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HealthStream Inc (NASDAQ:HSTM)

Q2 2014 Results Conference Call

July 22, 2014 / 9:00 A.M. E.T.

Executives

Mollie Condra – VP of IR and Communications

Robert Frist – CEO

Gerry Hayden – SVP and CFO

Analysts

Ryan Daniels – William Blair

Matt Hewitt – Craig-Hallum Capital Group

Scott Berg – Northland Securities

Richard Close – Avondale Partners

Frank Saraceno – First Analysis

Steven Rubis – Stifel Nicolaus

Terry Lally – Spotlight Funds

Operator

Good day, ladies and gentlemen, and welcome to the HealthStream second-quarter 2014 earnings conference call. (Operator Instructions) As a reminder, this conference call may be recorded. I would now like to introduce your host for today's conference, Mollie Condra, Vice President of Investor Relations and Communications.

Mollie Condra

Thank you, and good morning. Thank you for joining us today to discuss our second-quarter 2014 results. Also in the room with me today are Robert A. Frist, Jr., CEO and Chairman of HealthStream; and Gerry Hayden, Senior Vice President and CFO.

I would also like to remind you that this conference call may contain forward-looking statements regarding future events and future performance of HealthStream that involve risks and uncertainties that could cause the actual results to differ materially from those projected in the forward-looking statements. Information concerning these risks and other factors that could cause the results to differ materially from those forward-looking statements are contained in the Company's filings with the SEC, including Forms 10-K and 10-Q.

With that, I will now turn the call over to our CEO, Robert Frist.

Robert Frist

Thank you, Mollie. Good morning, everyone. Welcome to our earnings conference call. We have a lot to cover today and a well-prepared script. Hopefully we'll get through that quickly so that we can get on to your questions and provide some answers.

We operate in two business segments: a segment that focuses on workforce development solutions, and a segment that focuses on research patient experience solutions. For us, a solution is a combination of products and/or services that we offer to a healthcare organization to help them achieve a business or clinical outcome.

Our workforce development segment offers market-leading products and solutions in compliance, resuscitation, ICD-10 readiness, performance management, competency management, and learning management among others. In addition to government-mandated surveys, our research patient experienced segment combines survey results with consulting to create a solution to improve a patient's experience while in a clinical setting.

With quarterly revenues up 33% and adjusted EBITDA up 14%, I'd like to take a look at some of the contributors that are driving that growth. And first, we'll do a few definitions. Within our platform ecosystem, each individual end-user utilizes at least one HealthStream subscription-based solution is counted as one subscriber, regardless of the number of subscriptions contracted by or for that end-user.

As of June 30, 2014, HealthStream had approximately 3.69 million total subscribers implemented; and implementation is important because that's when revenue recognition begins. And 3.98 million total subscribers contracted. You can see that there is an implementation backlog between the contracted and implemented amounts.

So we are about to push through the 4 million mark on contracted subscribers, and we look forward to that exciting milestone in the near future. In the second quarter, we contacted approximately 130,000 new subscribers.

The workforce development segment continues to benefit both an increase in the number of total subscribers as well as greater courseware consumption across the subscriber base. As a result, our metric, annualized revenue per subscriber, increased by 20% from 29.40 in the second quarter 2013 to 35.39 this quarter. I think this is noteworthy given that the implemented subscriber count, the denominator, grew by 18% during this period.

For the last eight quarters, we've seen a steady upward trajectory in this metric, which is indicative of our progress of selling more solutions to our growing customer base. Strong contributors to this growth include product and solutions sales from ICD-10 readiness, resuscitation, compliance and clinical offerings, and our competency in performance center applications, which are gaining traction in the market.

To further support our growth, we expanded our senior leadership team in the second quarter. We announced that Michael Sousa, who has previously served as our Senior Vice President of Sales, was named the Senior Vice President of Business Development. His historical leadership in gaining new business for the Company, we believe, uniquely qualifies him to launch new revenue-generating opportunities for the Company as he assumes this new and exciting role for us.

At the same time, we announced that Tom Schultz has joined HealthStream as Senior Vice President of Sales. His 26 years of healthcare technology experience in human capital management and, in particular, his previous 16 years as head of sales for Lawson's healthcare business, which is now part of Infor, make Tom well qualified to further drive the Company's growth. We are excited to expand the senior leadership team and adjust the roles as we seek growth in the near future.

I'll now turn the call over to Gerry, who will dive into the financials in detail. Then we'll come back and do some business line updates.

Gerry Hayden

Thank you, Bobby. Good morning, everyone. I'll provide some financial color on our results. First, some financial highlights. As a reminder, all of the following quarterly numbers show our results in the second quarter of 2014 compared to the second quarter of 2013.

Consolidated revenues were up 33% to $42.5 million. Operating income was $4.1 million in both quarters. Net income was $2.4 million in both quarters, and adjusted EBITDA was up 14% to $7.3 million in the second quarter of 2014.

Let's now let's look at for years the income statement. Revenue growth, gross margin, operating expenses, and operating income.

Revenue growth. You've seen that overall revenue growth is 33% in the second quarter, which is a combination of strong organic growth complemented by recent acquisitions. The ICD-10 Radiant solution, an example of strong organic growth, contributed $7.2 million to the second-quarter revenues compared to $2.9 million in last year's second quarter. Even excluding the ICD-10 Radiant solution, our overall revenue growth is about 16%.

We continue to see positive results in many products and solutions. For instance, we are pleased to report that revenue from our clinical education solutions in partnership with Lippincott has grown by 96% year-to-date, and our Competency and Performance Center revenues have grown by 87% for the same period year to date.

This quarter, we saw improvement in our patient experience – research/patient experience segment, which reported 19% overall growth versus second quarter of 2013. In addition to contributions from the BLG acquisition, patient insights grew by 12% this quarter to drive the overall growth of 19%. While the first half of 2014 was strong, our research/patient experience segment – in that segment, we expect even stronger growth for the remainder of the year due to known expansions from existing customers who acquired investments in personnel capacity later this year.

Now let's look at gross margins. A similar pattern to the past several quarters, platform products with higher gross margins performed well during the second quarter of 2014 but lower than gross margin solutions. This is our ICD-10-rated solution; resuscitation and clinical solutions grew even faster, resulted in a gross margin decrease from 60% to 56%.

Let's turn our attention to operating expenses. We continue to make investments in our product development. Product development expenses as a percent of revenue have increased to 10.1% in the second quarter of 2014 from 8.7% in the same period last year. This equates to a 55% increase in our product development expenses. G&A expenses as a percentage of revenue decreased from last year's quarter level of 15.1% to 12.6% in Q2 of 2014. This trend of declining G&A expenses as a percent of revenue reflects our ability to invest in key areas of product development while leveraging our G&A infrastructure.

Operating income. As you know from our previous investor calls, GAAP accounting rules require us to write down acquired deferred revenue balances to fair value as part of recording the initial transaction. This accounting convention results in reduced reported revenue and operating income until we have amortized that initial discount. Accordingly, our second-quarter operating results include $703,000 of deferred revenue write-downs, most of which pertains to the ACCS transaction from back in March of this year.

Including the ACCS deferred revenue write-down, operating income was the same between the second quarters of both years. However, without the ACCS write-down deferred revenue, operating income growth on a pro forma basis would've been 17% quarter over quarter.

The balance sheet. Our cash position and overall balance sheet are strong, further enabling our ability to support growth and development activities. As of June 30, 2014, our cash balance was $112 million, a $10 million increase from the $102 million balance at March 31, 2014. So in essence, we've recouped about $10 million of the $13 million cash redeployed the ACCS transaction closing in March of this year. Also, as you already know, we have no long-term debt.

And one last financial metric, which reinforces our cash position, is cash flow from operations, which year to date in 2014 has grown by 95% over 2013, increasing from $11.4 million to $22. million this year.

We continue to review and evaluate a variety of acquisitions and business development opportunities while maintaining our discipline in terms of strategic fit evaluation. We're excited about the appointment of Michael Sousa to serve as our Senior Vice President of Business Development. With extensive knowledge of the healthcare industry, innovative use of technology to create new solutions, and proven experience makes him uniquely qualified to prioritize and help launch new business development and revenue-generating initiatives for the Company.

So finally, our guidance. Yesterday's earnings release contains updated guidance, and we now anticipate that consolidated revenues would grow between 26% and 29%. We expect our Workforce Development segment revenues to increase in the 28% to 32% range. And, for the reasons cited earlier, we expect research revenues to grow by approximately 15% to 19%. Part of which growth includes the revenues from the BLG acquisition, which we closed in September of 2013.

We are reiterating our guidance that operating income will decrease between 2% to 11% over the full year of 2013. This range includes between $2.5 million and $3 million related to the acquisition of ACCS, which includes the combined impact of the deferred revenue write-down, amortization of acquired tangible assets, incremental investments in sales, marketing, product development, and approximately $13,000 of transaction closing costs. This guidance does not include the impact from any other business development activities that we may complete during the remainder of 2014.

We are also reiterating our guidance that our 2014 capital expenditures will be between $9 million and $12 million. And we also expect our effective income tax rate to be between 42% and 44%. Our guidance takes into account our assessment of the ICD-10 deadline postponement. On April 1, 2014, the Protecting Access to Medicare Act of 2014, as signed by the President, which postponed the deadline for requiring the use of the ICD-10 coding system previously 2014 for at least one year. Although the deadline for the transition to the ICD-10 coding system set by Ascension Medicare Services DMS and medical organizations has been extended three times, in May of this year CNS reiterated its intent to confirm October 1, 2015 as the deadline.

Based on preliminary market indicators, our assessment of the impact of the postponement on results of operations is now included in the aforementioned guidance for this year.

Thank you for your time. I will now turn the call back to Bobby.

Robert Frist

Thank you, Gerry, for the detailed look at the financial performance for the quarter. I think it's time to take a look at business line, market and product updates. So I'm going to dive into a few of those for you.

First, as you know, we are having an entry into an ancillary or adjacent market, the post-acute care market, which employs, by our estimates and our definition, about 3 million additional healthcare workers. This target market is in addition to the 5 million healthcare workers working in the acute-care space.

And in the quarter we have a number of positive developments to report relating to our expansion into the post-acute care market. For example, we continue to add content partners who specialize in this space. In the second quarter, we signed a partnership with Home Care Institute to offer over 120 courses that are focused on the needs of home health and hospice workforce. This brings the total of content partners for our post-acute care space to seven. And we are excited that the library of content now available for this market is expanding at a steady pace.

During the quarter, we added thousands of new subscribers from the post-acute care market, so we are seeing some sales team effectiveness. We are happy to welcome Capital Caring hospice, Foundation Health Services, and Missouri Slope Lutheran Care Center as HealthStream customers new during the quarter.

In addition, we congratulate Brookdale Senior Living on their recent acquisition and welcome Americus' 30,000 employees to our platform. So, a strong add for Brookdale and a strong add for HealthStream.

Turning our attention to HealthStream Performance Center and HealthStream Competency Center product sets. During the second quarter of 2014, we continued to expand our customer base for these products. We added approximately 31,000 subscribers were contracted in the second quarter of 2014, which includes new customers like Texas Children's Hospital, Wake Forest University Medical Center, and Methodist Health Systems. We are excited to have these customers turn to us as their partner to support their broader talent management objectives.

We continue to add new capabilities to our overall Competency Management suite. In the second quarter, we launched Checklist Management. This is a powerful product and feature set that's used to create checklists for a wide variety of workforce needs in health care organizations. Use of our Checklist Management product eliminates paperwork, automating processes that are critical in assessing and validating competencies and skill sets. Already, 15 organizations have contracted for this new innovative product and feature set.

I'll turn our attention to the ICD-10 readiness products. These are important solution offerings from HealthStream to prepare America's healthcare workforce to the migration to the new ICD-10 coding standards. Revenues from our ICD-10 readiness solution were approximately $7.2 million in the second quarter of 2014. Sales and contracting for the ICD-10 readiness solution were strongest in the fourth quarter of 2013 and the first quarter of 2014. Accordingly, we expect revenue to be strongest in the second, third, and fourth quarters of 2014 and begin declining thereafter.

In our last quarterly conference call, we stated that customers had deferred contracting for ICD-10 solutions following the most recently announced postponement. Toward the end of the second quarter, modest contracting resumed as customers recalibrated around the new proposed deadline.

In the second quarter, 27 small contracts were signed for ICD-10 readiness solution. Through the rounding of numbers, then, our cumulative number of subscribers for the ICD-10 solution remains at approximately $1.6 million.

I'll now refresh a few details about the ICD-10 readiness solution. Retail prices for ICD-10 sales generally range from $15 to $125 per user per year, with the majority of contracts being two-year terms. Sales to date indicate an enterprise level of focus on orienting the wide range of employees impacted by the ICD-10 transition, which has led the average price per user to fall at the lowest end of the retail price range.

The vast majority of our customers that have contracted for ICD-10 solutions are also using other HealthStream products. In light of the postponement, we offered our ICD-10 customers the option to purchase a one-year extension of their current solution at a 50% annualized discount. Customers who accept the offer are eligible to blend unbilled payments remaining on their existing term with the discounted payments of their extension term, then spread the number of payments over the existing term plus the extension term.

Customers receive a discounted extension and lower periodic payments, while we receive greater total revenue recognized over an extended period of time. Our ICD-10 readiness solution is offered in conjunction with our partner Precise. Our partnership with Precise has produced outstanding results, and we are excited that this partnership has been expanded during the second quarter. We've expanded with a new five-year contract with Precise.

We anticipate working with our partner Precise as we transition our focus from ICD-10 readiness products, the current product set, to offer solutions that meet the ongoing development and training needs of coding professionals in the healthcare marketplace. So we're excited as we look forward with Precise to be working on and developing next-generation products focused on the coding professionals.

Compliance solutions. Our long-standing compliance solutions continue to be an exciting area of growth and innovation. Our product roadmap includes improvements to our regulatory courses for use on mobile devices, while our recent acquisition of ACCS has expanded our portfolio of compliance solutions.

We are pleased to be developing a direct sales channel to hospitals' chief compliance officers for our compliance solutions. In the 90 days following our acquisition, our growing sales team for compliance solutions had delivered 30 contracts for ACCS products with a new order value of over $1.6 million. Congratulations to the ACCS leadership teams for delivering such outstanding, immediate results.

For our resuscitation solutions, known as the HeartCode product suite, we continue to see high demand. This product suite is focused on teaching multiple levels of resuscitation skills to healthcare professionals and is offered through our partnerships with Laerdal Medical and American Heart Association. With over 100 renewals in the quarter, we also contracted an additional 35 new healthcare organization systems for our resuscitation solutions during the second quarter.

We are pleased to report that revenues from our patient experience and research segment in the second quarter were up 19% over the prior-year quarter. To support growth in this area, we have several thought leadership initiatives in progress, including a series of symposia with – our next scheduled symposium scheduled for next week in Philadelphia.

In a couple of months, we'll be holding a Patient Experience Symposium in New Orleans, where we'll also be hosting an awards banquet to recognize a series of outstanding achievements by our customers.

At this time, and with those business updates in mind, I'd like to turn the call over to the operator to take questions.

Question-and-Answer Session

Operator

(Operator Instructions) It looks our first question will be coming from the line of Ryan Daniels from William Blair. Your line is open.

Ryan Daniels – William Blair

Yes. Thanks for taking my question. Bobby, let me go back to you on ICD-10. You indicated that you've got a novel agreement allowing an extension for one year at a discount. And I'm curious, number one, when you started to offer that; number two, how long that discounted product offering will be open; and then number three, any view on how many of your customers from a percentage standpoint have gone with that additional year.

Robert Frist

It's a fairly recent offer. We took some time to absorb the market conditions. We waited for CMS to provide a little additional clarity. As you know, they haven't provided a final date. They seem to be indicating and reaffirming that it's one-year postponement.

So we waited for those actions to happen. Then we went through a long process of talking to key accounts about how they wanted to handle the fact that they now needed to extend the orientation and training program by a year and what their desired outcomes were.

And then we formulated the program working closely with Precise, and only recently we've began to extend the offer. So we're early to it. We seem to have receptivity. It was formulated based on the desire of the customers to continue with the training up to the new deadline. And, again, it's relevant for those whose contracts would have expired prior to the deadline. Many contracts were signed, say, in the first quarter this year already covered two years through the extended deadline.

So we're seeing some initial receptivity. We haven't signed many of the extensions yet, so we'll have to report on it. But we wanted you to be aware of the model. The effectiveness for us if the program works – and it does have a deadline to receive it out later this year – will help spread the revenue and smooth the revenue curve from this opportunity around orienting the workforce to the ICD-10 migration.

It's important to note that these products are really geared towards a transformation period for the US healthcare system. And these products help orient the entire workforce to the new changes that are imminent. Once through that period, these products have less relevance to the broad populations that we have been selling them to. And it requires that the partnership of Precise and HealthStream generate new products focused on coders and the coding staff that have ongoing training and development needs in order to have sustained revenues from this product set.

Accordingly, the orders on this product set, the current ICD-10 product set, really peaked during the fourth quarter of last year and the first quarter of this year. And behind the orders and implementation cycles and now a little bit of clarity, the revenue recognition for these products will peak over this three-quarter period, this being the first of three quarters. And so, then they'll begin to decline after this three-quarter period, again, beginning with the report of $7.2 million in this quarter.

So I hope that provides a lot of clarity. We're getting more clarity on the adoption utilization. We've pushed through this window of relative uncertainty. Although, again, I never put it past the government to make another change. And we've made an offer that we think our customers will be receptive to that'll allow us to both smooth our revenue curve a bit from this product offering and spread the time that the training is available to our customers.

Also give us more time to build new products in the area of coding and revenue cycle management. So with the extension of our partnership with Precise, we feel well positioned in this area of coding and revenue cycle management.

I hope that provides a lot more color and detail. I know this is a great area of focus for all of our investors, as it is for management. It's come with great opportunity and risk. As we finish the orientation phase for our America's workforce on ICD-10, we will need to generate new products and product sets to replace the revenue from this opportunity which was presented based on regulations.

Ryan Daniels – William Blair

Okay, that's extremely helpful. Let me ask one more follow-up. And you described this, but I want to make sure I have it right. So if a customer signs this extension for one year, they would immediately start seeing or you would start seeing a lower monthly revenue recognition because you'd incorporate that discount into the terms of the pricing.

So I guess, number one, is that a correct assumption; and number two, it sounds like you've incorporated then some level of conversion in your guidance to make sure that if there's heavy conversion it doesn't impact you in the back half of the year.

Robert Frist

That is correct. We have done our best to estimate the conversion rates, and it does have the effect on revenue that you've mentioned. Which, interestingly, has the effect of smoothing the revenue curve a bit and pushing some revenues to the future while also bringing an aggregate more revenue from the product set through the extension offer. And so effectively, it kind of amortizes the total revenue over a longer period of time and helps us push the challenges around this product set out further into the future.

Ryan Daniels – William Blair

Yes, no, it seems like a great strategy. And then maybe one final one for Gerry. It might be related to this, but there was a new long-term deferred revenue line that popped up on the balance sheet. Is that revenue you've received for these conversions that will span out over the 12-month period? Or any color there? Thanks.

Gerry Hayden

Yes, no, that's some – from ACCS, a long contracts we received cash in advance of one year, greater than one year. I think that's classified below current assets and long-term.

Ryan Daniels

Okay, so just do another deal. Great. Thanks a lot, and congrats on the strong quarter.

Gerry Hayden

Thank you.

Operator

Thank you. Our next question will be coming from the line of Matt Hewitt from Craig Hallum Capital Group. Your line is open.

Matt Hewitt – Craig-Hallum Capital Group

Good morning. First question for me. Given the push-out of ICD-10, I kind of anticipated that the number of newly contracted subscribers actually would dip a bit from the very strong Q1. Obviously that wasn't the case. I'm curious, as you look at the mix – and I was trying to work through some of the math; you had Brookdale additions during the quarter, I would assume that's in there. You also had ICD-10. You had the HCS and Performance Center additions. But when you look at the mix of new contracted subscribers, is that appears pretty broad-based. Is that accurate, or are you still seeing quite a bit of that mix related to ICD-10?

Robert Frist

Well, a couple of things. First, it was a strong quarter, again, of contracted subscribers. But we have to think carefully about the definition of contract subscriber. So the vast majority of our ICD-10 contracts, both the historical ones and the new ones, the 27 during the quarter, are sold to the existing subscribers. So ICD-10 on a relative basis has had a marginal impact on the total subscriber count. Meaning most of the 1.6 million subscriptions, the vast majority, were sold to existing subscribers. And so a lot – now, there are some cases where the ICD-10 solution readiness product is the first solution they have purchased from us. In which case, we would then count them, that person, as a new subscriber.

So similarly, the Competency and Performance Center subscribers we add during the quarter, I'm going to say again the vast majority of those 31,000 subscribers were already customers of HealthStream. So in both of those two cases, they don't add to the – well, they add some incrementally, but the vast majority were already in the number. So they only add incrementally to the 120,000 new subscribers during the quarter.

So what the effect is of those two cases is they add to revenue per subscriber growth, which was a strong metric for us and why we called out so many existing products. And even with that said, though, you see first-time customers coming in. The Emeritus expansion is an example of brand-new customers.

So as Brookdale acquired new facilities and new employees, we expand the services by contract of the Emeritus employees, and we welcome them on board to our platform, they will be counted in the one-time contribution to the 120,000. So in that case it was additive to the 120,000.

So in summary, you can see a couple of cases where growth in solutions just adds revenue per subscriber. And yet, even with that growth, we found 120 first-time subscribers to our network of solutions.

Matt Hewitt – Craig-Hallum Capital Group

Thank you very much for the clarification there. Maybe one more for me, and then I'll hop back into queue. Because you've been selling the ICD-10 solutions now for a couple of years, or almost a couple of years, you've had some experience with customers that were new to HealthStream via that product or via that solution. Maybe give us an update on the cross-selling opportunity within that customer base. People that came on, bought the ICD-10 solution as their first HealthStream exposure. Where are they today? Have they added more content to other solutions? Maybe talk about the penetration there. Thank you.

Robert Frist

Yes, it happens across really, as you can tell, all of our product sets. Once we get a customer in the network, it is core to our model to get back in with our other five or so solution teams and sell them additional solutions from our available suites of products and solutions.

And so it is true of the ICD-10 customers, those that were first-time subscribers presents an opportunity to sell additional subscriptions. And, in fact, there are some cases of that, as there are with all the other solutions.

So, again, it is core to the way our sales team is organized and structured that once an account is won for the first time they are assigned an account manager. And the account manager's job is to introduce any one of – and in a planful way, anyone of the six solution-focused sales organization teams. So – and we mentioned today the new Compliance sales team that we've been building up that targets the VP of compliance in a hospital. We've kind of built out that team now around the ACCS acquisition and continue to add sales personnel until it's completely mapped to our 10 territories.

And then back to the story is that I mentioned already, and it's called the HCCS team, is already up selling contracts – I believe about 30 in the quarter – back into the base of customers, and so growing revenue per subscriber. That is core to our model. It occurs whether they're a first-time subscriber to ICD-10 or a first-time subscriber to the Competency Center or first-time subscriber to our compliance products. Then the whole model is to then approach them with these additional solution-focused teams and upsell them on the other product.

The customer gets leverage out of that because once they are a subscriber to the core foundation, which is a little piece of technology that allows access to all of these products, they can add on additional products often at discounts. And so there are also financial incentives for adopting a broader set of HealthStream solutions.

Matt Hewitt – Craig-Hallum Capital Group

Great, great. Thank you very much, and congratulations on the good quarter.

Operator

Thank you. Our next question will be coming from the line of Scott Berg from Northland Capital Markets. Your line is open.

Scott Berg – Northland Securities

Hi Bobby and Gerry. Congrats on a really strong quarter.

Robert Frist

Thank you.

Gerry Hayden

Thank you.

Scott Berg – Northland Securities

A couple of questions, Bobby. I'll start with the pricing of the ICD-10 extension. Are you also getting some cost concessions from Precise as you sell that? I'm just trying to understand what the gross margin impact of that is going to be, given that the margins on those content businesses tend to be somewhere in the 50% range plus or minus.

Robert Frist

Right. Great question, and it's a great to show how our partnership model works. So we worked out that as 50-50 partners with Precise. And so in a close dialogue with Precise, we crafted the offer and took it to the customers. And so our margins remain the same, even on the reduced price because the partners were together in offer, and we maintained our 50-50 partnership in the offer.

And that's how it works for us. We work with our partners to structure offerings where we both win together. And the proverbial, if we didn't succeed in the offer, we would both lose together. So in this case the margins are maintained according to our partnership margins which, in the case of Precise, it's a 50-50 partnership.

Scott Berg – Northland Securities

Great. So then Gerry, can you talk about gross margins on a go-forward basis, or at least how we should think about them in the back half of the year? If ICD-10 revenues are peaking here in the back half of the year, gross margins have fallen since you, at least in absolute terms – excuse me, in percentage values since the ICD-10 revenues start selling. Do we start seeing a plateau effect on those margins like we've seen in this quarter, because they were up 30 basis points from Q1?

Gerry Hayden

Yes, well, Scott, just so you know, we don't give guidance by line item. But I think a couple of things are instructive. If you look at the historical – the recent historical trend and the gross margin is roughly 56% this quarter is also about 60% in the first quarter of 2014 as well. So that probably is some kind of historical pattern to those gross margins.

Scott Berg – Northland Securities

Great. So then my last question is around the guidance for the rest of the year, and I'm not sure who wants to take it.

Trying to understand how we think about the increased guidance, increased both ends of the range for total revenues by 1% in the solutions arena. Is this a reflection of the additional tiring, Bobby, that you noted from some of your customers given that some of the ICD-10 revenues might be a little bit lower reflecting how that amortization will work with those customers that sign the one-year extensions? Or is it more of a reflection of just strong net new seat additions over the last two quarters?

Robert Frist

Scott, it's actually a really nice blend of all of those things. Several things. I think if you look back to the prior quarter, we specifically excluded from our guidance the ICD-10 impact because we didn't feel we had enough information to work it in to the numbers for this year. So it created a huge variable or risk and interpretation of guidance, and it's just unfortunate the best guidance we could provide had a lot of uncertainty in it because of the variables introduced by the government around the ICD-10 deadlines.

I would say in this quarter we feel we've done our best to factor in both the extension offers, the new amortization of revenue model, the fact that we've seen a small restart in purchasing around ICD-10. The fact that the postponement seems like the date is going to hold. And in addition, we cited a lot of core performance metrics, products such as our clinical products series growing over 80% – two product areas growing over 80% year over year, and they are just performing very, very well.

And our Competency Center and Performance Center, while not quite as strong as prior quarters – 31,000 new subscribers is in striking distance of our historical strengths in our core learning business, if you think about the guidance I used to provide there of adding 22,000 subscribers per quarter. So – and those are going to be relatively higher-margin customers because they are subscribing to extensions of our platform, which have higher gross margins.

So what I would say is we're able to take off the bottom part of the range and provide a little more certainty about the operating income range. The operating income range remains broad and down from the prior year because of our continued desire to invest in these new product and solution sets; hire personnel; incrementally add in areas like sales and research and development.

And as we look into the future and think about usually provide guidance for next year in February of next year, we have a lot of excitement around new product categories like the area of leveraging and creating data and information products. So as we think about next year, we'll continue to see a focus on R&D and product development and new and exciting areas as well. So the guidance – we are able to firm up the bottom end of the range; provide clarity, at least our best estimates around ICD-10 impacts; and give a hint that we are still in investing mode in a lot of areas in our business. And hopefully that continues for a while as we try to continue to deliver growth.

Scott Berg – Northland Securities

Great. That's all I have. Thanks for answering my questions.

Operator

Thank you. Our next question will be coming from the line of Richard Close, Avondale. Your line is open.

Richard Close – Avondale Partners

Yes, thank you for taking the questions, and congratulations on a solid quarter. Just quickly on some of the new products, whether it's compliance, as well as the new initiatives with Precise on coding and revenue cycle management. Do you believe or have you guys put pen to paper in terms of some of those products in terms of what the market opportunity is within your base? And if so, maybe provide some details. Or do you feel confident that some of these other product initiatives that you have that are obviously being successful here initially can offset the decline in ICD-10 over the next year or so?

Robert Frist

Management, of course, is working hard to find and figure out that challenge in 2015 and 2016 now. Kind of pushing some of the issue out into the future. It remains an issue, though, because we've talked about the point in time nature of this. It turns out the government is spreading the point in time out over several years. So interesting how that happens.

But what I would say just broadly is with our cash position, our – we're getting a lot of clarity on how to leverage assets in our network; the fact that we have a network. And we've just got such a broad development pipeline and vision that we are working hard to get the right product and solution mix into the market to overcome what's turned out to be a tremendous opportunity on ICD-10 but one that will have a shelf life.

And in the area of ICD-10, our increased focus will be on the ongoing needs of the coders instead of the broad workforce orientation about ICD-10 and adding areas like revenue cycle management. We've kind of found some new buyers with the ICD-10, the VP of finance, the CFO, and revenue cycle areas, and we hope to build in that area in particular as we look in the next 18 months to build out a more comprehensive solution set, with ICD-10 being kind of the tip of the spear in getting us relationship in that area.

So there's just a lot of channels to develop, broad portfolio mix. And as you can tell, even with the release of the new Checklist Management product in the quarter, which is kind of a low-lying extension feature set of the Competency Center – just think of it as in an additional capability set around measuring competence the workforce. We've already got 15 new contracts in that product within the launch quarter. And so we are hopeful that by building out the way we've been building and adding new solution sales teams that we can continue to grow.

Again, we can't provide guidance yet until February. As you know, in the fourth quarter we do our strategic planning process where we refresh our three-year plans. And out of that we make a lot of decisions about actual targeted investment areas in areas like data and analytics.

One other point I should make about the quarter, which is kind of relevant to the whole growth model, is that the research/patient experience business, as you know, had a strong – stronger than historical growth in the first half of the year. We expect that to continue. That's due to known contract expansions in that area.

And late in the year, probably near the fourth quarter, we're going to expand capacity to deliver those services, which will require increased investments and personnel and in capacity.

So as we speak about the impact in this year, some of the negative-2 to negative-11 guidance on operating income is we factored in things like the need to invest in personnel and capacity expansion late in the year to accommodate the growth in the research/patient experience solution.

So I hope that gives some more color. We like to stick our guidance to the year. We'll refresh the 15 and the backfilling strategies in February of next year.

Richard Close – Avondale Partners

So just to hit a little bit more on the Checklist Management, definitely think that's interesting. Is that something that – some of that has performance or Competency Center – just essentially you guys flip a switch, and they get that in terms of – and that's just an incremental sale? Or how should we think about that as you add functionality to platforms similar to Checklist Management?

Robert Frist

So, sometimes we add functionality, which extends what they already have. And they get enhancements, and it's included in their subscription to whatever product set they have. So we're constantly adding – in fact, we essentially now do weekly deploys of new capabilities to the entire suite. And so sometimes those are included, and part of being part of the SaaS environment, you get the benefit of them immediately rolled out to all customers.

Some of them we bundle up as additional upsell. And so Checklist Management is an example of an additional upsell. It's common in hospitals to use paper-based checklists to track things to be a measurement tool for competency. And so in this case, our competency measurement suite – which is Performance Center, Competency Center, and now Checklist Management, and the Competency dictionary. Those four pieces, which have a mixture of content and software tools, really define our competency management suite. And each of those four pieces is a separate upcharge. And they all provide a complementary functionality to really get at what are the tools that are needed to manage and assess the competencies and, in particular, clinical competencies of our healthcare workforce.

So Checklist Management is a feature set. It was bundled-up feature set that's viewed as an incremental value add to our Competency suite. And we've already sold 15 additional contracts, which adds to revenue per subscriber. Again, in most cases, the buyers of that – it is more of a flip a switch. And general Checklist Management is easier to implement than, say, competency management, which requires a lot of strategic decisions to be made by the buyer about how to classify competencies. Whereas Checklist has replaced paper-based checklist systems immediately.

So we are very excited and hope this explains how we think kind of modularly. We are building out that suite, and in this case it was an add-on purchase, and we are already seeing contracting around it.

Richard Close – Avondale Partners

And then my final question, I guess, is you mentioned excitement, creating new products around data. I'm not sure if you mentioned analytics, but information products. Is this – that's a pretty open-ended area. We hear a lot about data and big data and analytics in the healthcare IT. Just trying to get a better gauge of where you guys might fit in that area of data and analytics – or how you're thinking about, I guess.

Robert Frist

Potentially vague. Not to generate too much excitement around it, but I'll give you some updates on this area.

We do have – mainly, I wanted to begin to outline that we have an ambition in this area and will begin investing in it. So, for example, we've taken a minority equity investment in a company called Juice Analytics a little over a year ago. And Juice Analytics has a team of experts in data visualization and telling stories through data and analytics. And we've been working with them for over a year. In fact, their founders moved to Nashville, and they're headquartered inside of HealthStream's offices now even though they serve multiple industries.

And I wanted the market and on this call everyone to know that we have a great interest. We think we have some contribution from the data flowing through our extensive network. We believe we have the most widely adopted SaaS application in healthcare approaching 4 million subscribers in the physical settings where care is provided that regularly access our SaaS platform.

And about that workforce, we have tremendous knowledge, demographic profiling data. And it's part of our journey to figure out how that is advantageous to these health systems to allow them to benchmark performance and knowledge and comparative analysis across such a vast network.

And I kind of wanted to be a little intentionally vague. Not to generate over-excitement about it, but we have made some concrete investments in looking at the data flowing through our network, thinking about how it could be helpful to save money and time, improve clinical processes in hospitals, and we are on the journey.

So I mentioned as we tee up and think about next year – and you know now we have an equity investment and a personnel investment in the area of data and analytics. We're going to be looking back to our core products that's like in compliance and seeing where our data could be useful in helping save money and time for health systems.

No concrete products yet. No clearly identified revenue streams. I want to have my disclaimer. But as an area of interest and an area of investment, we also feel that it's an area of study and importance to our future.

Richard Close – Avondale Partners

Great. Thank you very much. Congratulations.

Robert Frist

Thank you.

Operator

Thank you. Our next question will be coming from the line of Frank Saraceno from First Analysis. Your line is open.

Frank Saraceno – First Analysis

Hi, guys. Just two questions. First is on the expansion on the research side. I'm sorry if I missed this, but can you tell me just where the growth is coming from? Is it M&A through existing clients? Is it CG-CAHPS? What's driving the increment of growth going forward?

Robert Frist

Yes, it's actually – both of those are fair examples. We have reupped with some of our largest health systems who themselves are acquisitive in bringing us new business. And the CG-CAHPS business is also a continued contributor to our growth. And so just across the product set, we're seeing slightly improved demand in those areas. And we're adding capabilities around it to make it a more comprehensive solution like the consulting services. We're building out some increased curriculum and content offerings in the area of patient experience improvement. And so I just feel we have an improving product set there. We've begun publishing thought-leading position papers on the importance of improving patient experiencing and getting some attention in our approach to helping hospitals improve their patient experience and their outcomes in this area.

You know, it's all rooted in the financial reimbursement system around the HCAHPS scores and how hospitals were being reimbursed based on the scores. But it's a much broader issue now being a customer-centered and patient-centered organization. We're seeing a little bit of increased demand across the board. But you identified the two: CG-CAHPS is a driver, and customer expansion through M&A has also benefited us as well.

Frank Saraceno – First Analysis

And then lastly, just with Tom Schultz coming on board, I just curious, Bobby, has there been any change in the sales organization? And just curious how – or the reasons behind him coming on board.

Robert Frist

I think every few years, we hit a growth spurt, and we look to how to redistribute the talent across the entire Company top to bottom to manage and restructure our operations to accommodate growth. I think if you stay the same too long in a rapidly changing environment, that creates challenges. So we do that at all levels of the Company, including the senior team. And I think we are in this period where we have a growth spurt.

As you know, several of our senior officers have served in multiple capacities. Eddie Pearson, our current COO, served as president of research when the time was needed to integrate operations of two acquisitions. Art Newman, our Executive Vice President, served as our Chief Financial Officer during a certain period of time when that made the most sense for him. And so we evaluated our team, we realized we needed to add capacity and leverage the strengths of our teams.

As you know, one of our opportunities is we have about $111 million in cash, and it's growing through a strong cash flow from operations. And we feel responsibility to figure out how to deploy that in higher IR projects, both organic and inorganic.

So one of our superstars in our leadership team at acquiring new business and strategic thought on product categories and future revenue streams has always been Michael Sousa. And he kind of raised his hand and said, I'll – I'd like to take some responsibility for that if we can find someone we're all excited about to lead our very strong 100-plus person sales organization.

So we undertook a long and patient search that spanned many, many, many months and found what we believe is just exactly the right person to lead our existing sales organization, which has been very strong. And so we hired Tom Schultz. And Tom is relatively new to the job, and we're excited about his capacity. And now we're able to spread the workload of leadership across a broader executive team, and so we're very excited to have rebalanced in that way.

Operator

Thank you. Our next question will be coming from the line of Steven Rubis from Stifel. Your line is open.

Steven Rubis – Stifel Nicolaus

Hi. Thanks for taking my questions, and congratulations on a strong quarter. I'd like to start by following up on Richard's question around analytics. Do you guys view this as a two-year, three-year opportunity? Any sort of color? I realize that in terms of identifying revenue streams and driving revenue is still kind of nebulous. But what type of timing are you looking at in terms of having analytics help the platform?

Robert Frist

We're a year into thinking about it, and probably a year away from any kind of revenues. We'll be entering pilots with customers on some sample areas to see the usefulness of benchmarking products across our network. And later this year, early next year, probably not revenue-generating but again – this is just an area we like to explain areas where there is increasing attention from our Board and senior management team that create opportunities for investment. And we have been fairly disciplined in how we go about those opportunities, and this is just an area of study.

So I would characterize it as a three-year horizon. And where we'll be good students of the opportunity, we'll pilot various concepts with customers to see what's useful to them. Any time one of our solutions – as you know, we have solutions in resuscitation and patient experience and compliance, for example. The added element of data and analytics to them, we think, will increase the value proposition of those products. And we're on a journey to figure that out. But there's no certainty around it. It may just help us hold ground with existing products by adding an analytics layer, or it may add to the value proposition of the products themselves.

So I would characterize it as we are early. We're making real investments, as I've articulated, both in equity and in personnel. And we think it's going to be a multi-year journey to try to find answers out of it. And we don't want to over – we don't want to get too excited about it because it's highly experimental and we are new to it. But we do want everyone to know that when you think about the areas of investment, this will be one of them.

Steven Rubis – Stifel Nicolaus

Great. That's very helpful. And along those lines, when you think of all the innovation that's going on in healthcare, and do you think there's an opportunity for you all to benefit in terms of driving either educational solutions, training solutions, what have you, around some of the new innovation that is going on. One area that you might be an example is telehealth. There may be others. Can you talk about that opportunity?

Robert Frist

Yes, so telehealth specifically is not an immediate area of focus. But we are looking at ways – again, as we think about our three-year plan – that some of these innovations can plug into and leverage the network that we have so that everything doesn't have to be built by HealthStream. And I'll kind of leave it at that. But we have an interest in seeing how external innovations could be leveraged into our customer base. And so you've kind of hit on another area of explanation – or exploration as we think about the next three years and beyond.

Because you're right: there's just so much exciting innovation going on both in mobility. We have our own innovations in that area, as I mentioned earlier. But there is a lot going on outside of any one solution provider. And we've always held the belief that solving problems in healthcare has to come from a broad group of providers, not just one monolithic provider.

And so, for example, we have over 100 total different forms of partnerships that we bundle up into solutions. So we think there might be technological innovations that we could also bundle up into our network and provide to our customers. So that's an area of long-term exploration, as is data and analytics.

Steven Rubis – Stifel Nicolaus

And then my last question. You talked about some of these new products around coding. Can you talk about timing in terms of bringing the next generation of coding and RCM products? And have you received any feedback – or early feedback from clients around those products?

Robert Frist

No. Of course, Precise and HealthStream are diligently working on it. And in some ways, this year extension has been good because it gives us more time to try to figure out the next-generation products. What I would say is that the development is well underway. This is not something we're beginning this month or quarter; it's something that's been going on for a little while. And in this case specifically, we hope to do some innovative things with data in this area of coding training. And we have this great partnership with Precise that already has put out the number one rated products in their category. The highest class ratings available to the vendor have been won by their products. So they have a very innovative team at Precise. And they've been working for many, many months on what I'll call replacement products.

At HealthStream, we're adding to the definition as we found these new buyers in finance and revenue cycle where we may be looking at expanding into revenue cycle products as well as just coding products. So as a category, it's area of interest and study.

I don't want to get too much into futures, as we've covered three areas the last ten minutes about futures: futures in analytics, futures in leveraging other people's innovations, and futures for replacement products. Real investments are ongoing in those areas. We expect increased investments in those areas. But I want to bring reality back to the focus on things like Checklist Management, which is real. It's in the market. It generates 15 new contracts in the quarter. Most of the way we operate is about announcing things as they come. We're trying to get a little insight into the future here, though, through these questions.

Operator

(Operator Instructions) Thank you. Our next question will be coming from the line of Terry Lally from Spotlight Funds. Your line is open.

Terry Lally – Spotlight Funds

With earnings down year over year and adjusted earnings flat at $0.09, when expectations started the year at $0.10 before the borrowers lowered for 2014 from $0.40 to $0.28 – I'm not really sure where the cheerleaders are seeing the beating. But I guess if you deliver $0.30 versus the original $0.53 that the year started out in 2012 and $0.40 last year, I guess that's beating when it might be $0.10 to $0.20 below original expectations.

My real question comes into the revenue growth and why it's not translating into profit growth. You're expecting 26% to 29% revenue growth, profit growth down to 11%. Even if you adjust for the deferred revenue write-downs, profit is flat despite the 26% to 29% revenue growth. What is it about the business model that revenue growth doesn't translate into profit growth? And why aren't you getting leverage at the top line?

Robert Frist

Well, I think we've just spent the last 10 minutes talking about areas of innovation and investment that currently don't have returns. So in one area like building the Juice Analytics investment and deploying investment in personnel and capital into areas like analytics that are part of the future that are not generating revenue. There's clearly areas of R&D that are future oriented, that are not present value oriented. And having done this for 24 years, you have to stagger your investments over one, three, and five years.

So our Board generally tries to invest in projects that have three- and four- and five-year IRR horizons. And we're in the middle of several of those now that are, on a relative basis, in the last year so new. And so some of our outperformance in revenue is allowing us to power up investments in innovative areas that we don't know if they'll have the kind of return that we're hopeful for, but we believe they will.

And so it's fair to point out that some of the revenue growth is not translating into operating leverage. In fact, the second half of the year we declared that we'll have a decrease from 2% to 11% in operating income over the prior year. And a lot of that is because of the decisions we are making to invest in the future.

But the core businesses themselves are generating great operating leverage. We're just electing to put the capital and cash flow from those into other future-oriented projects.

Terry Lally – Spotlight Funds

So on the R&D investments, you saw some deleverage this quarter as R&D ticked up to $4.3 million, about 10% of sales. So that cost you about 130 basis points.

I mean, the real key issues seem to be the gross margin degradation as you – gross margins were down 380 basis points. How would we expect gross margins – you mentioned mix and particularly resuscitation and ICD-10. So as ICD-10 flattens out, the resuscitation stays strong, the HCCS acquisition kicking in, how should we see those different factors impacting gross margins? Does it stabilize around 56? Does it continue to deteriorate? Does it slightly tick up?

Robert Frist

Yes, Terry, it's a good question. I think some of our products that have been really strong winners, they're really solutions. And as we pointed out, our solutions are not just software. So they have a lower blended gross margin because they incorporate content that has royalties, as you pointed out.

So one of the strongest growth drivers has been ICD-10, which has some of the lower gross margins. So as it's been successful, it's driven the blended gross margin down. It – and it will be interesting to see, as some of that revenue tapers out, what happens to the blended gross margins. We're not forecasting beyond the end of this year currently. But it has been such a strong product with a lower gross margin, and it has moved those blended gross margins down. We as an organization focus more on EBITDA and cash flow from operations than the gross margin line because of the product mix issues that you have pointed out and we have tried to explain to the market.

We are not purely a software Company with higher gross margin software. We try to solve a problem in healthcare like resuscitation and outcomes. And to do that, we have to team up with Laerdal Corporation, American Heart, and that has higher cost of goods. So when we go to market with comprehensive solutions, they have higher cost of goods. And it's the mix of those versus platform sales that determine the blended gross margin.

Now, my view is the lifetime value of those customers goes up as they buy more solutions. And the EBITDA and cash flow from each of them is an aggregate adds to our financial strength. While maybe not as high a gross margin, it does improve the overall lifetime value of that customer and adds the cash flow out of the customer.

Terry Lally – Spotlight Funds

And I know you want to wait until next year, and you typically would give guidance on a Q4 call in February. But I mean there is a lot of moving parts with 215 and particularly with the ICD-10 tapering that you've talked about. Where I'm trying to go – and when I think about 215, you'll see revenue deceleration as the ICD-10 tapers. If you're not getting the profit growth this year when you have 26% to 29% revenue growth, what happens to the business model as revenue growth decelerates? And I guess what I worry about is the analysts do the same thing – is they start at $0.50, move down to $0.40, and you end up at $0.30.

Robert Frist

Yes, I think some of the analysts have to wait until our February guidance because that's been our model for a long time to adjust their model. And I think, again, we've pointed this out, and you've correctly identified that ICD-10 revenues will decline as the opportunity migrates. And so you've also hit the challenge for management as we enter into 2015 and 2016 is with one of the product lines or solutions declining, how do we backfill it with other solutions? And can we overcome that high-growth area with other growth areas?

So today we spent some time pointing out other growth areas on the call and specifically calling them out. It is both our challenge and our opportunity to overcome those declines. I guess we've had some good fortune presented by the fact that these timelines have stretched, which is stretching the use of that product and shelf life and helping smooth the revenue curve from ICD-10 product category, giving us more time and having maybe less backfill. We still have backfill to worry about. It's a legitimate concern, and it has been a high grower that will be challenged to backfill. So I think you've correctly identified that area of challenge.

That said, we have a lot of great things going on in the Company that we are working hard to make sure we have that backfill for that growth on ICD-10. So overall, I feel like we're fairly well positioned to continue to have strong years.

Terry Lally – Spotlight Funds

Good luck.

Robert Frist

Terry, one quick thing. I think I've noted, and we've known this for some time now, but a quick question for you, if you're still there. Do you have any – you're an analyst, I believe, but you also have a position in stock?

Terry Lally – Spotlight Funds

Yes, we do.

Robert Frist

And is it a short position?

Terry Lally – Spotlight Funds

It is a short position.

Robert Frist

Okay. I just thought that would be useful given that you are an analyst and you have a stake in the Company as well. Thank you for that disclosure. We'd like to turn the questions back to the operator.

Operator

At this time, I'm not showing any further questions.

Robert Frist

Thank you. If there are no further questions, we'll look forward to reporting the next earnings release. And thank you for following along with the Company.

Operator

Ladies and gentlemen, thank you for participating in today's conference. This does conclude the program, and you may all disconnect. Everyone, have a great day.

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Source: HealthStream Inc's (HSTM) Robert Frist Q2 2014 Results - Earnings Call Transcript
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