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HMS Holdings Corp. (HMSY)

Q4 2009 Earnings Call

February 19, 2010 09:00 AM ET

Executives:

William C Lucia - Chief Executive Officer

Walter Hosp - Chief Financial Officer

Analysts:

Corey Tobin - William Blair & Co.

Richard Close - Jefferies & Co

(Phil Luma) – Bank of America Merrill Lynch

Glenn Garmont - Thinkequity Llc.

Charlie Strauser - CJS Securities

Tony Perkins - First Analysis

Carter Malloy - Stevens, Inc.

Deepak Chaulagai - Doherty & Company

James Kumpel - Madison Williams

Presentation:

Operator

Good morning. My name is Jennifer and I will be your conference operator today. At this time, I would like to welcome everyone to the HMS Holdings Corporation Fourth Quarter 2009 Earnings Call. (Operator Instructions).

Mr. Lucia, you may begin your conference.

Bill Lucia

Thank you Jennifer and good morning everyone. It's a pleasure to have you join our fourth quarter and full year 2009 earnings call. I'm Bill Lucia, CEO of HMS Holdings. I'll be hosting the call along with Walter Hosp, our CFO.

The slide presentation designed to compliment the conference may be found may be found at our website at hms.com. Please see the quarterly results page under Investors and click on the link to the webcast.

We will be making forward-looking statements in the course of this call, so please refer to the list of qualifiers included in this morning's press release and the Safe Harbor statement on slide #2 of the presentation.

HMS finished a solid 2009 with a very strong fourth quarter financial performance. For the quarter, revenue was $66.3 million, up 26.5% and EPS was $0.33 per share, up 26.9% from the prior year quarter.

To start off this morning, Walther will take you through our financial results. Then, I'll briefly provide an overview of 2009 and the quarter and discuss the healthcare environment. Then, we'll take your questions. Walter?

Walter Hosp

Thank you Bill and good morning everyone. I'll walk through our fourth quarter 2009 results first and then turn to the full year results.

As Bill mentioned, revenue resulted in a quarterly record of $66.3 million, an increase of $13.9 million or 26.5% from the $52.4 million reported for the same quarter of 2008. Our reported revenues require some drilldown to better understand strength of HMS's revenue growth.

The acquisition of IntegriGuard added $3.7 million in revenue for the 2009 fourth quarter. Adjusting for the IntegriGuard revenue, growth for the quarter was 20%.

From a product view, program integrity grew 87% in the quarter to $13 million. Product sales for all other lines of business were $53.3 million for the quarter, up 17.4% and demonstrating the high teens growth rate that we had expected.

Regarding expenses, total cost of services for the quarter were $42.2 million, an increase of $7.1 million or 20% compared to the $35.1 million in the same quarter last year. Compensation expense related to the cost of services of $22.7 million increased $6.1 million of 37% from the same quarter of the prior year.

The unusually high growth in this line item results partially from a $2.5 million increase from the IntegriGuard acquisition and from cost shifting from the direct project cost line as we continued to hire temporary workers into full time positions.

The average total company headcount, including SG&A headcount was 1237 employees, an increase of 324 employees of 35.5% above the average headcount for the fourth quarter of 2008. But, IntegriGuard accounted for 126 of the 324 increase in headcount.

Data processing expense of $3.6 million, increased $0.6 million or 21% from the prior year quarter. Spending in this line item is associated with hardware expense and depreciation, software costs and data communication costs and decreased as a percentage of revenues to 5.4%.

Occupancy cost, $3.1 million will increase $0.3 million or 11% from the prior year. This increase was entirely related to the acquisition of IntegriGuard. We expect this line to fluctuate in the future as we continue to optimize our space and the consolidation of functions into our Irving, Texas facility.

Direct project costs of $7.2 million decreased $1.5 million or 17% from the same quarter of the prior year. As mentioned, this decrease was primarily the result of bringing work in house for which we formerly utilized sub-contractors, consultants and job-specific temporary help. We expect additional cost shifting of this type into 2010.

Other operating costs of $4.2 million increased 1.4 million or 46% year-over-year with $0.4 million coming from IntegriGuard. Other increases related to professional fees, travel, postage and delivery charges.

Amortization of intangibles was $1.4 million for the quarter, up $0.2 million or 20.2% higher than the prior year quarter. Intangibles increased slightly from the acquisition of IntegriGuard.

SG&A expenses were $7.9 million for the quarter earning increase of $2 million or 35% from the comparable period last year. As a percent of revenue, SG&A expenses did increase to 11.9% from 11.2% in the prior year. This increase is attributable to higher companywide compensation expense related from stock, also professional fees and local taxes.

Average headcount in our SG&A group increased from 66 to 76 employees or 15% year-over-year. This resulted in operating income for the quarter of $16.2 million, an increase of $4.8 million or 42% versus Q4 ’08. Operating margin for the quarter increased to 24% versus 22% in 2008.

Net interest expense was $0.2 million for the quarter, the same amount as in the fourth quarter last year. This was a result of reduced interest income from cash balances due to lower interest rates and reduced interest expense from lower debt levels.

Income taxes were $6.6 million for the current quarter for an effective tax rate of 41.6%, compared to $4.2 million with an effective tax rate of 37.4% for the same quarter prior year.

Our higher effective tax rate in the quarter resulted from a one time increase in our state apportionments due to a high level of option exercises in higher tax rate states. We do expect a lower effective tax rate in subsequent quarters and we maintain the 40.5% effective rate estimate we have guided to for 2010.

Net income for the quarter was $9.3 million, an increase of $2.3 million or 32.1% from prior year. Fully diluted weighted average shares outstanding for the quarter were 28 million shares and fully diluted EPS was, as mentioned, $0.33 up 27% for the quarter compared to the 26% reported for the fourth quarter of 2008. The $0.33 equates to $0.40 in cash or adjusted EPS and both EPS figures meet the consensus forecast of the analysts that cover HMS.

Looking at the full year income statement, revenue for 2009 was $229.2 million, 24% above revenue of a $184.5 million for 2008. Adjusting for the acquisition of IntegriGuard, annual total revenue increased 24% for the year.

From a product view, program integrity grew to $32.4 million in 2009, up 78% for the year. Product sales for all other product lines were $196.8 million for the full year, up 18.4%, again, validating the high teens growth rate we had projected.

Total operating expenses for the year was a $177.4 million, a 20% increase over 2008. As a percent of revenue, total operating costs decreased year-over-year from 80.1% to 77.4% demonstrating the operating leverage in our business model.

Compensation expenses related to cost of services of $77.2 million were up 27% or $16.6 million over 2008, $2.5 million of which was from IntegriGuard. Total headcount including SG&A averaged 1,053 full-time employees, a 24.3% increase over full year 2008.

Data processing expenses were $13.7 million, up 25% versus the prior year. Most of this increase related to software with the balance related to depreciation and amortization and data communications.

Our occupancy costs increased only 7.9% or $0.8 million year-over-year, as we subleased some higher cost space and replaced it with additional low cost space in Texas. Direct project costs decreased 0.2% to $28.4 million for the year again, mainly due to the cost shifting into compensation expense and other operating costs as mentioned before.

Other operating costs were $14 million, up 29% versus prior year. Most of this increase came from increases in non-payroll, contract personnel and consultants, which has been decreased substantially in the second half of 2009.

SG&A expenses for year of $28.1 million was 27% higher than the prior year resulting in SG&A as a percentage of sales of 12.3%, slightly higher than the 12% last year. The main driver of this increase over last year was higher company-wide stock compensation expense, which is all within SG&A.

Operating income for the year was $51.9 million, an increase of $15.1 million or 41% which resulted in a full year operating margin of 22.6%, a 2.6 point increase compared to the 20% operating margin for 2008.

Net interest expense of approximately $0.9 million increased slightly compared to the $0.8 million last year. Having fully paid off our term loan in the fourth quarter, we fully advertise our deferred financing costs at the same time.

Additionally, savings related to lower interest expense were offset by lower interest earnings on our cash balances.

Our full year tax expense of $21 million resulted in a 41.1% effective tax rate for the year and was slightly above our guidance rate of 41%. As mentioned, we continue to expect an effective rate of 40.5% for 2010 guidance.

Net income was $30 million for 2009, up 41% for the year. Fully diluted outstanding shares were $27.6 million for 2009 and fully diluted EPS for the year was $1.09 versus $0.80 in 2008, an increase of 36%.

Cash or adjusted EPS for the year was $1.33. The $1.9 GAAP and the $1.33 cash EPS were both $0.01 above the consensus forecast of security analysts.

We now turn to the balance sheet and look at our general financial condition at December 31, 2009. Our cash and cash equivalents were $64.9 million having decreased from $69.5 million at the end of Q3 '09. Cash decreased $4.7 million due to debt payments and acquisitions, which I will discuss later but remain at a very healthy level.

As at the close of business yesterday, we had over $73 million of cash on hand and this cash continues to be invested in federally insured money market accounts.

Accounts receivable of $64.8 million grew 43% from year-end 2008. Due to a higher level of business activity the number of day sales outstanding at year-end increased to 87 days, compared to 84 days at the end of September 2009.

On the liability side, accounts payable, accrued expenses and other liabilities were $26.5 million, an increase of 16%, again related to the level of business activity. We fully repaid all our $17.3 million in outstanding debt by October 2009 and so had no debt outstanding as of 12/31/09.

There still have been no borrowings under our $25 million revolving credit facility. For 2009, we anticipate that existing cash balances and funds generated by operations, will be sufficient for all of our cash needs.

Looking at the statement of cash flows for the year-ended 2009, cash provided by operations increased to $32.8 million, an increase of 6% compared to $30.8 million in the same period of the prior year.

Cash from operations did not grow as rapidly as revenues or profits due primarily from higher working capital requirement and accounts payable, accounts receivables and prepaid expenses. We expect strong cash flow in Q1 2010 as we work down these working capital items.

Cash used in investing activities was $23.2 million. Purchases of property, equipment and software development were $10.7 million. During the year we acquired Verify Solutions, which utilized $7.5 million and IntegriGuard, which utilized $5 million.

Cash provided from financing activities of $6 million consisted of $10.1 million received from stock option exercises and $13.2 million for the tax benefit from the exercised stock options. This was partially offset by the $17.3 million in principal payments on the term loans.

We expect that given our outstanding pool of unexercised stock options, our cash taxes will continue to benefit substantially from disqualifying dispositions into 2010. However, we also expect to pay increasing amounts of cash taxes in 2010. We are currently estimating cash taxes at $10 million for the year.

Now, onto guidance. As we are only in the first quarter of this year, which due to our seasonality is our weakest quarter, we are not at this time changing our 2010 guidance. We are however reaffirming it. Guidance for 2010 remains at $280.5 million for revenue and $1.34 for GAAP EPS or a $1.59 for cash or adjusted EPS.

Bill will comment more about the strength we are seeing in our business, as we work our way through Q1. Or if we have any material developments in the quarter we will revise our 2010 guidance accordingly.

That concludes our review of the financial results and the financial position of the company.

Bill?

William Lucia

Thanks Walter. I’d now like to spend a few minutes highlighting some of our key strategic successes from 2009, which combined served as an excellent platform for 2010 and why we are very optimistic about the continued high levels of growth for HMS.

In our state government market, we won competitive procurements in five states, two of which Mississippi and Minnesota were new to us. Many of these contracts include a broad range of services. We should note however with the scope of procurements expanding, we're finding that the line between our coordination of benefits and program integrity services is blearing.

As we announced this quarter, HMS has entered into a subcontract with ACS State Healthcare LLC to provide cost avoidance and retrospective recoveries for the state of Florida's agency for healthcare administration. We believe that this subcontract underscores the value that HMS brings to Medicaid programs across the nation.

Now in our MCO business, we added 4.4 million Medicaid managed care lives to our portfolio in 2009 ending the year with a total of 16.6 million lives under contract, 89% of which are implemented and now generating revenue.

In 2009 our managed care business extended beyond just Medicaid to now include Medicare advantage, commercial and behavioral health lives. At the Federal level, we were awarded a second Medicaid Integrity Program task order by CMS comprising 11 states and territories.

With this award, HMS became the next contractor for 22 states and territories and a key contractor to the Federal government for identifying potential over payments resulting from fraud, waste, and abuse in the Medicaid program.

We also expanded our program integrity footprint by securing a number of key contracts in both the state and managed care market.

On the state side, we secured a behavioral health audit contract in Virginia, utilization review services for the state of Massachusetts and real time pharmacy audit services in Indiana, just to mention a few. We also sold program integrity services to large managed care organizations including Centene, Molina Healthcare, and Coventry Healthcare. From 2008 to 2009, as Walter mentioned, our revenues from program integrity grew 78%.

And finally as a result of our M&A activity in 2009, we entered two new strategic markets. First with the acquisition of IntegriGuard, we became a key player in fraud, waste, and abuse service for the Medicare program. As a CMS contractor, IntegriGuard is recognized as having the expertise and capabilities to perform program integrity work to protect the Medicare trust fund under the Medicare integrity program. Their potential impact can be significant.

As an example, IntegriGuard worked behind the scenes for more than 6 years, providing thousands of hours of audit, investigation, medical review and data analysis services to the Office of Inspector General. Their efforts provided the U.S. Attorney's Office, the OIG, and the FBI with information that helped to resolve a law enforcement investigation that led to a $60 million Medicare settlement.

We’re confident that these fraud analysis and investigative services can also be applied to our Medicaid and managed care markets over the years to come.

And in late December, we completed the acquisition of Verify Solutions. HMS through Verify now offers a proven dependant eligible audit product for self-insured employers. This audit services assures that our clients are paying healthcare costs only for those employees who are truly eligible.

And as recently reported by Price Water House Coopers’ Health Research Institute, employers are increasingly hiring experts to audit their benefit plans. According to PWC, 3% to 8% of people fail to produce dependent verification. And at $1900 average annual cost per dependent, savings can range in the millions of dollars for employers.

Based on Verify's experience we believe these rates are actually conservative. Demand for these audits is expected to continue to increase in 2010. We have also begun to cross-sell these services into our large government and managed care markets. And we believe that the large self-insured employer will ultimately benefit from our broad range of program integrity services.

Now lets touch briefly on healthcare reform. Given the recent events, the outcome of healthcare reform remains unclear. The Senate and House must reach agreement on a final bill. The two major parties appear to be far apart idealogically, so this debate will be complex and political.

However, national healthcare spending is estimated to have grown 5.7% and reached $2.5 trillion in 2009. CMS reports that national health spending is expected to grow at an average annual rate of 6.1% to $4.5 trillion by 2019.

Medicaid spending in particular will grow significantly. Federal and State Medicaid spending combined is projected to have grown 9.9% in 2009, the fastest rate of growth since 2002.

And regardless of what reform ends up looking like, medicaid is already conservatively projected by CMS to continue to grow an average 7.5% for the years 2013 through 2019, more than doubling in size. And, new claims for unemployment climbed unexpectedly last week, while people filing continuing claims did not drop. Many economists believe that unemployment will continue to rise this year.

Unemployment is the largest driver of future medicaid growth and the conservative estimates we see from CMS may not be factoring in the continued high unemployment and under-employment.

This comes at a time when individual buyers of health insurance are seeing record increases in premium rates. Insurers state that older and sicker individuals are keeping their insurance, while the younger and healthier drop coverage.

Reform proposals in Congress are aimed at addressing this issue, mandating that most individuals buy coverage, but are also assisted by premium subsidies to acquire more competitive and comprehensive coverage. You might ask as we do, how is this going to be financed? Well for medicaid CMS's fiscal year 2011 budget proposal includes $25.5 billion in medicaid assistance for states.

This expands on the Federal stimulus that already granted states $87 billion. It’s clearly an indication that the federal government will continue to support states as they deal with their expanding medicaid roles in this economic environment.

Given this rate of growth, the Federal Government must focus on cost containment and in CMS's 2011 budget is $1.7 billion to fight fraud, including $561 million in discretionary funding for Health Care Fraud and Abuse Control and $52 million in discretionary funding for the Office of the Inspector General.

Healthcare fraud has become a high profile issue and we expect to see increased interest in our program integrity offering as a result. In summary, our company has become larger and more diverse with an ever expanding range of services offered to more classes of healthcare payers.

We continue to seek bolt-on acquisitions that we can leverage across our growing client base. The programs we serve continue to grow and continue to need our services. All of these factors are very positive for HMS and our shareholders as we proceed into 2010 and beyond. We look forward to building on our strong performance in 2009.

This concludes our formal discussion about the business and we will now be happy to take your questions.

Question-and-Answer Session

Operator

(Operator Instructions). Your first question comes from Corey Tobin - William Blair & Co.

Corey Tobin - William Blair & Co.

I wanted to just hit upon the PI business for a second. Can we talk a little bit about market dynamics here? Specifically, can you give us sort of a feeling of how many PI contract decisions are occurring in the total marketplace by your estimate each quarter?

And again and it's tough number to get a precise entity with, I mean we're talking ten type of decisions, hundreds of decisions? And then, of that how many PI contracts would it be typical for you guys assign per quarter and what do you think, I guess based on those two numbers, what do you think your win rate is right now in the PI segment?

William Lucia

Those are good questions. Let me try to answer that with a little description about what’s included in PI and I’ll first take a step back and remind you that one of the things I said was, there is a real blurring of the lines between coordination of benefit and PI. And I say that because most of the re-procurements that we have done in our traditional coordination of benefits business this year included components of program integrity services.

So, if I were to answer the question related to just that, I’d say we are five-for-five this year. But there are individual program integrity procurements that have been released as well. And some of them don’t necessarily match to our strength, some are just software solutions and we are not a software company.

But, within that program integrity umbrella are large clinical procurements, financial audits and procurements from all three major markets, Federal, State and commercial. So it would be hard to give you a win loss rate, because we don’t bid on every procurement that comes out.

I can tell you that on the areas of focus for HMS, we’re increasingly successful in what is a very new market for us.

Corey Tobin - William Blair & Co.

Can you talk about the competitive barriers in the PI market today, both where they are at this point in time and where do you see them trending toward not just for your business, but what kind of competitive barrier you expect to see throughout the whole market place for PI, over the next five years or so?

William Lucia

Well with the nation's focus and the very public focus on healthcare fraud and abuse, I think that we'll see continued new entrance into this market but I would take a step back and remind everyone that lot of the entities that are focused in this space are software companies or they are companies that provides software as a service for the client either state Medicaid agency, the Federal government, or commercial health plan to mine their data and find the outliers which many of these entities are ill equipped to then take these outliers and do the forensic investigative services or the clinical review that has to be done to then challenge that the appropriateness of that claim.

That’s really where HMS comes in and has built a very strong framework to be able to close the loop for our clients. Now we own our own proprietary software where we do the mining for outliers. So we have the full solution, we just today are not a software vendor delivering the software only to our clients.

And I think we have said in the past that our clients sometimes had been really our largest competitor and that we are an outsourced service in many ways in the coordination of benefits business, I think we'll see that same – we see that same analogy in program integrity.

Walter Hosp

I will add one other comment on that because its clearly the integration of all the way from analytics to collection if you would that will be a competitive issue but also the breath of service offerings.

And what we see in the competitive framework at least today are many providers that have a niche or a single product area, whereas what HMS has developed is a rather broad offering and an integrated offering as well.

Corey Tobin - William Blair & Co.

That’s great. Two other real quick ones on this plan if you could. Back to your point on that you’re not going after every contract, for the contracts that you are aggressively going after, where would you peg your win rate at roughly speaking? Is it north of 50%?

William Lucia

I would probably say -- I would have to qualify my answer by saying you asked about what we’re aggressively going after, and what we aggressively go after is expansions of existing contracts to include program integrity and/or helping our clients who are re-procuring understand our program integrity as a critical component of the work we do.

So it's hard – again it blurs because it's hard to say that. I can say on contract where we’re not bidding on our core end program integrity, we probably have about a 50% win rate. But I would caution that just by saying that we are experimenting in a lot of new areas. So as we find the most profitable and most effective areas of program integrity for our clients, I would expect to see the win rate increase.

Corey Tobin - William Blair & Co.

Great and the last one if I could, Walter, can you remind us what is the growth expectation you have baked in to your estimates for 2010 for PI?

Walter Hosp

We have a wide range on that, but it's a growth number that would approximate the 75% level that we did this year generally.

Operator

Your next question comes from Richard Close - Jefferies & Co.

Richard Close - Jefferies & Co.

Congratulations on another solid year. Walter, just really quick, I missed the actual revenue on PI for the year. Can you repeat that?

Walter Hosp

Yes. I'll give it to you both for the quarter --.

Richard Close - Jefferies & Co.

For the quarter in the year?

Walter Hosp

Right. For the quarter, it grew 87% to $13 million and for the full year, program integrity was $32.4 million, up 78%.

Richard Close - Jefferies & Co.

And then, I know you gave the (lines) on the managed care, did you give the revenue for the year?

Walter Hosp

We didn’t, but I can give that to you. So our Medicaid managed care business had a very strong quarter, approximately 75% growth in the quarter to $16.9 million. And for the year, it was up 62% to $57 million.

Richard Close - Jefferies & Co.

Okay, one thing I do want to hit on is, in your discussion you talked about the cost shift and getting rid of some sub-contractors and part-timers and bringing people on full time. Can you talk a little bit about the margin dynamics of that? How do you benefit going out? Is there much more you can do on there with respect to the cost shift?

Walter Hosp

Well, I will answer your question maybe a bit broader, because it really does say, is there additional leverage and margins, because when you look across our P&L, there is many line items that are leverageable.

Clearly some of that cost shifting we do that not because it – well there is a margin pick up for that, but you really have to look at it as an integrated delivery and the costs associated with that. So our model, which has shown again, the 2.6% increase in operating margins, it demonstrates that as we grow we have this continued operating leverage and we have said we clearly expect that to continue into the future.

We always caution against that when you look at total results because we also invest in program integrity, which has a dampening effect on margins. And through the year it will be the balance of how aggressively we’re investing in program integrity which dampens the margins offsetting the growth and program integrity as we grow in our core services.

For our guidance, we've guided for no increase in margins. And that is a target, if you would. We’ll have to see where that comes out during the year, but that would imply that we’re going to be aggressive at investing in program integrity.

Richard Close - Jefferies & Co.

Okay. And then, just as a follow up to that. Bill you know in talking about, in Corey’s question in terms of aggressively going after business in PI, I think you stated you liked to add on to your coordination of benefits, presents and those lines are blurring.

Do you see that lines as blurring between coordination of benefits and PI as a positive for you guys, for HMS or a negative?

And I'm trying to relate this to Walter’s comments on PI having a dampening effect on the margins. As an add-on to coordination or benefits does that allow you to maybe get better margins from PI business and if you weren't doing the coordination of benefits?

William Lucia

Let me answer the first part of your question first. And that's, do we see that at the positive or negative? We definitely see it at the positive. I'd like to take a step-back and just say that the term program integrity is more used in the state market or government market, and in the commercial market its often called payment integrity.

But in reality coordination of benefits falls under that very broad umbrella. It's just one of the ways that assure payments are made appropriately on behalf of the right individual.

With that said, it's a positive for us because it gives us marketing presence and power to be able to sell something to existing customers under a framework that they understand and be able to show them without even having a contract what we found. I mean, as we see their claims data we know where they have problems. So from that perspective it's extremely powerful and a positive for us.

It doesn't really impact negatively, I believe, the margins for program integrity and in fact in some ways maybe more positive on the margins because where we have combined contracts we have economy of scale. We are not reformatting claims again, we're using the data we have already.

So, I think that net, that's all a positive for us. And I think we have a hand in making sure that customers realize that we're a one stop shop.

Richard Close - Jefferies & Co.

Yes. I guess that’s what I’d be saying here is, that you are probably aggressively going after this business within your existing base and thus it's going to have less of that dampening effect on margins that Walter eluded too?

Walter Hosp

Well we are going against our base. Again the dampening effect, I want to point out is, yeah we are really focussing on that in 2010. What it does on the plus side for us -- the investment in program integrity is, it accelerates our top line growth and because we are at early stages in terms of where program integrity will be, we also feel that over time we’ll be able to go up the margin curve with a portfolio of program integrity.

Now we’ll have incremental EPS growth as a result of it and we’ve guided towards that, but what we are doing is building and taking advantage of an opportunity today that should bare fruit well into the future of multiple years, including at some point, going up the margin curve with the whole program integrity portfolio as well.

Richard Close - Jefferies & Co.

And just one final question here with respect to, Bill you mentioned the President’s budget, or proposed budget and all the focusing on fraud, waste and abuse. Have you seen or are you beginning to hear of any chatter of specific contracts or initiatives come out of that particular budget, or is that just way too early to tell?

William Lucia

We haven’t seen specific proposals for contracting coming out of it. We have seen work plans that are available publically from CMS and proposals from the administration of the types of areas they would like to focus on.

From our review of those proposals they're very positive for us in how we are positioned as a company but I think what we'll see as the budgets are nailed down, I think we will start to see combination of both new procurements but an expansion of existing contracts. I mean CMS is often using dollars to expand activities with their existing trusted vendor partners.

Operator

Your next question comes from (Phil Luma) – Bank of America Merrill Lynch

(Phil Luma) – Bank of America Merrill Lynch

Just wanted get some commentary around the business developments in Florida and if you could just give us any brief comparison between the way that’s progressing and in existing relationship that you have in Texas.

William Lucia

Fu, this is Bill thank you. We as you know we announced this in an 8K about our subcontract with ACS in Florida. It is progressing we are in the process starting our first set of deliverables.

In the state of Texas, we have a, what I would consider a collaborative relationship with ACS as they manage the broader MMIS solution for the state of Texas Medicaid program and the two companies do work together on finding solutions for the stay.

We believe once we get through implementation in Florida that will have very similar opportunities in the state of Florida. And we’re glad to be turning the previously competitive relationship into one of a more collaborative one with ACS Xerox.

(Phil Luma) – Bank of America Merrill Lynch

And do you have a timeframe for when that should be, I guess, at the regular run rate in Florida?

William Lucia

Well, because the existing subcontract is narrow in scope, meaning we do some cost avoidance work and some retrospective recoveries on very old claims, we expect that we'll start to see impact in Q2 of this year, it will ramp up. But it will never be at the run rate – under this subcontract, it will never be at the old run rate we had for Florida. Again until that relationship has more stability, and we’re able to work closely with ACS and the state of Florida.

Operator

Your next question comes from Glenn Garmont - Thinkequity Llc.

Glenn Garmont - Thinkequity Llc

Just two quick ones. I guess continuing the line of questioning related to Florida, Bill I guess I'm just unclear as to why you weren't able to dislodge ACS in Florida? And maybe provide greater scope of services down there, you guys were there, you had the track record, they did not. I'm just wondering why you just couldn't take the business; can you help me understand the dynamic there?

William Lucia

I'll try to on a brief conference call, but it really does speak to state procurement and the politics around state procurement. And I think that we made an assessment that it was not good for the Medicaid program, the State of Florida tax payers or us to get even more aggressive in trying to dislodge ACS.

Remember ACS is a partner in the State of Texas. ACS Xerox is a large company that may bring other opportunities to the table and we felt that supporting them to solve the problem for the State of Florida was our best bet considering their contract would not end until at least the primary contract till late 2013. And there are very few states that terminate contractors in contingency contracts.

So, it was really an assessment of the opportunity and risks and a decision to move forward.

Glenn Garmont - Thinkequity Llc.

Okay, but it's fair to say there's opportunity down the road to expand the scope there. Okay, could you do it prior to the expiration of that contract, or will the existing scopes sort of be how things proceed there until that primary contract expires?

William Lucia

No, I mean, we are planning – ACS and HMS are working together to get the first phase of our implementation done. The sub-contracts for which we are working under, the terms of that have a narrow scope. But we are hoping that we will be expanding that scope through the balance of the term of this contract.

Glenn Garmont - Thinkequity Llc.

And then, real quick, if I could ask you another one. Walter, just getting back to the MCO business, good, great growth in 2009. Just remind us what the growth expectation is baked into your 2010 guidance? If you’ve provided that I apologize. I missed it.

Walter Hosp

Yes. It’s in the 40% to 50% range.

Glenn Garmont - Thinkequity Llc.

Okay. And how do you build that up? Is that just more lives on existing contracts or you factor some new business in there as well?

Walter Hosp

Yes, of course we factor new business in there. We continue to sell to medium sized regional type Medicaid managed care plans. But the growth has shifted over the years from brand new accounts to growing the base of the accounts that we already have in place as well, okay? We still have a backlog entering the year and it’s all these factors that add to the managed care growth.

Glenn Garmont - Thinkequity Llc.

So 62% growth for the full year. What was your expectation going into 2009?

Walter Hosp

About 50%.

Operator

Your next question comes from Charlie Strauser - CJS Securities.

Charles Strauser – CJS Securities

Just one quick question Bill. just more general when you think about all the new kind of growth avenues you are entering into and have moved down the road over the last few years. We obviously know what your competitive situation looks like in the core business.

But can you refresh us in terms of what are some of the competitive dynamics in the various new marketplaces you are in? Are there any large public companies that compete with you there or is it more kind of the fragmented industry that you’ve seen before?

William Lucia

Let me kind of take that market by market. I mean in the large employer market for what we do, for those firms that specialize independent eligibility audits, we don’t see large public companies. They are typically smaller companies, private companies.

There are large benefit brokerage companies that do this work they don't specialize in it. It's sort of an add junk because their clients require it or expect it.

In the commercial market space, managed care space for program integrity, there are a large number of companies that serve that space. I don't think many of them are public companies though maybe a few are.

But again it's like I answer the question earlier, there are a number that provide software, the ones that provide true services that are complete solutions similar to HMS, there are fewer of those. They are typically specialty vendors and in that case we don't see very large public companies in that space.

The one company that does compete in program integrity, but again, primarily focuses on software data solutions, that we see in this market is Ingenix of course the subsidiary of UnitedHealth care. But that's really – the rest are in the federal level like some of the big iron companies that are in this space.

Operator

(Operator Instructions). Your next question comes from Tony Perkins - First Analysis.

Tony Perkins - First Analysis

I was wondering if you could give us some insight into your thoughts on penetrating the self-insured employer market, leveraging verified solutions offering and the possible cross selling opportunities there?

William Lucia

Sure Tony. The first thing we want to do with Verify is to grow it. So, our first job at cross-selling is really to cross-sell Verify into our existing markets.

So we are focused heavily on training our account managers and manage care to both sell to their clients who are large employers, but also to sell to the commercial entities as branded products that they can sell to their employer clients.

And, we are doing the same on the government side, state employee benefit plans and county and municipal plans are very large employers. So that cross-selling has begun. And then, related industries, those that serve government are one of the other areas we are going to.

In fact it’d be important to note that two of the large agencies at the Federal level have sent out letters to all their contractors stating that they are requiring them to do dependent eligibility audits, because in the Federal market a number of contracts are cost plus and they feel that the cost of ineligible dependents is being shifted in those loaded rates that are charged to the Federal government. So we think that’s an opportunity.

On the reverse side is our ability to sell program integrity to large employers and that we are just starting to identify which services within our program integrity portfolio apply and then working with Verify to determine what are the best avenues to sell that and what partners do they have today that will help us and expanding in that row.

But the first step is really to expand Verify’s footprint in the market.

Tony Perkins - First Analysis

Do you have any thoughts, I know you said you are early here in trying to penetrate the self-insured employer market. Do you thoughts, I mean is this is more of a 2011, 2012 time frame once you have everything ironed out or do you think that work would start here in 2010?

William Lucia

I think that our plans are to grow, Verify in that footprint in 2010. I mean, we've not yet included Verify in our guidance as Walter had said earlier, we are looking at a combination of that and other precipitating events either the way we end our first quarter of the year or potential other acquisition where we would then revise our guidance.

But I can tell you that in 2010 out plans are to grow Verify and we just closed on the deal December 31st and we are already in aggressive marketing mode.

Walter Hosp

Just to clarify Tony, we did say that Verify Solutions would add $7 million in revenue this year and be slightly accretive but we haven’t baked that into our guidance.

Operator

Your next question comes from Carter Malloy - Stevens, Inc.

Carter Malloy - Stevens, Inc.

As I look at the guidance out for 2010 versus 09', I've taken into account your, if I look at the 09' numbers and back out MCO in program integrity, I get kind of a $140 million in the core business.

Even if I take into account your expectations for those two businesses for 2010, I get the core business at about $140 million again. Is something off in my math here or can you help me explain, the core business guidance here.

Walter Hosp

I think when you are backing off MCO, you are backing off, its all really a definition of core, right. When you back, a lot of what we consider core which would be our historically traditional coordination of benefits business is in MCO. So I don’t know, if you’re trying to get to Carter, what is our state government business?

Carter Malloy - Stevens, Inc.

Yes, correct.

Walter Hosp

Yeah, in our state government business, if you adjust for Florida, both in the fourth quarter and the full year, it was up approximately 19%, and in our 2010 guidance although we’re assuming around 75% growth in program integrity, again we expect high teens growth for the rest of the business.

Carter Malloy - Stevens, Inc.

Correct but if I carve out the MCO at a 45% growth rate, then that would imply that the state business is still at about a $140 million rate, which simply puts it flat year-over-year I'm trying to recognize that?

Walter Hosp

No, we don't assume the state business to be flat year-over-year again –

William Lucia

I think you also said you were carving out program integrity?

Carter Malloy - Stevens, Inc.

Yeah.

William Lucia

Yeah, and probably about three quarters of program integrity is in our government business.

Walter Hosp

That’s right, you’re doing an overlap of products and markets in those two numbers and you can't do that. Program integrity is, as Bill pointed out, is across all our markets. So you have to do one adjustment or the other, you can't do both.

Carter Malloy - Stevens, Inc.

Okay so but backing out program integrity and MCO is not giving me a basic state coordination of benefits number?

Walter Hosp

No, because there’s other things beyond state, there’s federal, there’s other business that we have as well. So, and program integrity is in all of those markets.

Carter Malloy - Stevens, Inc.

Okay, maybe I can call up offline.

Walter Hosp

Yes, certainly.

William Lucia

Yeah, I mean you’re pointing out something important here. I mean our metrics of business is products and markets and you have to look at it with a separate lines of each and netting the two out or reconciling the two is very hard to do. It's not impossible.

Operator

Your next question comes from Deepak Chaulagai - Doherty & Company.

Deepak Chaulagai - Doherty & Company

What is your Medicaid enrollment growth rate expectations for the next fiscal year-end? What is that on a waited average basis for this year, in the states you do business?

William Lucia

Yes, Medicaid enrollment, we have some numbers that track volumes of activities internally. But Medicaid enrollment consistently has lags on it. If you look at the latest reports from Kaizer, you would see a growth rate of approximately 5.6% in enrollment in Medicaid in 2009. We will see what the final numbers are. That’s against the historical growth rate that has been approximately 2% in average type. So it's been up there.

We would expect to see in Medicaid, enrollment levels similar to that to continue, but that’s all conditioned upon the sustainability of unemployment, the stickiness and lags that work through Medicaid as well. And it's difficult to have a forecast on that precisely.

We would rather focus on the expenditure rate which includes, obviously embedded in the expenditures is the enrollment rates of that. We examine it to see that the two numbers are consistent. But what we have built in our planning is that underlying 10% overall growth in the Medicaid program, somewhat adjusted for the areas that affect us most.

So for example in Medicaid, there is a large long-term care component of expenditures that doesn’t affect our business greatly. And we look more at the acute care expenditures of hospitals, physicians and drugs as well.

And so we discount that 10% of it down to the 8% range or so, that we’re looking at, that effects our areas.

Deepak Chaulagai - Doherty & Company

In terms of the assets that you have acquired and looking forward when you look at penetrating all these new markets, especially the commercial market where I believe you guys penetration is low at this point. Are there any strategic assets that you would like to acquire? Are you looking at those or do you have all the capabilities you need to go after that market?

William Lucia

That’s a good question. We are. We do have an active M&A program and while there – I can't really speak to a specific entity or type of service. The services we are looking at are related to the expanded program integrity services. But, we are looking more bolt-on acquisitions that will broaden that footprint and enable us to sell more services to the commercial market and hopefully some of the entities we buy will come with commercial customers.

Walter Hosp

And I’ll just add that they can be of similar size to what we've done in the past or larger. The larger they are, the fewer we have I would, say in our pipeline of potential acquisitions. But we have very rigorous screens and we also have a history paying fair prices, but not exorbitant prices for these as well. But we really should set your expectations to see more of the same of what we've done in the past.

Operator

Your next question comes from James Kumpel - Madison Williams.

James Kumpel – Madison Williams

Can you actually just expand on what you are doing today on the Medicare side and what you see as the opportunities coming forward, either with health reform or with some of the acquisitions and product developments that you've made internally?

William Lucia

Thanks James. You mentioned Medicare, and our first real, real entry into Medicare was through the acquisition of IntegriGuard. We expect to continue to expand the footprint in the Medicare Integrity Program as CMS focuses on increased activity.

We are the vendor behind the scenes in many cases as I mentioned with the $60 million settlement who is doing the data analysis and the investigative work to help the Department of Justice, OIG or CMS resolve these very large issues.

So we will see that expanding. We are also – I think we just sold a Medicare advantage plan with about 200,000 lives this quarter. So we expect that the Medicare advantage market will grow as an opportunity for us as well.

James Kumpel - Madison Williams

As it relates to IntegriGuard and helping behind the scenes, are there ever elements of contingency payments on those settlement or is it for the most part, a fee for service kind of arrangement?

William Lucia

In our contracts today they are cost plus or fixed fee components. We do not have contingency fee. While the numbers in the settlements can be large, that's probably a good thing in this market because sometimes it could take five to six years until the investigation is - not just the investigation but the legal settlement is negotiated.

So that kind of, what we are used to, a little bit of doing the work and then not getting paid for it for a couple of months, doing the work and not getting paid for it for five years would be different.

James Kumpel - Madison Williams

I guess the last thing would be, do you see other competitive situations out of Florida where essentially, you are becoming more of a partner to some traditional competitors through business? And how would that, how could we look at that development in-terms of margin outlook?

William Lucia

Well, we are always open and you could see it as an extension of our acquisition program as well. But we are always open to various types of business partnerships and arrangements. We work with MMIS providers in various states. We are working with EDS, Unisys etc. So in that regard the relationship with ACS is not any different particularly in Texas.

And beside some uniqueness in Florida, but we see that developing as something more akin to what we have in other states. So we continue to look for business partners in the MMIS space and in other spaces as well.

Acquisitions are one way to do it. We have various software partnerships with other suppliers and we look constantly at innovation with various partners as we are spearheading some of the development in this relatively new space of program integrity.

And we do in both state and Federal market, have other partners HP-EDS, Unisys, Molina, First Health, now Magellan are all partners with us in the state market depending on the specific state, so.

Operator

Our final question comes from Richard Close - Jefferies & Co.

Richard Close - Jefferies & Co.

Why wouldn’t you include Verify in your guidance, what's the process there, top process?

William Lucia

Well the process is simply that we don’t necessarily want to be in a position of adjusting guidance every quarter, Verify although it’s an important transaction as I say it's only mildly accretive it doesn’t really change the EPS guidance in a material way.

So what we’ve done is supply the information about where revenues are but the first year of an acquisition we incur integration cost and amortization of intangibles. Again you've heard Bill talk about how we expect to grow this business and it will add to it.

But we're just, we are careful about revising guidance until we have something substantial and as I mentioned earlier in my formal comments that we’d like to get a quarter of results down before we reexamine guidance there.

Now as always if we have events that come up before a quarter end and other acquisition per se or a very important contract or etcetera on that then we would we revisit guidance and adjust accordingly.

Richard Close - Jefferies & Co.

Okay but you have not included Verify in the guidance, so nothing has necessarily changed from the standpoint of your pre-existing guidance in terms of – just to be clear I want to make sure that that revenue is in there.

William Lucia

That revenue is not in there, and we haven't changed from the $228.5 million in revenue although since we've gotten Verify Solutions, it would be appropriate to look at an increase from that number and our dollar – I'm sorry I'm giving you last year's numbers here, our $280.5 million number, it would be appropriate to put in $7 million more on that. And our $1.34 in GAAP EPS would not – again formally adjusting that but – because we’re saying Verify Solutions in this first year would be only slightly accretive.

Operator

At this time there are no further questions. We will turn the conference over to Mr. Lucia for closing remarks.

William Lucia

Thank you, and I would like to thank everybody for attending and just to leave you with a few closing comments.

As we've mentioned in the course of this call and in the Q&A, the environment, the demographics that support our business are stronger than ever. We believe we've structured a set of services and approach to new markets that will continue to drive steady growth from HMS and a very positive outlook for the company and its shareholders.

So we thank you for your attendance today and look forward to seeing in our next call.

Operator

Thank you ladies and gentlemen. This does conclude today's conference call. You may now disconnect your lines.

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Source: HMS Holdings Corp. Q4 2009 Earnings Call Transcript
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