PRGX Global's CEO Discusses Q3 2013 Results - Earnings Call Transcript

| About: PRGX Global, (PRGX)

PRGX Global, Inc. (NASDAQ:PRGX)

Q3 2013 Earnings Conference Call

October 29, 2013 08:30 ET

Executives

Romil Bahl - President and Chief Executive Officer

Bob Lee - Chief Financial Officer

Analysts

Alex Paris - Barrington Research

Matt Hill - William Blair

Kevin Liu - B. Riley & Company

Geoff Miller - Baird

Richard Close - Avondale Partners

Beth Lilly - Gamco

Operator

Good day, ladies and gentlemen and welcome to the PRGX Global Inc. Third 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 follow at that time. (Operator Instructions) As a reminder, today’s call is being recorded.

I would now like to turn the conference over to your host, Romil Bahl. Sir, you may begin.

Romil Bahl - President and Chief Executive Officer

Thank you, Shannon. Good morning, good afternoon and good evening to each of you around the world. Thank you for joining PRGX Global Inc.’s third quarter 2013 earnings call. We appreciate 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 to your questions.

As you saw in our earnings release, the PRGX team delivered an excellent set of results for Q3 2013. Revenue continued to increase for the second consecutive quarter this year with revenue of $53.4 million, reflecting an improvement of 6.4% over Q2 2013 and 18.4% over Q1 2013. In addition, we grew revenue of 2.5% over the same quarter last year. Adjusted EBITDA increased to $10.8 million in the third quarter representing the highest quarterly performance we have delivered in over five years. Third quarter adjusted EBITDA was 34.1% higher than Q2 2013 and nearly three times that of the comparable Q1 2013 results. In addition, we grew adjusted EBITDA 21.9% over the same quarter last year. Further, this quarter’s results were in line with the expectations we set following our disappointing first quarter. Overall, the year was panning out as we suggested with our core recovery audit or RA business rebounding on both sides of the pond.

As we continue to improve the effectiveness of our cost-to-serve reduction program, we remain confident in our overall EBITDA growth story. Case in point, our core business just had its best EBITDA quarter in nearly five years. Our Americas business had a solid revenue quarter that was comparable to the same quarter last year. Importantly, reversing recent trends our Europe/Asia-Pacific or EAP business delivered revenue growth over the same quarter last year. As we mentioned on our Q2 call, we expected the first half of 2013 to represent a low point in our EAP business segment. And given this quarter’s results and the building momentum, we remain optimistic that this will indeed be the case. Our efforts to standardize our delivery model across Europe are beginning to gain traction and we are coming out of the investment phase related to our large audit wins in the Pacific region.

New Services continue to perform at or better than our expectations. Although New Services segment revenue performance decreased from Q2’s $10 million plus level as we suggested would happen during our last earnings call, it did not dip as significantly as we had anticipated. Our New Services segment generated $9 million in revenue driven by a solid quarter from our profit optimization, or PO services and a better than expected quarter from our healthcare claims recovery audit or HCRA service area. I will get into some of the drivers of these results during my operational update, but the revenue strength from this segment resulted in another consecutive quarter of $1 million plus adjusted EBITDA performance, which reflects the opportunity represented by these newer services.

As a reminder, however, the financial performance of our healthcare business is being adversely impacted by scope changes in our current RAC program subcontracts. While we are awaiting the revised RFQ from CMS for the new Medicare RAC program and remain optimistic that we will be awarded one of the contracts. We expect to incur losses in the near-term. This is because we continue to carry most of our healthcare team even on the face of the reduced scope over the remaining few months of auditing under the current subcontracts. We view these expected near-term losses and those associated with the ramp up phase of any new contract as an investment in the future of the business.

I will end my introductory comments by saying how proud I am of the PRGX team’s efforts this quarter and really the entire year. Our team has battled through much adversity across factors as diverse as the macroeconomic environment in Europe, the impact of delayed claim approvals in our RA business and all the changes and uncertainty around the RAC contract in healthcare. And despite these challenges the PRGX Global team delivered excellent results this quarter.

With that introduction, I will pass it over to you Bob.

Bob Lee - Chief Financial Officer

Thank you, Romil and good day to everyone. I will be reviewing our financial results for the three and nine months ended September 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 and is also presented in Schedule 3 to our third quarter earning press release.

Now to begin the review of our financial results for the three months ended September 30, 2013. Our revenue was $53.4 million compared to prior year’s third quarter revenue of $52.1 million, an increase of 2.5%. On a constant dollar basis adjusted for changes in foreign currency exchange rates 2013 third quarter revenue increased 3.4% compared to the same period in 2012. Recovery Audit Services Americas revenue was $32.4 million compared to the prior year’s third quarter revenue of $33.2 million, a decrease of 2.6%. On a constant dollar basis adjusted for changes in foreign exchange rates Recovery Audit Services Americas third quarter revenue decreased 1.3% compared to the same period in 2012. Recovery Audit Services, Europe/Asia-Pacific revenue was $12 million compared to the prior year’s third quarter revenue of $11.4 million, an increase of 5.3%. Changes in foreign exchange rates had only a negligible impact on Recovery Audit Services Europe/Asia-Pacific revenue for the third quarter compared to the same period in 2012.

New Services revenue was $9 million compared to the prior year’s third quarter revenue of $7.4 million, an increase of 21.3%. Our New Services segment is comprised of our healthcare claims recovery audit services as well as our profit optimization services. The New Services segment third quarter of 2013 revenue represented 16 .9% of total revenue compared to 14.3% in the third quarter of 2012. Our cost of revenue was $30.9 million in the third quarter of 2013 compared to $32.5 million in last year’s third quarter, which was 57.8% of revenue in 2013 and 62.3% of revenue for the same quarter in 2012 representing a 450 basis point improvement this year versus last.

Total SG&A in the 2013 third quarter was $13.9 million compared to $13.2 million in last year’s third quarter, or approximately 26.1% and 25.4% of revenue in each period respectively. Depreciation expense increased $0.3 million and amortization decreased $0.2 in the third quarter versus the third quarter of 2012.

For the three months ended September 30, 2013, our net earnings were $4.9 million or $0.17 per basic and $0.16 per diluted share, compared to net earnings of $2.6 million or $0.10 per basic and diluted share for the same period in 2012. Our adjusted EBITDA for the third quarter 2013 was $10.8 million compared to $8.8 million of adjusted EBITDA for the same period in 2012. Third quarter 2013 adjusted EBITDA excludes a $1.3 million charge related to stock-based compensation, $0.7 million of acquisition-related charges, $0.2 million of transformation, severance and related expenses and $0.6 million of foreign currency gains on short-term intercompany balances. The comparable adjusted EBITDA for the third quarter of 2012 excludes a $1.8 million charge related to stock-based compensation, $0.1 million of acquisition-related charges, $0.5 million of transformation, severance and related expenses and $0.3 million of foreign currency gains on short-term intercompany balances.

Beginning in the third quarter of 2013, we now include acquisition-related fair value adjustments to contingent consideration in our calculation of adjusted EBITDA for all relevant periods. Previously, we included acquisition obligations classified as compensation and acquisition transaction costs as adjustments to EBITDA. Now, we also include these fair value adjustments and had renamed the line in our Schedule 3 to our earnings release as acquisition-related charges (benefits). We have made these changes in all period – prior periods presented in our earnings release and also will include such changes in the presentation of adjusted EBITDA and our future filings on Forms 10-Q and 10-K. On a year-to-date basis, this change increased our adjusted EBITDA for 2013 by less than $0.1 million.

Now to begin the review of our financial results for the nine months ended September 30, 2013. Our revenue was $148.7 million for the nine months ended September 30, 2013 compared to the prior year’s nine-month period revenue of $155.4 million, a decrease of 4.3%. On a constant dollar basis adjusted for changes in foreign currency exchange rates, the first nine months of 2013 revenue decreased by 3.6% compared to the same period in 2012.

Recovery Audit Services Americas revenue was $88 million compared to the prior year’s revenue of $91.6 million, a decrease of 4%. On a constant dollar basis adjusted for changes in foreign exchange rates, Recovery Audit Services Americas revenue decreased 3.2% compared to the first nine months of 2012. Recovery Audit Services Europe/Asia-Pacific revenue was $33.8 million compared to the prior year’s revenue of $39.1 million, a decrease of 13.6%. On a constant dollar basis adjusted for changes in foreign exchange rates, Recovery Audit Services Europe/Asia-Pacific revenue for the nine months ended September 30, 2013 decreased by 12.7% compared to the same period in 2012.

New Services revenue was $26.9 million compared to the prior year’s revenue of $24.6 million, an increase of 9.3%. The New Services segment revenue for the nine months ended September 30, 2013 represented 18.1% of total revenue compared to 15.9% in the prior year. For the nine months ended September 30, 2013, our cost of revenue was $92.8 million compared to $100 million in the prior year, which was 62.4% of revenue in 2013 and 64.3% of revenue in 2012, 190 basis point improvement.

Total SG&A for the nine months ended September 30, 2013 was $38.3 million compared to $38.6 million in the prior year, or approximately 25.7% and 24.8% of revenue in each period respectively. Depreciation expense increased $1.3 million and amortization expense decreased $1.4 million compared to the first nine months of 2012. The increase in depreciation is primarily due to improvements we made in our IT infrastructure and the depreciation related 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 the nine month periods ended September 30, 2013, our net earnings were $6.2 million or $0.21 per basic and diluted share. For the nine months ended September 30, 2013, our net earnings were $3.9 million or $0.15 per basic and diluted share. The nine months ended September 30, 2013 included $1.3 million credit resulting from the release of a portion of the reserves held for uncertain tax positions. Approximately $0.8 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 nine months ended September 30, 2013 was $22.4 million compared to $22.7 million of adjusted EBITDA for the same period in 2012. 2013 adjusted EBITDA excludes a $3.8 million charge related to stock-based compensation, $0.2 million of acquisition-related charges, $0.8 million of transformation severance and related expenses, and $0.1 million of foreign currency gains on short-term inter-company balances. The comparable adjusted EBITDA for the first nine months of 2012 excludes a $4.5 million charge related to stock-based compensation, $0.2 million of acquisition related benefits, $1 million of transformation severance and related expenses, $0.6 million of wage claim costs, and $0.2 million of foreign currency gains on short-term inter-company balances.

I will now highlight certain 2013 balance sheet and cash flow information. As of September 30, 2013, we had unrestricted cash and cash equivalents of $42.4 million and had no borrowings against our revolving credit facility. Bank debt outstanding was $3.8 million, representing the outstanding balance on a variable rate term loan due in quarterly installments of $750,000 through December 2013, with the final $3 million payment due in January 2014. At September 30, 2013, current assets exceeded current liabilities by $50 million.

Net cash provided by operating activities for the nine months ended September 30, 2013 amounted to $10.3 million compared to net cash provided by operating activities of $12.2 million in the same period of the prior year. Before working capital changes, cash provided by operating activities amounted to $20.1 million for the first nine months of 2013 and was $18.1 million in the first nine months of 2012. Capital expenditures on property and equipment for the nine months ended September 30, 2013 were $4.5 million.

Net cash used in financing activities for the nine months ended September 30, 2013 amounted to $0.7 million compared to $6 million net use of cash in the first nine 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 you Romil.

Romil Bahl - President and Chief Executive Officer

Thank you, Bob. If you have been following the PRGX journey, you will likely know that the premise of our turnaround in the highly competitive and fragmented space of accounts payable recovery audit is the reduction of our cost-to-serve. PRGX spent much of the decade of the 2000s losing its dominant position in RA. We went from a high of more than 1,200 customers to a low of less than 300 and from a high of almost $0.5 billion in revenue to a low in the range of $170 million in 2009. The overriding reason we lost clients in our then focused segment of retail was price. The capability gap between PRGX and our competitors had diminished greatly due to the lack of effective investments by the company, which in turn made it easy for competitors to pick off our clients using price as their key lever.

Since 2009, the PRGX Global team has reestablished itself as the leading global RA provider, not only in the retail segment, but also in the commercial segment, which we have effectively penetrated over the last three years. We have invested significantly in our processes and IP and have strengthened our auditors’ forensic ability with world-class data transformation and enrichment capabilities. In addition, we are well into the process of standardizing and centralizing our delivery model to enable the use of lower cost shared service centers and have thereby set ourselves in a journey to continue to reduce our cost of revenue over the coming three to five years.

In line with this goal, our Americas team continues to drive our next generation service delivery model with increased centralization and offshoring of a growing number of claim categories, including some of the more complex types of auditing. By the end of this year, we expect to be able to support the majority of our claim categories from one of our shared service centers, preferably our lowest cost center in Pune, India. In addition, we continue to have success in developing new business and in retaining our clients. On the latter point, once again, our Americas team has been successful with all client contract renewals year-to-date in 2013. This is truly incredible performance. In effect, our last client loss in the Americas occurred about two years ago in 2011.

In addition to superior client retention, our new client penetration efforts continue to be impressive, especially our win rates when we get an add-back. While one always wants more add-backs, retail RA is a tough business to get those opportunities due to the multi-year contract nature of the business. We are seeing more opportunities in commercial or non-retail and are pleased with our results in this space adding several new clients in the third quarter, including a significant win at a large manufacturer that showcases how our global footprint is a real competitive advantage.

In September, we hosted our annual Profit Discovery Forum in Miami, Florida. The event brought together nearly 60 finance and recovery audit leaders from more than 35 North American companies to discuss profit recovery, profit optimization and data analytics topics in presentation, roundtable and client case study formats. These events serve as a fantastic opportunity for us to solidify client relationships and to better understand customer needs.

On to our EAP or Europe and Asia-Pacific segment, during our last investor call, I mentioned that our efforts to rejuvenate our client relationships develop new business and drive our next generation service delivery model across our European operations were beginning to payoff. And that we were confident we would have a stronger second half of the year in our EAP region. Crossing the $12 million revenue mark in our EAP RA segment is clearly a significant step in that direction as is our EBITDA performance, where we more than doubled the comparable adjusted EBITDA for the same quarter last year reflecting the results of our transformation investments in this region.

Of course, retaining clients and driving success in new business development is also a crucial part of rebuilding the EAP segment back to the $60 million mark that was achieved in 2011 and to then growing the segment beyond that mark. And recently, there are some good signs of success. We have not lost any clients in 2013 in EAP other than one small client that did not meet our profitability profile. Also we have one both new retail and commercial accounts as we continue to upgrade our market-facing function in this region under new leadership that has been in place about a year now. In addition to what are now best-in-class retail and commercial RA offerings, our contract compliance offering is developing nicely. We are close to being able to boast an industry leading suite of contract compliance services on the cost side and we will then look to expand to the revenue side on behalf of our clients.

I mentioned on our last call that we have built a nice pipeline of opportunities in this space. And since then, we have converted a handful of these and expect revenue from some of these engagements as early as the fourth quarter. In fact, the largest opportunity we have won in this space is a multi-year deal with a large energy company, which is adding to our qualifications to penetrate this key target industry segment.

Our profit optimization services continue to be an exciting growth area for the future and also link very nicely to the contract compliance services expansion I just discussed including the fact that both of these services leverage more sophisticated data analytics. As we are working on our PRGX 2.0 strategy process, we are driving more clarity around our go-forward focus areas within the PO growth lever. In each of these focused service areas, we capitalize on our core capabilities and strengths and now have proven results from client engagements as credentials to drive future growth. Finally, our pipeline in this area continues to look promising and we feel better about how we are positioning these services with existing clients.

Now, let us turn to healthcare. As you are aware in 2013, our healthcare team was enjoying its more successful year in terms of revenue and EBITDA contribution since the launch of the national Medicare RAC program in 2009. All the way through August, we had terrific results that were better than originally estimated, but then our results fell off a cliff in September as the scope and audit restrictions imposed by CMS began to impact our financial performance.

Let me provide an example of the scope and audit restrictions. Record requests related to the short-stay claims within the medical necessity audit area have been disallowed since May and this restriction began to impact our revenue in late August. This audit category was by far the majority of our revenue year-to-date 2013 and also over the lifetime of this program. That said, we remain confident that we can win a contract in the new RAC program competition and that has an incumbent in three of the four current regions, our time to ramp up on the new contract should be amongst the shortest of the current contractors. With this in mind, we are keeping the majority of our healthcare team intact as part of the investment required to hopefully win a contract for the next five years of the RAC program. In turn, we believe that serving CMS as a prime contractor will be the foundation of our healthcare business going forward.

In summary, our business is largely back on track for the year just as we said it would be after a weak first quarter. Our core business continues to strengthen globally and we remain focused on improving our service excellence and cost-to-serve advantage. There was a bit of a valley to look over in the New Services segment, but given our opportunities in profit optimization and healthcare, we believe our future is bright.

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

Question-and-Answer Session

Operator

(Operator Instructions) Our first question is from Alex Paris of Barrington Research. You may begin.

Alex Paris - Barrington Research

Good morning guys. Congratulations on a really surprisingly good quarter.

Romil Bahl

Thank you, Alex.

Bob Lee

I appreciate it.

Alex Paris - Barrington Research

Just a – I will start off with healthcare, I think it’s been well advertised that there is going to be a valley era golly between now and in the contract though it’s been a moving target with medical claims supposed to have ended or medical requests for information supposed to have ended in May, then June, then November, then scope changes and audit restrictions, but just to get an idea and the magnitude of what we out to face over the next several quarters, essentially there is going to be very little revenue from Medicare RAC in Q4 and Q1. Is that accurate?

Romil Bahl

That’s pretty accurate, Alex.

Alex Paris - Barrington Research

Yes. And then even if we somehow or another get the awards made before the expiration of the current contract in February, there was going to be a ramp up period. So it’s reasonable to assume that there was not going to be a lot of Medicare RAC revenue in Q2 and maybe we only start seeing it ramp up in Q3 if they make that February deadline. Is that reasonable?

Bob Lee

Yes, I suspect so Alex although certainly, I am sure all of us who hope to win a contract for the next five-year period will be working very hard with CMS to accelerate that ramp up as quickly as possible. I mean, if you look at our case, for example, we work in three reasons as you know. We work with the majority of the current MACs or Medicare Administrative Contractors, the intermediaries and we have joint operating agreements, JOAs with each of them. And so we think we can move pretty quickly, but I don’t want to take away from your germane endpoint, which is that it’s likely that we don’t see revenue on the new contract till the second half of next year, yes.

Alex Paris - Barrington Research

Yes, that makes sense. And yet you are going to maintain your staff, particularly if you in anticipation of winning and then you will certainly have to keep it in place once you have won if that’s the way things pan out, so that we will be carrying this cost. So I don’t want to beat a dead horse on that, but we are going to have several quarters that are going to be difficult from a year-over-year comp basis. And I don’t mean to just focus on the negatives, a win of a prime contract with CMS is going to be a big positive and it’s going to be big payback over the next five years.

Romil Bahl

That’s exactly how we are looking at it, yes.

Alex Paris - Barrington Research

You said in the press release that we expect near-term losses, are you talking about segment losses, are you talking about consolidated losses. I think it’s very reasonable to assume a loss in the fourth quarter on a consolidated basis just carrying the cost and no offsetting revenue. Should we be expecting losses on a consolidated basis?

Romil Bahl

So just to be clear, I mean, on a consolidate companywide basis, the core business is such a big part of our business that there is no question we will have positive EBITDA results. On a New Services segment basis, it is reasonable to expect losses, yes.

Alex Paris - Barrington Research

Okay. And then just moving on from healthcare – I just ask one last follow-on question about healthcare and then I will rejoin the queue. Any indication from CMS on this whole re-bid process, we have been waiting for the new RFQ, you have been waiting for the new RFQ, all year long and there has been a number of things what has slowed it down in your opinion? And when do you think we will a new RFQ from CMS?

Romil Bahl

Yes. Alex, there is no formal news first of all, let me put that out there. So we sort of don’t know. That said, CMS has been busy and I know you have been following as many of the analysts and folks that follow us and our competitors in this space. CMS has been making a series of rule changes just on the way Medicare operates and the way the providers, the guidelines to the providers. Those in turn have ripple effects to the contractors who are performing the recovery audit services and undoubtedly, they wanted to be clear about those rule changes, the impact of those rule changes before they put out a new RFQ with the sort of final scope of the services going forward. So I suspect that’s been a big part of the change or reason for delay I should say. Certainly, the go-live date of the new Affordable Care Act items, the healthcare.gov websites all of that sort of stuff has been a very time consuming effort. And then we have little things like furloughs when our clients aren’t working right. So there is all sorts of reasons for delays, but to cut to the chase as you rightly point out, we are starting to run short of time to get a decision made before this contract runs out in February. So we expected really any day now.

Alex Paris - Barrington Research

Okay. Well, good luck on that and I will rejoin in the queue.

Romil Bahl

Thanks Alex.

Bob Lee

Thanks.

Operator

Thank you. Our next question is from Tim McHugh of William Blair. You may begin.

Matt Hill - William Blair

Hi, this is Matt Hill in for Tim McHugh this morning. Going back a little bit to the healthcare business in the New Services, I was wondering could you give us a little bit any type of split between the profit optimization in the Medicare RAC business, just because of the expected weakness in the next couple of quarters. Just trying to model that out?

Romil Bahl

Yes, Matt, we are going to continue to resist doing that as we have since we launched the New Services segment. One day, hopefully one day soon, both of these businesses will reach that sort of critical mass level and we will be required to break them out and report to them that way, but until then we are going to stick with New Services if that’s alright.

Matt Hill - William Blair

Okay, that’s fine. And then in the recovery audit Americas, it look like there was a nice pickup sequentially, just wondering is there any large project that, that’s specific to or is it just a general improvement in the segment?

Romil Bahl

Well, the Americas segment has really done pretty much what we expected it to all year with that one singular exception at the one large client where we had a one in a million technology failure sort of in the first quarter and that impacted our results in the first and second quarter. And so just as that performance of that client has come back to life so to speak, the business again just continues to do what we expected it to do.

Matt Hill - William Blair

And historically, the third quarter is the strongest quarter for the Americas also?

Romil Bahl

That’s a real good point, but there is a bit of a seasonality pop in Q3 for the Americas. It’s really more of a Q4 story for EAP, but yes, you may not see another sequential increase in Q4 in the Americas for the exact reason that Bob just mentioned.

Matt Hill - William Blair

Okay. And then just lastly on international expenses, down again this quarter, is that more of the transition to shared service model? And then just any update on relative to the Americas segment, how far along is that process internationally?

Bob Lee

I will answer the first part and I will let Rom will shit the second. Yes, we are starting to see a bit of the impacts from the process in Europe that we saw starting last year in the Americas. We still think we have got quite a long way to go there. But yes, we are starting to see some of the early benefits of the program.

Romil Bahl

Yes. And look I mean, the entire premise of the cost-to-serve reduction program is as you have sort of alluded to is the centralization of where we delivered our services from, right, that’s what we sort of call the service delivery model. And we have started to move some work from EAP to our Pune center. We have moved some work to other centers, including in Canada and made it more consistent certainly in terms of, for example, for our commercial recovery audit group. We are driving a lot of that work coordinated out of our Grand Rapids center, which is our core commercial recovery audit shared service center here in the Americas. We are leveraging that as well into EAP.

And then of course, we have launched the Bruno center in the Czech Republic and have just opened up a center in Manchester. And so look, we are just getting started, right. I mean, we have a long way to go across EAP to get those margins up sort of anywhere close to where the Americas are. And we may not get to exactly the levels of Americas for many reasons, including scale and taxes and other employment costs overseas, but we fully intend to sort of keep going right. I mean, getting to 45% margins globally was a step in the right direction as a key target we have talked about certainly internally for a few years. And now we are going to talk about a higher target for the next few years and it’s not just restricted to EAP. Americas has room to grow as well in terms of gross profitability.

Matt Hill - William Blair

Alright, thank you very much.

Romil Bahl

Thank you.

Operator

Thank you. Our next question is from Kevin Liu of B. Riley & Company. You may begin.

Kevin Liu - B. Riley & Company

Hi good morning. I guess one question on healthcare, you talked about the impact of the scope reductions and what that could do over the next few quarters, I guess when you look to the next iteration on the program and I realized an RFQ isn’t out, how certain are you that there won’t continue to be any significant limitations on the types of audits you can perform and kind of what are you factoring into your expectations there?

Romil Bahl

Yes, it’s a good question Kevin. Look we – I mean we could sort of drive ourselves crazy with conjecture around the scope of the future contract and audit scope, but clearly the audit scope that will be outlined in the RFQ that we are expecting will drive our pricing strategy, right. So if for example the scope would remain exactly as our understanding of it is today for the next three odd months that we can audit price would have to be significantly different, significantly higher to ensure a fair and proper return for us contractors and I suspect we won’t be the only contractor saying that. So I think scope and price will go hand in hand. The other factor I do want us to remember is that just like in our core business of recovery audit where for some 40 plus years people have been telling us we are going to go out of business and our clients are going to put us out of business, our business continues to evolve, continues to grow and we continue to put more dollars on our client’s bottom line than we ever had before. I think that number was about $1.3 billion in profits last year. So we fully expect our audit capabilities in the healthcare to continue to grow and evolve. We continue to innovate new audit categories and so to find new sources of revenue to replace any scope that may go away or that maybe fixed in fact that’s what’s should happen right. I mean the sentinel effect here should be the providers in healthcare get better on certain things and then we go find other inaccuracies and inefficiencies in the system. So we are so far away. I mean 40 years from now we can now maybe talk about whether healthcare is getting towards the end of auditing, it’s not today.

Kevin Liu - B. Riley & Company

Got it. And then maybe just on the EAP side if you can talk a little bit about the sequential increase there what were some of the drivers was it primarily new client ramps, did you guys have any significant claims that came in the door. I just want to get a sense for whether you can continue to build out the space moving in the new few quarters?

Romil Bahl

So that’s an EAP question, right Kevin?

Kevin Liu - B. Riley & Company

Correct.

Romil Bahl

So yes, look I mean I think when we – when we sort of had the relatively poor quarter in Q1 we talked about the fact that at least part of the issues were being caused by while A, of course the economy and the macroeconomic impacts just being subdued but also some delays in claim approvals. So getting some of that back is certainly part of the sort of tailwinds in the second half of the year, but also just better more consistent more standardized audit processes and making sure that we are getting some uplift from even just our existing accounts has been helping. And of course as you know our Pacific claims that the two big retail wins down under have been coming on as well, so a little bit of all of those factors really driving the improvement and we certainly expect that to continue in the rest of the year. And we will see how next year goes, but we expect we saw the trough in the first half of this year.

Kevin Liu - B. Riley & Company

Great, that’s all I had. Congrats on the strong quarter.

Romil Bahl

Thank you, Kevin.

Operator

Thank our next question is from Geoff Miller of Baird. You may begin.

Geoff Miller - Baird

Congrats on the quarter as well. Just to follow-up on that last point that you made delays in our claims approvals in EAP, was that more of a one-time catch up in Q3 or should that flushing through also benefit Q4 as well?

Romil Bahl

Yes, I mean it’s sort of hard to talk about these things as really one-time, right because in our business we are writing claims all the time. We are identifying right with our forensic tools and IP. We are identifying over payments, writing them up, getting them approved and getting them into sort of – and managing them through a work in process pipeline of claims and when that whip sort of builds up, it’s because claims aren’t getting approved as quickly as we would like them, so we have a little bit less revenue. And so certainly there has been a whip buildup in general over the past 12-ish months certainly in EAP it’s been pretty dramatic. We do expect that to normalize not just in Q4 but into next year over time and really get back to business. I mean it’s set a different way. Our core capabilities, our core business haven’t been suffering as much as it would appear based on our results.

Geoff Miller - Baird

Right, so what I am wondering is did that whip buildup, did it just stop building, did it start to come down. I mean it sounds like it’s nowhere near normal. So it maybe…

Romil Bahl

It’s not near normal yet, it certainly has not been building at the rate it was building three and four quarter ago and will come back down to normal over the next three to four quarters.

Geoff Miller - Baird

Okay. And then on the HCRA investment in terms of maintaining the (indiscernible), can you just give us any sort of order of magnitude of the size of that investment to maintain headcount. And then as things hopefully come back online there if you get a win, I guess how geographic specific are those resources versus how centralized are they meaning if you get a win in one of the three regions that you are currently working and can the headcount that was previously serving the other two regions sort of the new region or will you need to make some adjustments there?

Romil Bahl

Yes, so let me just answer the second part of that question first because it’s a little bit easier. Our team, our healthcare recovery audit team is a centralized workforce that doesn’t mean everybody sits in once place, it just means that we are completely able to perform remotely. Now, certainly we are aware that as we hopefully win this foundation contract with CMS and then expand into the private sector that we will be required to do more work at clients and are completely prepared for that sort of building that mobile workforce, but our workforce today as required for the CMS RAC program is a centralized operation completely mobile from the standpoint of moving it from our current three regions or jurisdictions within three regions to any one of those regions or another region for that matter in the future.

If you look at it, it’s going to be hard for me, we don’t provide guidance as you know, but let me just sort of remind you what we have said before, Bob and I have said before on earnings calls that our costs in healthcare are about $1.5 million a month, right and I will try to manage that a little bit, but that’s about where it is. And if you now extrapolate that back to the conversation we just had with Alex Paris about there is not being a whole lot of revenue when you get a sense for the magnitude of losses we will have in Q4 and Q1 as part of our New Services segment results and hopefully not much longer than that, because again, we will certainly be pushing hard. And in fact, keeping the team intact and in place is to allow us to ramp fast and hard when that new contract comes.

Geoff Miller - Baird

Got it. And then in the press release, you have alluded to setting even higher targets for the next five years, but it didn’t sound like you are articulating formal five-year targets at this time. So just any update there or when should we expect that?

Romil Bahl

Yes. So I guess I answered that question and then I would like – look it’s a – it’s not first of all, it’s not a done deal. We continue our sort of refresh of our strategy for the next three to five years. As you know, we announced our strategy in late ‘09 and have been executing to that in the sort of perfect timing to be refreshing for the next three to five years. Right now, we are sort of calling it the 2.0, the 2.0 version of PRGX if you will. And as a part of that, we are looking very hard at a five-year model of where we think the core business can go. I think it’s safe for you to assume that we will be aggressive. I mean, I don’t know you obviously haven’t followed our story that closely, but if you think back to 2009, the majority of the leadership team that’s in place got here, the business was in pretty bad shape. I mean, we were losing clients. And by the time we realized even though we had been told EBITDA is positive, things are great. It was in pretty tough shape. We lost a few clients. And it takes a while for a turnaround to take hope. In fact, if you go back and look at that first quarter in 2010, I think our gross margins were somewhere in the 27% range. Right, so it’s a long way from there to where we are today talking 45. And I have no doubt in my mind that we can get as a global business to 50% gross margins in the recovery audit space, but again, that target in exact modeling is underway. And we will talk about it maybe on the next call.

Geoff Miller - Baird

Thank you.

Operator

Thank you. Our next question was from Richard Close of Avondale Partners. You may begin.

Richard Close - Avondale Partners

Yes, thank you for taking the questions. Congratulations on a good quarter. Just to talk a little about EAP, what is your thoughts in terms of sustainability with respect to the improvement that has made, I know there were some questions, where there is some catch-ups and whatnot in the quarter, but just as we think about this as we go forward to just the level of sustainability in the gross profit and whether you expect a steady stair step improvement in the margin on a go forward basis there?

Bob Lee

Yes. So as I said Greg, we are very confident that the principles we have applied in the service delivery model program, the centralization, the cost reduction can work, will work. Can they work to exactly the same extent as they work in the Americas? Perhaps not, but they will work. You all recall, right and it’s a really good time to say this when you just have the best quarter in five years, but you all recall that we are a lumpy business right that we hit, I am sorry, Richard that there are times when claims don’t come through, right and then there are times when they do and so that lumpiness will cause our margin to look strange in any given quarter. And that’s really important to remember. But that said, over any 12-month period, we expect to see improvements. Right so the next 12 months you would look better than the last 12 months in EAP and then the 12 months after that should look even better than that. And that if you look at it sort of that way, we are very confident the business is headed in the right direction.

Richard Close - Avondale Partners

Okay. On the healthcare side, obviously you have scope reduction right now based on implementation of the two midnight rule and the moratorium associated with being go after the short stay inpatient. Have you guys any type of analysis with respect to the impact of the two midnight rule in terms of how much that potentially reduces the bucket to go after on short-stray inpatient?

Romil Bahl

Yes, look so we have looked at it pretty hard, but again there is a pretty wide range of outcomes both in terms of how the rule will be implemented, how effectively the provider side training and education will go on and of course then how hard CMS allows us to go after it thereafter. So providing kind of a number of any sort today, even if we were to choose to do so would be dangerously close to just sort of complete conjuncture on our partners.

Richard Close - Avondale Partners

Okay. And let’s say that dramatically decreases the potential of pool, our pool of errors to go overpayments to go after, do you think there is enough other buckets out there to potentially offset that? Obviously, you have said in your comments here today that, that has been the most fruitful area to go after since the program has – since you have been operating in the program you also talked about pricing would have to change. Obviously, it’s been good from that point as well return on your efforts. Do you feel as confident that the other pools out there could maybe offset that or just any thoughts in and around that?

Romil Bahl

Yes, look I feel very confident like I just said. I mean, I think we are 40 years and because it’s healthcare maybe 80 years from getting to the levels of penetration of recovery audit that we are just in retail and in our core business, for example. So as I have no doubt, there are many, many audit categories. I mean, there are so many that as a RAC – current contract group, we haven’t even gone after in these first five years of the program, because there was this low hanging easy fruit right there that we were going to get after and help our clients clean up. So I have no doubt that there will be a different leading sort of short-stay like category for the next five years and then the five years after that and the five years after that.

Richard Close - Avondale Partners

Okay and then would you have to go through the normal channels. And again this is conjecture obviously, but you have to submit I guess an application or a request to go after certain areas, do you envision it being the same process in terms of getting approval to go after new areas that it’s not necessarily it doesn’t goes turned on immediately from day one of a potential new contract, but you are slowly getting new approvals to go after certain areas?

Romil Bahl

Yes, look I think certainly the audit concepts that have been approved to-date will be available immediately and that the ongoing study process of new audit concept approvals will be initiated right with the new contract and we will get on with it absolutely.

Richard Close - Avondale Partners

I guess final question for me would be in and around healthcare side on the commercial you have talked about that in the past I would think in some comments here earlier you talked about in your workforce that it centralized, but as you I guess move into the private sector, commercial sector, you would have to move some people the clients, client’s headquarters, can you talk a little bit about the opportunities on the commercial side for you in the healthcare market and whether we are seeing an uptick in opportunities going forward?

Romil Bahl

Yes, I now look I mean think the opportunity in the private sector of healthcare is very significant, it is a growing space. And in terms of the sort of the penetration of payment integrity services, recovery audit services prepayment sort of post adjudication, but prepayment recovery audit services, fraud services and it’s a very, very rich $2 billion plus market growing at 30% and 40% CAGR. So the opportunity is there. Our sort of desire to be conservative and how fast and hard we exempt sales people out there chasing that market has been driven by a couple of different things. First, the stage of our own capabilities internally and being able to just serve our current government set of clients well making sure that was solid and profitable not getting sales too far ahead of delivery that sort of thing. And then certainly as we have come to the – come close to the renewal of this contract for the next five years, it’s been making sure we win this foundation contract before we go off and sort of launch a bunch lifeboats. So we will get cracking on the private sector after again a hopeful win in the CMS region. And like the mobile workforce is just one and again it will be a small part of our overall workforce that will need to be mobile. But that’s just one of several new capabilities we do need to either build or acquire as part of getting our full suite of services ready for the private sector.

Richard Close - Avondale Partners

Final question for me would be on profit optimization as well as compliance you talked a little bit about compliance, how quickly do you see an uptake in profit optimization and then the compliance offerings as well just think about some of these newer services, newer offerings and the adoption rate there?

Romil Bahl

Yes, so the contract compliance really is very, very adjacent to our core business. And we expect sort of continued quick uptake of that service both across our existing clients and as a service that’s going to help us deliver new clients. On the PO side I mean there is no reason we can’t grow that business sort of 20%, 30% a year is just given how small it is right now for the foreseeable future. We are starting to crack the code. I think just a couple of years ago we struggled to get even 10% of our revenue from our existing client base. We are getting like three times our revenue from our existing client base. About eight of our top ten retail and top ten commercial clients are now using PO services, so it’s just launching new services it takes a while and we have learned a lot over the two to four years. We are looking forward to applying those learnings in the next three or four years.

Richard Close - Avondale Partners

Alright, thank you very much.

Romil Bahl

Alright, thank you.

Operator

Thank you. Our last question is from Beth Lilly of Gamco. You may begin.

Beth Lilly - Gamco

Good morning Romil.

Romil Bahl

Good morning, Beth, how are you.

Beth Lilly - Gamco

Just perfect, how are you?

Romil Bahl

Good thanks. We were determined to not cut you off this time.

Beth Lilly - Gamco

Thank you very much. So I have two questions. The first question is if you look at the gross margin in the quarter and there was a question about 5 or 10 minutes ago about the sustainability. And you at 42% gross margin and 20% EBITDA can you talk about the sustainability of those margin levels. And then I guess just in terms of the overall picture of PRG, this has been a lower turnaround than a slower turnaround than I think anybody expected including yourself and so would you say that you are happy with where the company is today and you think that you finally are on the right footing?

Romil Bahl

So yes so I think I have made comments about the profitability and the sustainability already. I mean this business has BPO, right Business Process Outsourcing like characteristics I mean it is a multi-year nice annuity business on the one hand. On the other hand there is both a little bit of lumpiness from quarter-to-quarter. But some price pressure when you renew a contract for another few years. So in any given year you are going to have a little bit of a decline due to what’s you give back on rates. And you need to fill hopefully small holes right hopefully you are not losing too many clients, 100% client retention is unsustainable. It’s just brilliant performance by the team, but it’s unsustainable. There will be a time when we will lose clients but and those are slightly bigger holes to then fill right but otherwise even in the 100% client retention type scenario you are giving up little holes in rate holes that you have to fill with either scope expansion on existing clients or new sales, new services, contract complaint services and all that sort of stuff. So it’s a tough business certainly from a top line growth dynamics perspective certainly until we can open up significant new geographies internationally that are underpenetrated for recovery audits.

That said if we can stay even sort of flat to sort of 3%, 4%, 5% growth in the core business as I have always said, we can deliver double-digit EBITDA growth margins – or EBITDA growth and we really have been doing that. I mean when you say the turnaround has been slower than anyone expected 21 and change in EBITDA in million dollars in 2010 to 31 last year, it was a little over 50% over those two years. I am not sure how many companies in the world did that and even despite the tough year, this year with the healthcare contract coming to an end and so forth, we will still be in that neighborhood. And so I certainly believe our future is bright.

Beth Lilly - Gamco

Okay. So you think the levels that you have achieved this quarter are sustainable?

Romil Bahl

Again, a quarter can be lumpy in our business, right, but there is no question in my mind that there is improvement to be had in our overall gross margins.

Beth Lilly - Gamco

And my comment wasn’t made, I mean that I didn’t mean to insult you, just finally I feel as though we are starting to see the firth of all the hard – the heavy lifting that you have done over the last several years, so…

Romil Bahl

There was nothing you would say that would itself be.

Beth Lilly - Gamco

Alright. Well, I just wanted to be clear, so.

Romil Bahl

Yes.

Beth Lilly - Gamco

Thank you very much.

Romil Bahl

Thank you so much. Yes.

Operator

Thank you. I would now like to turn the conference back over to Romil Bahl for closing remarks.

Romil Bahl - President and Chief Executive Officer

Well, thank you all for your interest in questions. I know we went a few minutes late today, but I definitely wasn’t going to have Beth calling me tell me that I dropped her again. We certainly appreciate your attendance of our earnings call. Look forward to speaking to you at the next one.

Operator

Ladies and gentleman, this concludes today’s conference. Thanks for your participation. Have a wonderful day.

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