth expectations. Do you need to generate incremental growth in the number of physicians on a year-over-year basis? I know in any given quarter its lump, but I guess more of like a fourth quarter trailing period?

Carl Byers

This is Carl. I think that people get sort of a little, the shots in the twists is where they put the lens of analysis. So full year versus digging out different sequential time periods and the way I would look at it is, look back over the last four quarters trailing, including the quarter we just ended, and ask ‘could I drive that doc count up by 30% or more?’ Absolutely, and that’s what’s necessary to meet our growth commitments.

So, I think as Jonathan said, staring too hard at one extraordinary number on the chart can lead to some odd compares, including the period we just ended, but if you look forward and say, does athena have the resources and the differentiation to drive doc counts, especially given the anchor deals I mentioned that we’ve always slided into some of these quarters, we feel very confident in our ability to grow the business in line with our growth commitments.

Jeremy - William Blair & Company

Then just shifting gears, a point of clarification Carl; in your comments you talked about, I think almost a 6% same store collection per physician number. I’m wondering whether that number strips out effectively the clinics, the collections associated with the clinics.

Carl Byers

No, it does. I mentioned in the script that MinuteClinic was live for part of Q3 of ‘08. So if you pull that out, it’s not as dramatic of an up tick, but it’s also as I said, perhaps at a period where we are shifting from flat to slightly elevated results.

Jeremy - William Blair & Company

And I guess, with you experience, you only had that live for about a year now, but in terms of flu season, I imagine your comments kind of relate to somewhat of an expectation, a pickup in the number of people visiting clinics, and kind of those providers of that nature. So wondering if that kind of foreshadows a bit of improvement in that number in your view?

Carl Byers

Well, I think first of all the samples that I was talking about, the same store instance of flu did not include the MinuteClinic, because that wouldn’t have been apples-to-apples. And so, our commentary on the flu, first of all, we are not just talking about flu shots or exams, we’re talking about the diagnosis if someone has the flu. And I think it’s interesting to see in real time the data which indicates that there is a dramatic increase in people with the flu showing up at doctor’s offices.

Now it could be that last year they had the flu and stayed home and eroded out, and this year they are worried, and so they see a doctor, but we do think the interesting data point, as for MinuteClinic, obviously the flu shot is their lead product, and so, to the extend there is a high flu season that will inure to their benefit and given our business model ours as well. So we don’t want, we’re not trying to guide people’s numbers with that information. I think it just points out that as a clinical network Athena has rich data that is useful to analyze.

Jeremy - William Blair & Company

Okay, one last one if I could with respect to Anodyne. Is there anything you can share with respect to the kind of the typical contracting price for a typical doc on a subscription basis?

Jonathan Bush

Clinicals or Collector.

Jeremy - William Blair & Company, L.L.C.

For Anodyne’s product?

Carl Byers

Anodyne’s works out to about $500 per provider per year.

Jonathan Bush

So you can pay a pretty bit multiple over that revenue and still be a fraction of what our revenue is.

Operator

Your next question comes from David Bayer - Cantor Fitzgerald

David Bayer - Cantor Fitzgerald

What I was going to ask is sort of have been addressed in the call. Two items and I think they can probably be discussed pretty quickly. One is, are there any progress in the country where you are still seeing some weakness that we should be aware of, it sounds like you served as more localized in just one or two spots and not anymore.

Then I got the sense that you feel pretty good about the way the things are still developing in terms of various practices in the network, and then any thoughts on the veterans administrations current efforts to develop electronic medical records. Are there any interesting lessons to be learned for Athena from what’s on there. They are beginning to gain a lot of press on that lately.

Carl Byers

David, on the data, we certainly can slice and dice it in a lot of different ways. There are no specific regional trends that we have prepared to share. Just not because we don’t want to, just because we have no particular reason to slice the onion that thinly, but it does point out the data asset that athena certainly can.

So, when you look at data that indicates what’s going on we have it in space and we have it in real time, and so, information that people pay for today, a lot of money for, we could give people fast and we just have never put our energy into monetizing that data asset. But as you point out we do have that data. I’ll let Jonathan address your question about the VA.

Jonathan Bush

I am glad someone asked about the VA. So Vista is great example of what the VA has done, and then also now recently the Obama Administration points to other vertically integrated delivery system as success stories, and what they have as an asset that most of healthcare doesn’t have, is that owned everything. So they could buy the absolute worst, most expensive, inefficient system in the world but they can put the entire clinical information supply chain on it.

What we see out in the market with physician practice is of course if they don’t control the laboratories and mammography centers and the hospitals and the other things that they sent and receive information to and from when they buy an EMR and those connections aren’t there, and so what’s unique about athena is as a national network we will be able to connection to a laboratory for one practice and that connection is now in the network for anybody else whoever wants to send to that lab.

So what we are is the next generation of clinical information connectivity whereas the first generation was either none or only connection for those like the government who own everything, Kaiser or something, to now you don’t need to own everything to be able to talk and listen to everything. That’s a very exciting contrast I think.

Operator

Your next question comes from George Hill - Leerink Swann.

Dave - Leerink Swann

This is actually Dave in for George. I was a little bit unclear, could you say that you were bumping up against capacity to be able to install and implement EMRs or that you have plenty of room?

Jonathan Bush

I said the former. So we are right up against our clinical service implementation capacity. We are growing faster than we are growing Collector, multiples percentage rate of growth and it’s newer.

Now, we know how to solve the problem. We are refractoring the process and we have hired to excess capacity and so we will be back with run. We just added for example another 17 people in the Clinical’s professional services group and we added 10. So, we are now ready to handle as much demand as people can give us, but the fact is that we still, in our Clinicals implementation process still have some vestiges of the early EMR thought that went into building it.

EMR is a shitty way to get a practice online, it’s just garbage, and we still have that stock inside of some of our thinking. It’s almost gone, it’s like the Taliban they are sort of back up in the hills, I hope it’s not like the Taliban, hoping it would do better than that, but we are getting much more of our thinking oriented towards this is a clinical information network, we can show all of the fields except for the ones that a doctor actually uses in the exam room and those don’t need to be relevant to pay for performance and the things that actually drive the economics of this thing.

So it’s just a re-factoring, it’s taking with a code base and the thinking we have finding the sort of hanging cats and clipping them off, and it’s a big project but we know exactly how to do it, we have done it before and I’m extremely confident that it ain’t going to get in our way.

David Bayer - Cantor Fitzgerald

So, like if there was like say a 3000 doc practice like UMass memorial, which is pretty close to you guys?

Jonathan Bush

Do you know anyone there?

David Bayer - Cantor Fitzgerald

I do give me a call.

Jonathan Bush

Jonathanbush@athenahealth.com.

David Bayer - Cantor Fitzgerald

Is that something that you guys bid on or would that just have been just too big?

Jonathan Bush

We bid on heartbeat, the efficiency of implementation for the large enterprises is much higher. So would detect a team of 5 or 10 people. Cook Children’s is only a team of five people and it’s still 368 sub specialists plus a platform that will be presented to 1400 primary care pediatrician. So the scale of enterprise installations is extremely favorable to us, but the point is we want to be able to implement hundreds and hundreds of small groups at the same time.

David Bayer - Cantor Fitzgerald

Right. So, even though you are bumping up against capacity, you have 17 people and it sounds like the Clinicals code a bit you would still be able to have implemented 3000 doc practice, how do you won it?

Jonathan Bush

Oh yes, no question, and in fact its 27 people by the end of the year so. We are not where we are starting, but slot people or push back or anything like that, but we have just moved our focus in our development and process innovation, we are squarely on to the implementation process and primarily the clinical implementation process.

Carl Byers

This is Carl, just one to point out is, the business model is totally different, I mean implementing essentially traditional software locally, you really have to bring up the Russian army and build locally all of the resources that are essential on the connections and the interfaces locally.

Athenahealth is an internet based network, so when we build a connection to a given lab or a pharmacy or when we take all of the key data needed in the workflow we build it as a centralized utility on a network, so when you log on to the network you are ready to go. That’s how we build our business so that it isn’t throwing bodies at the challenge of digitizing a medical office but instead asking people basically to log on to a cloud based service that’s ready to go.

David Bayer - Cantor Fitzgerald

Okay, that’s great. Just one last question. So you have affiliated docs in a community around a mother ship hospital, let’s say that mother ship is either Meditech or Sun or McKesson, their sort of mainframe at the hospital. Is your EMR product now very easily able to connect to those systems and send and receive info to those systems for all the different components?

Jonathan Bush

You have it right, that’s the whole point. This is a web native network, not only does the connections that we build for let’s say a Cook Children immediately accrue to the benefit of any practice in the Cook Children’s voluntary staff or any other hospital, same story right, but also athenaClincals doesn’t actually make you go slower, which kind of helps. Like if you give somebody free interfaces and free software, and it make you go 18% slower, who cares, right, I mean that’s not a favor.

So we have got the small practice orientation of the application, but it’s fixed into all over the hospital’s ancillaries and admissions etcetera, to fantastic play and I promise you many, many of our hospital clients are wide awaken aware of it. We are building a series of go to market teams to partner with the hospital clients that are doing this and actually building entire things with grand rounds in marketing and setting up all of these different interfaces and subsidizing the implementation which is covered under start, so that’s a huge avenue of growth for us as a result of all of the acquisition activity I described earlier.

Operator

Your next question comes from Doug Simpson - Morgan Stanley.

Doug Simpson - Morgan Stanley

I was just wondering, Jonathan could you talk a little about the larger deals you guys signed a year ago, and just how did they progress relative to your own expectations, what have you learned from signing some of these larger deals, some of the other names in the space some of the years, they face challenges dealing with larger customers when they were used to dealing with smaller customers, what have you guys learned and how are you managing that?

Jonathan Bush

Well obviously, where we are with enterprise customers is far of ahead of where I thought we would be two years ago. So, that’s a good column. We run into the idea of large system politics, the way the other vendors do, and we don’t have massive professional golfers on the ground ready to be buddies with these people the way some of them are more giant competitors do.

The athena jet doesn’t fly people into the experience center to have a day of visualizing the software of the future or whatever, and so there is a lot of learning on the pure sort of their side like politics of some of these places. That being said, we have some fundamental systemic differentiators in that space, right. There is no hosting, we work really well in the independent community.

We actually bring something to the table that the hospital benefits from, which is lots of practices that are on that hospital’s voluntary staff, they are already on athena net. So there is a huge bump that the hospital gets when they sign their employee docs up, which is they almost instantly add the docs that we have already signed up independently to their network if they want or with merely sort of a signature and permission.

So, there is a lot we bring, which I think will allow, and the fact that we actually get back to state, bestir it more, that never hurts. That allows us to not have to purely compete on the kind of out charmification of the key people. But we are definitely new into the politics of these health systems, we don’t think politically about and running other key players and things like that the way some of our competition has become good at doing. And I’m hoping we never become really, really good at that. I hope that our product just ends up speaking for itself.

Doug Simpson - Morgan Stanley

As you think about that then you are not worried or you don’t think you are going to need to spend incrementally to support those implementations? Do you think you have the infrastructure in place to deal with that?

Jonathan Bush

I am worried. We do already spend incrementally on relationship management there, we have a very sophisticated group of folks that are what we call ERMs, Enterprise Relationship Managers, whose role is to get in there and think big and pull people together. While they are very strong, we are very new at it.

So it’s not something you would have to dial differentially into your model, I don’t think. But it’s definitely worth noting that that stuff is chunky, and in fact I’ll add the politics right now going on with CIO is trying to get a big opportunity to expand their waterfront with the acquisition of practices and their facility with big software type installations are things that are going to cost us.

So we will win some of these things where we’ll get a huge win. We know health was a great example of the price that has already tried one of these traditional software based EMR for three years and we are just dying, because they weren’t being subsidized by anyone, they actually had to pay it out of their own bill, and it was coming home to roost, and so they threw the new thing out and put it in athenaClinicals.

We expect to see that and we expect to lose on the same basis where the mother ship, we have got committee of people that we didn’t know about, got together and determined for reasons that we didn’t get to weigh in on that all the practices we have should be shut off and moved over to some sort of master sonar system or whatever. So, I think that in fact this is an area to focus on, at least until the world learns that software is dead, no one has got that memo except us right now.

Doug Simpson - Morgan Stanley

Then Carl, can I just ask and I apologize if you already put numbers to these, but could you just size for us the clinical service implementation capacity, potentially the spend there. Then also on the warranty liability I know you had determined that you didn’t feel it was appropriate at this time to take that, but had you done that, just in order of magnitude what would that have looked like in the quarter, where was your head at three months ago in thinking about that number?

Carl Byers

Sure, I would be happy to talk about those items. Well, first of all, the end capacity, Jonathan mentioned we have got 17 going to 27 on Clinical’s professional services. So, you can use that to ballpark it, but we are not trying to foretell margin compression or anything like that, I mean, the beginning of this year we said the first half would be flat, second half of the year will be margin at gross margin expansion, we expanded in Q2, we expanded in Q3, and we are not changing that expectation at all.

As Jonathan pointed out we can fit that into our gross margin planning, I think what he was saying more so than the professional services people was that our R&D teams are focused on building the network, just log on and go vision as close as we can and so you will see that we continue to spend on R&D.

At the beginning of the year we said that we would expect it to be relatively flat and if you average the first three quarters of this year it looks like about 7% of revenue, and we think that that pays enormous dividends both in terms of gross margin expansion through the work they do on that front, and from a product standpoint, you know what that means in terms of future growth and other advantages in the market place.

I’m sorry, what was your other question about, the guarantee.

Carl Byers

Well, we issued a triple digit number in terms of the number of these warrantees in the third quarter, Regional Health, certainly taking the lion share of them. And so, at the time we sized this as the potential service credit could be happy year of Clinicals, and so, four grant roughly.

So they can give you a sense that certainly would have been well north of a penny, but at the same time we are working hard to make sure we are doing the right thing with this and what carried the day at least for Q3 was that because of our level of readiness that there really is no obligation to recognizing the balance sheet at this time.

Operator

Your next question comes from Newton Juhng - BB&T Capital Markets.

Newton Juhng - BB&T Capital Markets

I just had one follow-up question just regarding the client basis volumes being flat year-over-year. I’m thinking you just talked about a little bit in terms of going forward with flu, just in hindsight finding that your number is a little bit different from where some of the other groups were coming out with numbers. Can you give me some idea or some of your insights as to why you think your customers were seeing a kind of a different trend in what some of the other guys were saying?

Carl Byers

Well, this is Carl. I’d move kind of quickly here because we have a number of questions to get through before next 15 minutes, but what I would say is that we can only report what we see and we are across 40 states in 60 specialties. I think the payers have been all over the map on their commentary, medical loss ratio as being up or down and recession causing people to run to the doctor, use up their benefits before they die versus stay away, so they don’t pay the copay, and I think the easiest thing in the world for someone to do if they miss an expectation is to site economy, right.

So, we are just giving you the data as we see it. I think healthcare has proven to be resilient and I think fears related to it being different this time around have proven to be, at least based on the data we have seen, unfounded. But obviously we will call like we see it as time goes on and hopefully we are heading toward a recovery here overall that will return us to a more normal footing in terms of health insurance coverage and so on.

Again, even there we haven’t seen a payer mix, we have seen very slight shifts here and there, yes, but even on the payer mix front we haven’t seen a dramatic change, and so, I think that just shows you there is a very resilient underlying and diverse portfolio of patient activity on our network.

Operator

Your next question comes from Leo Carpio - Caris & Company.

Leo Carpio - Caris & Company

I sort of came on the call late and you probably gave answer to this question. Regarding Anodyne, the acquisition, what is the EPS impact of the acquisition this quarter and what have you guided to for annual dilution.

Carl Byers

Sure, well, first of all let we announce the deal. We said we expected about $0.03 of transaction costs, we saw $0.02 in Q3 and so you should expect one other penny in Q4 that will pull out of the adjusted numbers; that’s the first point.

Second point is, they purchased intangibles. We have done several drafts with the outside guidance from Ernst & Young on that accounting, but that is not completely final, but we have told you guys to expect about a penny per quarter of amortization there. If anything, it will be less than that, but just as managed expectations would say, as much as a penny for the purchased intangibles.

As for their core business, their gross margin is basically in line with ours, and their P&L is currently neutral. So we have some investments we want to make, and that’s why we are basically guiding that on a cash basis, we could imagine that being slightly dilutive next year and then accretive the year after that.

Newton Juhng - BB&T Capital Markets

Okay, and then in terms of your sales and marketing alliance, that kind resulted a bit higher than I projected. Can you talk to us in terms of the time lag between your expense and sales and marketing and turning that into bookings, I mean I think you have talked the dynamic in the pass, that’s for every dollar of incremental sales and marketing you would receive about $2 in booking, I’m just trying to get a sense of how quickly that turns into an actual booking.

Carl Byers

Well, that spend relates primarily to the generation of bookings, and so the spend lag to revenue typically is two to there quarters. We had some marketing initiatives kicking in Q3 that Jonathan was giving some color around, and we have a number of other activities that we think will drive growth in line with that ratio.

I should point out that that two to one ratio, spend a dollar to get two dollars of recurring revenue on the other end, that’s a number we have essentially exceeded, in the not too distant past, because if you look at what we spend as a percentage of revenue, and double it for sales and marketing you will see that that’s a number that’s actually less than our growth rate in recent periods.

So, at the enterprise level, there is an upside to that ratio possible. As we look forward we still are planning on spending a dollar to get two of recurring revenue, and I am not planning on spending more than that at this point even though it would be economic to do so, but we are also not forecasting a major reduction in that basic economic relationship, given that the internal rate of return on that type of spending is approximately 75% cash on cash, we think that’s a wise thing to do, and we will take every opportunity we get to do it.

Jonathan Bush

You could imagine Leo us feeling like we found the big one, spending a ton of money, and then coming back to you and say, well, we thought we found a way to spend not $1 to get $2, but $2 to get $4 and it didn’t work. So far we don’t feel that way, so far we feel like we are sort of spending $1 and getting $2 and it’s kind of happening in a leaner manner. But everyday, we are looking for the mother load, we are looking for the same that if we quadruple spending, we’d more than quadruple sales.

Newton Juhng - BB&T Capital Markets

Okay, and that kind of marketing initiatives, does that have an EPS impact this quarter?

Carl Byers

Well sure, I mean we spend money on marketing and that hit the EPS. I mean in terms of sort of where we came out versus consensus estimate, to do the consensus math, and the averages don’t actually threaten upon you. If you take every 25 analyst and average their expectations and then do the math on the averages, it actually doesn’t foot to the bottom line, and I think everyone has different puts and takes.

Some people basically can explain, variances just for the tax rate, and on that point I want to comment that I swear that tax rate is going to be in the low 40s. But we keep getting hit with when we have a relatively early bottom line is excluded items like stock comp, and now the deal cost associated with Anodyne are permanently excluded as tax deductions and so it builds a delta between your cash taxes and your GAAP pretax.

So, that has bumped up, I think that will come down, and in the long term model we see that as a low 40s number, it certainly could get into high 30s over time. So we would expect that the trend downward. But really if you look at that tax number, that’s probably the main people, main place there is a delta as opposed to sales and marketing.

Newton Juhng - BB&T Capital Markets

Okay, would it be fair to say that tax was probably about one to $0.01 to $0.02 impact this quarter?

Carl Byers

All depends on what you are expecting.

Newton Juhng - BB&T Capital Markets

Okay, and then lastly, in terms of the competitive environment, have you seen any intensification in the environment in terms of some more player becoming more aggressive or pretty much as the same as last quarter?

Jonathan Bush

Yes, we are seeing our first real competitors, and they are hospital CIO’s buying legacy software and wrapping them up with lipstick to look like a athena Net, and it’s happening a lot. So we are hoping to find the enlightened CIOs who don’t want to go into the software enabled service business using Citrix servers and software.

We hope they just go into it with us, but when they go into it that way, they then go into the market, into those voluntary staff position practices and say, ‘here, use my beautiful lipstick adorned software product over a Citrix server’ and that’s a real competitor, because the packing looks the same as us. Obviously the insights are very different, but that is real competition whereas I have always thought of the software players like, whatever they are called Misys and stuff as more substitutes.

Carl Byers

This is Carl, we are down to nine minutes and five questions, so we are going to do kind of lightening round here.

Operator

Your next question comes from Charles Rhyee - Oppenheimer.

Charles Rhyee - Oppenheimer & Co

Obviously not to take it much further here, Carl you just touched on it briefly, I think in response to another question. Managed care this quarter interestingly everyone seems to be reporting lower cost trends, obviously citing different things for the reasons for that.

How does a lowering cost trend maybe in the managed care side is particularly if maybe some of those costs are shifting away from specialty care to primary care, how does that affect your mix of business and is that something that moves the needle for you guys or is that something that is sort of neutral, maybe you can just touch on that, that would be great? Thanks.

Jonathan Bush

Well, to my point Charles, some of the payers have cited not a reduction in services but the shift from specialty care to primary care as the reason for a lower medical loss ratio. Athena is roughly balanced between primary and specialty care whereas the market is roughly skewed towards specialty care, and so what that means is a shift towards primary and that’s the positive on a comparison basis.

Similarly, if you look at some of the initiatives in Washington around shifting RVUs, related value units and what you get paid from specialist to primary that also would probably be a net positive for athena. Obviously, Washington DC is a wild card for all kinds of other reasons. But to your question a shift to primary care certainly doesn’t hurt athena, probably helps us and that being said we try to get every dollar we can for every client, whatever specialty they have.

Operator

Your next question comes from Eric Coldwell - Robert W. Baird

Eric Coldwell - Robert W. Baird

You guys have spend a lot of time and effort on webinars, conference calls, web based marketing and I’m curious what your success rate is on closing providers who jump on the web for a click to learn session or expressing the interest via the web? Thanks.

Jonathan Bush

The small group sales force is almost 100% responding to inbound inquiry, that’s not true, I’m sorry. About half of small group sales force comes from leads that PSS reps have stirred up for us. So they go in and they say, ‘Hey, how about you do this thing’ and they close about 13% to 15% of those inquiries from PSS reps supported leads. The rest, the other half of the initial meeting come right in over the web either from the videos or the webinars or just Google, and those we close 30% to 40%, and the sales cycle is very brisk.

So, we are very dependent on sort of organically sourced visitors to our videos and webinars and to our web page in general, and that portion of our business is growing at more than two times our regular growth rate. So that has a share of our new lead is growing enormously, we have a largely new communications team that we have added in addition to our very successful PR team, and the impact of that group is starting to be felt in space.

Carl Byers

I will also add, this is Carl. If you draw a line on the calendar of when we launched our guarantee program and one halvement in terms of what we call hand raisers and inbound inquiry and organic search there is a market change that is either coincidental or related to it and either way we’ll take it.

Jonathan Bush

That changes specifically in the organically sourced through our website and videos channel. So it’s not a spike from PSS or a spike from Eclipses or a spike from all of our other channels that we monitor. It’s from people hitting the web and webinar stuff and then running in through the inside sales agents.

Operator

Your next question comes from Charles Brady - Citi.

Charles Brady - Citi

Just a little bit elaboration on your longer term M&A plans, the Anodyne sounds like a homerun, you talked about it leap froging you a few years relative to if you had home grown something like that, can you talk about what opportunities are out there, how you prospect for them and what your criteria are or pipeline is for other potential transactions?

Jonathan Bush

Yes, happy to. Basically have three screens that we look for. One is what we call a light based to cross sell into. So, how many docs are being served by someone who we would acquire. Somebody who is serving hundreds and hundreds of thousands of docs, gets an A on that screen.

The second screen is how far ahead did they move our core, how close to and how far do they move our core product strategy. So if someone has got a really great product but it’s not something that’s core to us, you will run into companies that do a really good job at organizing detailers for lunches. That’s not really right up our core strategy. But they might be really good at it they might have hundreds of thousands of docs, so they might be good.

Then the third screen we use is, are there capabilities, IP or leadership that what could use to round out our own company. So with Anodyne as an example obviously they have brought us 14,000 docs on enterprise and large group accounts, their product is years ahead of ours in terms of multi-system reporting and reporting is right about stuff that we could use to cross sell, and even had our first successful cross sell amidst of the acquisition amazingly.

Then the team is extraordinary. They are very good at getting meetings with enterprise groups and turning them into close deals. So that’s an example of a green, green, green on our three point screen.

Operator

Your next question comes from Gene Mannheimer - Auriga.

Gene Mannheimer - Auriga

Just two quick ones; with respect to the 30% attachment rate, is that skewed toward one segment of the market, i.e., small and mid sized practices or across the board. Thanks.

Carl Byers

It’s skewed towards small, because we looked at the number of accounts, but everything, the number of accounts are skewed towards small, because there are many more accounts to million dollars of revenue.

We are going to see this across the board, I mean we have seen big enterprise deals attached as well. So, while the 30% was a wallet account and obviously the majority of all accounts are small, I think the underline shows that the attach rate is happening across the board.

Gene Mannheimer - Auriga

Then secondly can you delineate for us, I don’t know if you get to this level of granularity, but the difference in collections per provider for a group practice, say a 20 dot practice versus a large academic like a university hospitals.

Jonathan Bush

Yes, and the large academics, where there are endowments and NIH grants, there are no patient care, and so you see a decline in the collections per doc in the bigger more academic type settings, and obviously in practices that are paying for their Lexuses right out of their patient care you see a lot more volume, so that’s absolutely true.

Operator

Your next question comes from Frank Sparacino - First Analysis Corp.

Frank Sparacino - First Analysis Corp

Hi guys I will make it short and I will just take it offline, thanks.

Jonathan Bush

Thank you guys. Look forward to seeing you on the next quarter.

Operator

Again, that does conclude today’s conference call. Thank for your participation.

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Source: Athena Health Inc Q3 2009 Earnings Call Transcript
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