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HMS Holdings (NASDAQ:HMSY)

Q2 2012 Earnings Call

July 27, 2012 9:00 am ET

Executives

William C. Lucia - Chief Executive Officer, President and Director

Walter D. Hosp - Chief Financial Officer, Chief Administrative Officer and Executive Vice President

Analysts

Jeffrey Garro - William Blair & Company L.L.C., Research Division

Rohit Vanjani - Oppenheimer & Co. Inc., Research Division

Scott J. Green - BofA Merrill Lynch, Research Division

Deepak Chaulagai - Dougherty & Company LLC, Research Division

Richard C. Close - Avondale Partners, LLC, Research Division

David H. Windley - Jefferies & Company, Inc., Research Division

Jamie Stockton - Wells Fargo Securities, LLC, Research Division

Operator

Good morning, ladies and gentlemen. My name is Katherine. I'll be your conference operator today. At this time, I would like to welcome everyone to the HMS Holdings Corp. Second Quarter 2012 Earnings Call. [Operator Instructions] The slide presentation designed to complement the conference call can be found at our website at hms.com. Please click on Events & Presentations on the Investor Relations page to join the webcast.

Before we begin, let me remind you that some of the information presented today regarding the company's future expectations, plans and prospects are considered forward-looking statements under the Safe Harbor provisions of the Private Securities Litigation Reform Act of 1995. These statements are based on the company's current expectations, and actual events may differ materially from those expectations. We refer you to the company's filings with the Securities and Exchange Commission, including its annual report on Form 10-K and its quarterly reports on Form 10-Q, which identify important risk factors that could cause actual results to differ materially from those contained in the company's projections or forward-looking statements. The company disclaims any intent or obligation to update any forward-looking statements as a result of developments occurring after today's call.

During this call, the company will also be referring to several non-GAAP measures. The press release issued this morning includes a reconciliation of these measures to GAAP measures and is available on the Investor Relations tab of the company's website.

Thank you. Mr. Lucia, you may begin your conference.

William C. Lucia

Thank you, Katherine, and good morning, everyone. Thank you for joining our second quarter 2012 earnings call. I'm Bill Lucia, President and CEO of HMS Holdings. I'll be hosting the call, along with Walter Hosp, our CFO.

HMS had another strong quarter. Revenue was up 34.4% to $120.1 million compared to $89.3 million for the same period a year ago. Adjusted EPS grew 35% year-over-year to $0.23 per share. The backdrop for our call today is the Supreme Court decision to uphold the constitutionality of the ACA, providing clear support for HMS' long-term growth strategy. This ruling has removed many of the uncertainties related to the ACA, and many states are now moving forward with the law, including the Medicaid Recovery Audit Contractor program. I'll talk more about this later.

Walter will now review our financials and then I will discuss our sales and the Supreme Court ruling and its impact on HMS' growth strategy. Walter?

Walter D. Hosp

Thank you, Bill. Good morning, everyone. As Bill mentioned, revenue for the second quarter of 2012 increased 34.4% year-over-year due -- to $120.1 million. This nearly matches the $121.2 million consensus forecast of security analysts who follow HMS.

Revenue growth in the quarter was mixed across our markets. In our Medicaid market, which includes State Government and Medicaid managed care clients, year-over-year revenue growth was 12.2% for the quarter. In our federal business, we previously announced our decision to not rebid one CMS audit MIC contract. We also spoke of specific Medicare ZPIC contracts that we terminated due to conflicts with HDI's Medicare RAC contract. As a result of these decisions, revenues in our federal business was down 14.9% year-over-year. HDI revenues for the quarter were $23.8 million. Because HDI was not part of HMS in the second quarter of 2011, there is no comparable growth rate. However, we would estimate that HDI's year-over-year organic growth for the quarter is approximately 90% after adjusting for differences in revenue recognition. We are also reaffirming the 2012 revenue guidance for HDI at approximately $95 million.

Revenue growth across our products was also mixed. Our core Coordination of Benefits revenue grew 13% year-over-year in the quarter. Excluding the federal business area, Program Integrity revenues were flat year-over-year. This reflects the longer ramp-up time for the Medicaid RAC. We expect to see growth rates in the non-federal Program Integrity products area to increase in the second half of this year.

Total revenues in the quarter, excluding HDI and our federal businesses, were up 10.1% year-over-year. As a reminder, we continue to see revenue shortfalls in Q2 relating to 5010, D.0 transition issues with our trading partners as reported earlier this year. We expect these issues to be resolved in the second half of this year.

Revenue for the first half of 2012 increased 32.4% year-over-year to $227.4 million. This included $47.3 million of revenue associated with the acquisition of HDI. Excluding HDI, revenue for the first half of the year was $180.1 million.

At this time, we are also reaffirming our 2012 revenue guidance in the range of $500 million to $515 million.

Now let's look at expenses for the quarter. Total cost of services for the quarter was $79.6 million. Excluding HDI, total cost of services for the quarter were $60.4 million, an increase of $2.2 million or 3.8% compared to the $58.2 million last year.

Total cost of services for the first half of 2012 was $156 million. Excluding HDI, total cost of services were $120.3 million, an increase of $6.4 million or 5.6% compared to the $113.9 million last year.

Compensation related to cost of services was $40 million. Excluding HDI, total compensation related to cost of services for the quarter was $31.6 million, an increase of $0.1 million or 0.4% compared to the $31.5 million in last year. As a percentage of revenue, this expense was 33.3% versus 35.3% in the prior year.

The second quarter had an average non-SG&A headcount of 2,171 employees, a 33.3% increase of 542 employees versus the same period last year. Of this increase, 451 employees were attributable to the acquisition of HDI. The average total company headcount, including SG&A employees was 2,380 employees, an increase of 635 employees or 36.4% above the second quarter of 2011. Of this increase, 508 employees were attributable to HDI.

Data processing expense was $8 million, an increase of $2.3 million or 42% from the prior year quarter. This expense was 6.7% of revenue for the quarter and versus 6.3% last year due to increased expenses in our technology infrastructure required to support our growth.

Occupancy expenses were $4.2 million, an increase of $0.5 million or 12.6% from the prior year quarter. As a percentage of revenue, occupancy cost were 3.5% in the quarter versus 4.2% last year.

Direct project costs were $13.2 million, an increase of $2.1 million or 19.3% year-over-year. As a percentage of revenue, direct project costs were 11% versus 12.4% last year.

Other operating costs of $6 million were $1.4 million or 30.2% higher than the same period last year. This expense was 5% of revenue in the quarter and 4.9% for the first half.

Amortization of intangibles associated with acquisitions was $8.1 million, an increase of $6.5 million year-over-year. This increase was primarily due to the acquisition of HDI.

SG&A expenses were $14.9 million for the quarter versus $10.7 million, an increase of $4.2 million or 39.4% in the same period last year. After adjusting for HDI-related expenses, SG&A increased 13.2% year-over-year.

Operating income for the quarter was $25.6 million versus $20.5 million in the prior year quarter. Operating margin was 21.3% for the quarter compared to 22.9% last year.

Interest expense was $4.2 million in 2012 compared to $23,000 in the prior year. This increase relates primarily to the $350 million term loan taken in connection with the HDI acquisition. Income taxes were $8.7 million for the current quarter compared to $8.3 million for the same quarter last year.

The effective tax rate for the quarter was 40% versus 40.1% for last year. Our full-year effective tax rate estimate for 2012 remains at 40%.

The above resulted in net income for the quarter of $13 million versus $12.4 million for the same period in 2011, an increase of $0.6 million. Fully diluted weighted average common shares outstanding for the first quarter were 88.4 million shares.

Fully diluted GAAP net income per share was $0.15 versus $0.14 for the same period last year. Adjusted EPS was $0.23 for the quarter versus $0.17 in the prior year, up 35.3%. Both GAAP and adjusted EPS exceeded the consensus of analyst forecasts for the quarter by $0.02. We are also reaffirming our current EPS guidance for 2012 at a range of $0.58 to $0.64 for GAAP EPS and a range of $0.91 to $0.96 for adjusted EPS.

We now turn to the balance sheet and look at our general financial condition at June 30, 2012. Our cash and cash equivalents were $105.3 million at the end of June, compared to $97 million at the end of last year. Cash on hand as of yesterday was approximately $115 million.

Accounts receivable was $112.4 million, a decrease of $0.1 million from the end of December 2011. The number of days sales outstanding, DSOs, at the end of the quarter was 84 days compared to 92 days at the end of 2011.

Other current assets of $26.8 million increased by $6.1 million from the end of December. This change primarily resulted from an increase in prepaid expenses.

All other noncurrent assets decreased by $7.5 million from last year end to $624.2 million. This reflects the increased depreciation and amortization expense taken during the current period.

On the liability side of the balance sheet, total liabilities decreased by $22.9 million from the end of December 2011. This is primarily related to an $11.1 million reduction in accounts payable and an $8.8 million reduction in our long-term debt balance.

Looking at the statement of cash flows, cash provided by operations was $38 million for the first half of 2012, an increase of $13.8 million from the $24.2 million reported in the same period prior year. This result is after adding back the substantial amortization of intangibles and capitalized software related to the HDI acquisition.

Cash used in investing activities was $23.1 million for the first half of 2012, an increase of $7.9 million from the $15.2 million reported in the same period last year. This increase was comprised primarily of purchases of property and equipment, much of which is related to the movement of our data center from New York to Texas. There were also investments and acquisition payment adjustments made during the period.

Cash used in financing activities was $6.4 million for the first half of 2012, a decrease of $20.2 million from the same period last year. This decrease was primarily attributed to purchases of treasury stock and the repayments towards the outstanding balance of our term loan. We paid $10.8 million in taxes and $6.9 million in interest during the period.

For 2012, we anticipate that existing cash balances and funds generated by operations will be sufficient for all our cash needs.

And that concludes our review of the financial results for the quarter. Bill?

William C. Lucia

Thank you, Walter. Now, I'd like to take -- talk about our sales for the quarter. First, in our State Government business, I'm pleased to announce that HMS secured Medicaid Recovery Audit Contractor or RAC wins in 6 new states, placing us clearly at the forefront of the Medicaid RAC market. Four states, Alaska, Idaho, Montana and Utah, selected HMS on a multistate RAC award. You will recall that HMS was awarded Utah's initial contract for RAC-like services a couple of years ago, which had a 2-year limit on claims review. The new contract allows us to perform our services on the full look-back period, which is 3 years. We also won competitively bid RAC procurements in both Minnesota and Virginia. We were also successful in reprocuring both our Alaska and our South Dakota Medicaid TPL contracts. In Illinois, we won a limited scope TPL contract for safety net cost avoidance services for the Medicaid program. In Pennsylvania, we were awarded a long-term care audit services contract and also rewon our contract to provide cost avoidance for the CHIP program. And we're very excited to have been awarded a contract by the Commonwealth of Virginia to provide a customized system to detect fraud, waste and abuse. Virginia is the second State Medicaid agency to procure HMS' prepay edit engine and fraud identification platform, which will serve as the basis for their new system. Our Georgia TPL contract was renewed for an additional 12 months through December 2013, and Louisiana extended our child-support services contract for another 36 months. Finally, for both the connector program in Massachusetts and the New York State Office of the Medicaid Inspector General, we're now performing additional cost avoidance reconciliation services to ensure they pay claims appropriately the first time.

In the RAC market, HMS solidified its leadership position this quarter with the addition of 6 new contracts. We are now a RAC contractor in 24 states, representing over 60% of the RAC contracts awarded today. We believe that this early leadership position reflects the market's trust in our knowledge of the Medicaid program and our proven audit and recovery processes. As we absorb our 24 RAC contracts, the remainder of 2012 into 2013 will be focused on implementation activity, which will pave the way for a solid revenue stream from this market over the long term.

Moving to the managed care market, we won a contract with Health Partners of Minnesota to provide coordination of benefits billing and cost avoidance services to more than 90,000 Medicaid members. We also received an intent to award from Windsor Health Group, an Atlanta-based managed health care company that operates Medicare Advantage Plans in 20 states. This is HMS' first contract providing prepayment claims editing and fraud, waste and abuse services to Medicare Advantage Plans. We've also expanded the scope of our contract with the Family Health Plus line of business at Fidelis and with Neighborhood Health Plans in New York and Massachusetts. At UnitedHealthcare, we added pharmacy coordination of benefits services to their Evercare line of business. We also added UHC's Medicaid population in the state of Washington to our current scope of business.

And we're making steady progress installing a number of our managed care clients on HDI's processing platform and in cross-selling their specific auditing services to HMS clients. HDI will soon be performing their complex clinical and automated reviews for HMS' AmeriHealth Mercy client. Our contract with Humana has also been expanded to add specialty audits for dialysis and long-term care services, as well as medical bill audits.

Now let's talk about the Supreme Court's landmark decision. The court upheld the individual mandate, saying that the penalties placed on people who don't buy health insurance are regarded as a tax protected by the Constitution. This was likely the most contentious provision in the ACA, but one that is critical to appropriately expanding the individual health insurance market. With regard to Medicaid, the court upheld the expansion but limited the requirement by ruling that the federal government cannot withhold existing Medicaid funding from states that elect not to expand their programs in accordance with the ACA's new eligibility levels. So states may refuse to expand their Medicaid programs and the federal government cannot penalize them by taking away their overall Medicaid funding for doing so.

In light of the Supreme Court's decision, a number of issues regarding the Medicaid expansion will likely remain unclear until more guidance is provided by HHS and CMS. For example, it's not yet clear whether a state can adopt the smaller or phased-in expansion or if they can expand their Medicaid program sometime after 2014. Policy clarification resulting from the court's ruling will likely be addressed by HHS after the November elections. Regardless, the Affordable Care Act is, in fact, the law of the land.

Now I'll talk about the impact of Supreme Court's decision on HMS' long-term growth. While states are having serious discussions regarding the Medicaid expansion, we believe that final decisions including the issues related to timing of expansion and partial expansion, will take place after the November elections. With that said, we are seeing considerable movement forward. In its recent report, the Congressional Budget Office, or CBO, projected that most governors will choose to expand their programs even though some states may not do so by 2014, and others will try to negotiate for partial expansion with HHS. The CBO also projected that 7 million additional people will be covered by Medicaid in 2014. Only a few governors have publicly declared that they will not expand and many states are leaning toward expansion. Kathleen Sebelius, Secretary of HHS, has urged states to move forward with expansion and to take advantage of the fact the federal government will pay 100% of the coverage expansion's cost from 2014 through 2016 and at least 90% in later years. In fact, it's estimated that under the ACA, expansion will raise state Medicaid spending by only 2.8%. It's a compelling argument when you examine states' individual healthcare funding concerns.

And as states weigh their options, many stakeholders will likely be making their voices heard to make sure expansion, in fact, happens. Even states that have gone on record to say that they will not expand will feel pressure from providers, patient advocates and insurers. According to the Texas Health and Human Services Commission, a Medicaid expansion in that state would generate $100 billion in federal funding over a decade and would provide coverage to an estimated 2 million residents. Because Texas' Medicaid population is currently handled largely by private insurers, who will have a lot to gain from a Medicaid expansion, they are now among the stakeholders who may pressure the state to accept the federal assistance. And of course there are hospital associations around the nation that have already signed off on cuts to reimbursement rates and Medicaid disproportionate share payments on the assumption that they will gain new paying customers under the ACA that would more than cover their losses. This group, a powerful lobby, also has a lot to gain from expansion.

In addition, states may very well feel pressure from employers with a large number of low-income workers. These employers, including big retail and restaurant chains, were anticipating that Medicaid expansion would provide coverage for this population. Without it, they will be subject to tax penalties if they don't provide affordable coverage to these workers. And many large employers find it difficult to provide comprehensive benefits at an affordable price for this set of employees. We also know that states will lose uncompensated care funds under the ACA. Independent studies estimate that there will be reductions in net spending on state and local government safety net programs to provide care to the uninsured of about $100 billion between 2014 and 2019. This also may compel states to move forward with Medicaid expansion.

We believe that these and other factors will ultimately result in an expansion of the Medicaid program for most states, as outlined under the ACA.

The cost of reform has also been at the forefront of the debate, and new estimates from the CBO may impact state decision-making. For example, CBO projected that the insurance coverage provisions of the law will now cost $100 million less over the next 10-year period than previously estimated. And other independent analysts have found that states choosing to fully implement the ACA could save through reductions in spending on the uninsured. Taking into account this recent information, as well as other analysis from CMS and other resources, we anticipate that Medicaid spending will grow in double digits in 2014 and that by 2021, Medicaid will grow to more than 20% of all national health care spend.

With public health care costs rising at these levels, everyone on both sides of the aisle agrees that rooting out fraud, waste and abuse is one of the most proven and significant ways to contain costs and make these programs sustainable. With our deep knowledge of the Medicaid program and established audit and recovery platforms, HMS is perfectly positioned to drive that agenda forward in both expansion and non-expansion states. Speaking of which, the Supreme Court ruling also clarified other requirements under the law, including affirming the law's Program Integrity initiatives, such as the Medicaid RAC program. With the uncertainty about the ACA's constitutionality now behind us, we believe that state implementations of their Medicaid RAC programs will accelerate.

Finally, regarding health insurance exchanges, CMS recently clarified that states will still receive additional funding for exchange implementation even if they decide not to expand Medicaid. Because of this, we're seeing states continue to issue RFPs and procure health insurance exchange contracts. Among Republican states, 4 have already passed legislation or have decided to proceed with an exchange via an executive order, and an additional 5 states have issued RFIs and RFPs for at least the technical component of an exchange. In fact, to date only 6 states in the nation have announced that they are planning to rely on the federal exchange instead of developing their own state market-based exchange. As mentioned before, HMS is currently engaged with partners on developing eligibility-related services for the state health insurance exchange market, where we can help states verify eligibility for their new members.

So the outlook for HMS remains strong well into the future. We are firmly positioned in the Medicaid and Medicare markets, and both of these programs continue to grow. HDI's success provides us with an excellent springboard into the commercial insurance and Blue Cross Blue Shield markets, where we can provide a wide range of payment integrity services. Our broad range of payment integrity services apply equally well in the commercial market. Commercial carriers will have an increased need for these services as they manage to new MLR requirements and seek to reduce administrative expenses.

We are the leader in the RAC market in both Medicare and Medicaid. With the Program Integrity components of the ACA firmly in place, we now expect states to accelerate implementation of their Medicaid RAC programs, and we also expect the federal government to procure additional services to assure the integrity of the programs we serve.

Because of the growth in these programs, the diversity of our products and markets and the very favorable regulatory environment, we expect continued high growth rates of approximately 20% over the near term. And as health care costs continue to grow at an unsustainable rate, there is clear political and regulatory support for containing costs through the identification, prevention and recovery of fraud, waste and abuse throughout the system. This is HMS' core capability, and clients in all of our markets will continue to look to us for cost-containment solutions.

I thought I'd end with a sense of the magnitude of the impact we have on our clients. In one state where we performed third-party liability services, a recent state auditor's report outlined that the work performed by HMS had a return on investment nearly 10x our fees versus most of their other vendors who had little or no ROI on a cash recovery basis. In our most mature RAC contract, in just over 1 year of operation, the work performed by HMS had a return on investment of over 14x our fees. Now cash-strapped government programs need ROIs like the ones HMS delivers. We believe our performance will continue to speak volumes as we advance to improve the integrity of our nation's healthcare system.

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

Question-and-Answer Session

Operator

[Operator Instructions] We'll take our first question from Jeff Garro with William Blair.

Jeffrey Garro - William Blair & Company L.L.C., Research Division

So I want to start off with more of a housekeeping issue. Last quarter, you discussed some of the HIPAA 5010-related revenue pushing up Q1. And you mentioned that there's still kind of more of that to come, but I wanted to get a better sense on if the majority of it was recognized in Q2 or how much we should expect in the back half of the year.

Walter D. Hosp

Yes. Jeff, this is Walter. So we said in the first quarter that we had $5 million to -- $4 million to $6 million of revenue that was impacted in Q1. We made progress on that in the second quarter in recovering some of that. But in -- early in the second quarter, there was also some additional impact from that issue. So net net, in the quarter, for Q2, it's about a $1 million to $2 million negative impact. All of which, the cumulative impact of this issue, we expect to recoup in the second half.

Jeffrey Garro - William Blair & Company L.L.C., Research Division

Great. That's very helpful. Turning to the full year outlook, this year is shaping up to be kind of back-half loaded in terms of revenue and earnings as you guys well forecasted last quarter, but I want to see if there's anything in particular in terms of timing of new contracts or particular programs that we should keep in mind for the balance of the year.

Walter D. Hosp

Well, you're right. When you look at the numbers there, we said when we revised our guidance last quarter that in terms of revenues that 54% to 56% of our annual revenues will be in the second half. So it is backloaded. The fourth quarter will be bigger than the third quarter, additionally, if you want to spread it that way. And it's a combination of a number of things that we've alluded to already. We have seasonality in our Coordination of Benefits business, that you could see year in and year out, that makes the fourth quarter our biggest quarter in that area. And then as Bill has explained, we have this ramp we're going up in the Medicare -- the Medicaid RAC programs as well. You also have HDI growing at exceptionally high rates, which makes any subsequent quarters much higher than prior quarters as well. So all those factors are contributing to this heavy weighting in the second half.

Jeffrey Garro - William Blair & Company L.L.C., Research Division

Great. And then in terms of achieving your guidance, you talked -- gave us some nice color there, but is there anything in terms of new business wins that needs to be won to achieve the guidance? Or is it all a matter of execution of what you spoke of previously?

William C. Lucia

Primarily, we -- basically, we're primarily in implementation mode. So there is always some upsells that we're counting on. But when you look at our entire portfolio, we've sold the business that should generate revenue for the balance of the year.

Walter D. Hosp

Said differently, there isn't reprocurement risk, if you would, or even new contracts that we absolutely have to have in order to meet our numbers.

Jeffrey Garro - William Blair & Company L.L.C., Research Division

Great. That's helpful. And then one final one before I jump back in the queue. I'm just trying to look a little bit bigger picture. You talked about some tremendous opportunities ahead. So I want to try to get a sense of how you're planning to balance the spending and investment the next couple of years alongside your near-term growth objectives. You talked about the RAC opportunity and the Medicaid expansion and exchanges coming on board in 2013. You also have a growing commercial opportunity. So is there kind of any concern about how you're going to balance all these and whether the results could be a little noisy as you look to kind of capture more of this growth?

William C. Lucia

It's a good question. We, on a regular basis, are balancing investments in future opportunities. In fact, this year, we are spending -- because of our contingency fee nature of our business and the 24 RAC engagements we've won, we are spending ahead to make sure that they are staffed with data analysts, clinicians, recovery specialists to be able to execute on the promises we've made to those states. We've also both significantly increased our data processing capacity, moved our data center from New York to the Dallas area to be able to scale up for the growth that we see ahead of us. So we are, every year, balancing investment back into the business and the new product opportunities, as well as investment in our infrastructure to support our growth.

Walter D. Hosp

Yes. And just an additional comment. So achieving that balance, as Bill said, we face it all the time because we have such a large available set of opportunities in front of us. So the first thing is prioritizing those opportunities, and then secondly, putting together plans that achieve that balance. Part of that balance will be though -- and we've said it -- 2012 is a big investment year. If you look at margins, yes, the margins aren't expanding this year. I would also add that we're incurring additional costs with the integration of HDI. But as you look forward, you're going to see the revenue growth that is associated with a lot of the investments that we're making this year. And so we will continue to make investments for the items mentioned here, but we should also see margin expansion in subsequent years.

Operator

And we'll continue on to Bret Jones with Oppenheimer.

Rohit Vanjani - Oppenheimer & Co. Inc., Research Division

This is Rohit in for Brad. I was just wondering if you could quantify the MIC and ZPIC contracts that you're letting lapse. Do you know what the financial impact will be and which quarters you'll realize them?

Walter D. Hosp

Yes, but these were previously announced and, well, even starting back in the fourth quarter of last year. So we -- yes, we mentioned. So this is not news -- not new news, but we keep mentioning them because in each quarter, they do have this impact. So the MIC contract that we mentioned is one task order that we did not rebid on -- that we mentioned in third or fourth quarter of last year. That's -- obviously, the impact of that is hitting us on this quarter and will roll off in Q4 of this year. The ZPIC contracts were related to conflicts when we acquired HDI. HDI is a Medicare RAC vendor, and you can't be both the RAC vendor and a ZPIC contractor in the same region. So we had to let go of a number of ZPIC contracts there. And that impact will carry throughout the rest of this year.

Rohit Vanjani - Oppenheimer & Co. Inc., Research Division

I'm sorry. I thought those were new announcements that you're making. Sorry. And then secondly, the pharmacy claims issue, you said that you saw them at the beginning of the second quarter, but have those completely gone away? As the quarter progress, you won't realize anymore of those in the third quarter?

William C. Lucia

Well, we're not identifying new issues but we are still resolving issues with some of the trading partners on both the medical and pharmacy claims. And we plan to have all of those resolved, and the payers that pay the claims plan to have them all resolved by the balance -- through the balance of this year.

Walter D. Hosp

And just to appreciate it, I mean, there are these errors that first have to be corrected in the submissions, and then they have to go through the whole cycle again, being resubmitted. So you're talking about at least a quarter to correct errors in a quarter. And that's why it's carrying over.

Rohit Vanjani - Oppenheimer & Co. Inc., Research Division

Okay. And then lastly, for the 6 states that you won in the Medicaid RACs, the Arkansas, Idaho, Montana, Utah and Minnesota and Virginia, were those states that were sitting on the sidelines before the Supreme Court ruling? Or were they already under an RFP process even before that?

William C. Lucia

They were all under an RFP process prior to that.

Rohit Vanjani - Oppenheimer & Co. Inc., Research Division

So have you seen any states move over to implementation that weren't already there before the Supreme Court ruling?

William C. Lucia

Well, we've -- what we're seeing now that there is an affirmative on the ACA, we're seeing the implementation activity accelerate. So states are now -- this is the law. We -- and they're also seeing results that by talking to some of their -- other states in the nation, they're also seeing some results that are being generated, and it makes sense now to start the implementation. So while we had -- while we have 24 contracts, not all of them were in implementation. We're now seeing an acceleration of their efforts on that side.

Operator

We'll go on to Scott Green with Bank of America Merrill Lynch.

Scott J. Green - BofA Merrill Lynch, Research Division

First one is on EBITDA margins, if I think about the trajectory from first half of the year to second half, there is typically some favorable seasonality. In the last few years it's been like second half margins are 250 or so basis points higher than the first half. And then should I also be thinking about the $5 million or $6 million in HIPAA-related revenues you would get that jumps [ph] through to EBITDA so we could be seeing like a 400 basis point higher EBITDA margins in the second half than the first half?

Walter D. Hosp

Yes, well -- Scott, just to reiterate something we've said before, we don't give the quarterly guidance there on that, but let's take it bit by bit. So yes, we traditionally have EBITDA and operating margins expand in the second half. That should continue due to the seasonality of the COB business. Basically, we have higher revenues in those quarters. Expenses aren't growing at the same levels related to that. So what you -- the levels that you've seen in the past would continue. Offsetting some of that this year is going to be expenses related to gearing up for all these Medicaid RACs, okay? We've got a bunch of them. We're hiring folks for it, and that's somewhat muting some of the growth in margins that will happen in the second half. We also have the addition of HDI, which is different than prior years. And again, with that very high growth rate of HDI, as it continues, margins there are expanding and we're also getting towards lower levels of integration cost as the year progresses on. So it's a complete mix of things. I would just say the underlying trends are very similar, if not a little more pronounced, than in prior years. But you can back into the guidance that we gave for the full year on the EPS to really gauge the margins.

Scott J. Green - BofA Merrill Lynch, Research Division

Okay. All right. That's helpful. Next on Medicaid RACs, I guess can you just put in perspective what you need to see happen in the back half of the year to hit your guidance, which is calling for reaccelerating growth in Program Integrity x federal business?

Walter D. Hosp

Yes. So they hit our revenue targets. Again, it's back-end weighted. But when we reduced our guidance last quarter -- as you'll recall, we made 2 adjustments. One was in the core area, reflecting perhaps lower expenditures in the Medicaid expansion, and we said that the rollout of the RACs are just taking longer than we had originally anticipated. So the net result of that new guidance there is that we don't need huge levels of RAC implementations and RAC revenues now to hit our guidance although I shouldn't say that none is in there. Some RACs, like New York and New Jersey, we've been working on and we will have revenues from. Those, of course, we're depending upon to make our targets. A lot of the newer implementation ones we've adjusted our estimates in terms of when revenues are going to come from that accordingly.

Scott J. Green - BofA Merrill Lynch, Research Division

Okay. And do you have any enhanced visibility since the SCOTUS ruling that leaves you increasingly confident in the revised RAC guidance -- maybe if states are stepping forward as you had hoped they would after the ruling?

Walter D. Hosp

Well, when you say revised RAC guidance -- I mean, we've been very careful not to give any very specific guidance for any time period. What we've said -- gone on record is that we've said this marketplace, when it's up and running for a full year, would be approximately $100 million marketplace for all RAC vendors and that we expected to get at least half of that. Now the timing of when that full year run rate -- has been pushed out. And clearly, that's not going to be full year calendar 2013. It's going to be a portion of '13 and a portion of '14. Now that half -- the level of half, we'll see as the rest of these procurements settle and when they get implemented, too. Right now, as we've reported we're doing better than half the business at least on a count-the-state numbers. There's obviously a disproportionate impact in terms of what states that you win. We've been very fortunate in winning New York, New Jersey, California, the largest RACs that have been out there so far, but there is some still large states to go.

Scott J. Green - BofA Merrill Lynch, Research Division

Yes. I meant more on the whatever undisclosed amount you were assuming in the back half of 2012 .

Walter D. Hosp

Yes. As I said, that's -- we've reduced our estimate the last time when we gave guidance on that. We feel confident on that.

Scott J. Green - BofA Merrill Lynch, Research Division

Okay. And then on -- can you speak to CapEx this year? It looks like it's doubled year-over-year. What's driving that? And should we expect the operating cash flows to be kind of back-end loaded this year, a little more weighted towards the back end like they were last year?

Walter D. Hosp

Sure. So the biggest marginal impact this year is the move of our data center from New York to Dallas, Texas in an outsourced location, and that we're not physically moving a lot of equipment but actually reprocuring whole new configurations, which leads to directly large increases in CapEx. Obviously, those investments are ones that will have very good ROIs over time. They are making much more efficient operations, lower-cost operations. And we'll get the benefit of that in subsequent periods. And I will report also that, that move is going extremely well and we're not seeing any interruption to our business. And we're not completely done but we're very far along the way of completing that project.

Scott J. Green - BofA Merrill Lynch, Research Division

All right. And very lastly, what were the Medicare RAC revenues in the quarter? I think they were like $11.5 million last quarter.

Walter D. Hosp

We don't disclose HDI's specific breakdowns between Medicare RAC and their commercial sales. So we haven't given a single number related to that, but it's -- the proportionality is similar to the first quarter.

Operator

Deepak Chaulagai with Dougherty & Company.

Deepak Chaulagai - Dougherty & Company LLC, Research Division

I just wanted to clarify, Walter, so you had no revenue from the HIPAA 5010 issue recognized in Q2? Does it -- I mean, issues from Q1 that you had nothing recognized in Q2?

Walter D. Hosp

No, that's not true. So we had this approximately $5 million impact in Q1. That was -- there was progress made on that in Q2. The issue was -- is that it didn't stop. The issue wasn't fully arrested by the end of Q1, and so new issues were added to the pile that have netted this out at a $1 million to $2 million negative impact for the quarter, okay? And as I say, we'll catch up on all the cumulative impact of these issues by the second half. So it really should be looked at as not a change to our overall guidance. It's just the timing of the shifting of revenues.

Deepak Chaulagai - Dougherty & Company LLC, Research Division

And so you were estimating $1 million to $2 million of that disruption recognized in Q3?

Walter D. Hosp

Yes, Q3 and some may spill over into Q4 because these things do take more time than maybe initially thought of in terms of resolving.

Deepak Chaulagai - Dougherty & Company LLC, Research Division

Okay. That's helpful. On the Medicaid RAC front, just to follow up on Scott's line of questioning, what -- if you could just quantify or give more color on how implementations have come for the older contract, I'm assuming, they are farther along. And what is the status of the contract that you have signed up in calendar '12? Just so that we can gauge the ramp-up to the back half of this year and as you alluded to, getting those programs fully ramped in 2013 and 2014.

William C. Lucia

Deepak, this is Bill. I'll start by saying once you've seen one Medicaid RAC, you've seen one Medicaid RAC. It's a big distinction that we should draw between Medicaid and Medicare and that there are 50 programs with multiple auditing entities within the state government and their ability to get us the appropriate data for us to do our work. So where we see faster results are the contracts that have previously been HMS customers. We have a pretty good data set, you need more data to do RAC than you do third-party liability, where they're able to augment the data quickly. And we have a longstanding relationship with the agency and the providers in the state. So that's -- those go up typically a little faster. Where it's a brand-new relationship with a state, they have not done a lot of external auditing, those contracts are longer to bring up. I mean, they're -- we're still -- with one state -- I won't name states, but with one state, we're a year into the contract and we're still working on getting adequate-enough data to perform our work. So I wish I could tell you that there is a standard I can apply to it. And maybe 3 years from now, we'll be able to have a very strong standard that we can say an average implementation takes 6 to 9 months and they -- it's just way too early in the program to be able to do that. What we do believe is as more states share their actual results -- and CMS will be asking for this data in the near future. But as more states share their actual results and the results that they'll share are predominantly driven by HMS and the marketplace, there'll be an even further emphasis from the states that are not performing as well to get up to speed. So we really think it's going to be a sentinel effect on states that are dragging their feet.

Deepak Chaulagai - Dougherty & Company LLC, Research Division

That makes sense and that's helpful color as well. So you had, I'm assuming, not much in terms of revenue recognized for Medicaid RAC this quarter but you are assuming some revenue impact in the back half of the year. Is that a fair way to state it?

Walter D. Hosp

Well, absolutely. I mean, we've been -- we've had revenue from RACs in Q1, the New York, New Jersey programs, which were approved early. They're sizable programs. South Carolina, other ones, we have absolutely RAC revenue there and we expect that to grow. So it's not as though it's all or nothing. It's this combination of now a portfolio of RACs, all at various stages, all at different sizes, all with different scopes, being implemented over time. And again, as Bill says, we wish we could provide you some sort of rough parameters that you could apply across the portfolio, but that would be misleading at this stage.

Deepak Chaulagai - Dougherty & Company LLC, Research Division

That's helpful. And then on HDI, I know you have previously stated that you expect some ramp-up in the commercial book of business there. So I'm assuming the Medicare RAC, which has grown tremendously, that portion of revenue has been higher than -- much higher than 50% in the first half of the year and you sort of expect the commercial business to ramp up in the back half of the year as well. Is that a fair way to assess it? Or if you could just help us out, that would be wonderful.

Walter D. Hosp

Yes. Both are growing rather significantly. The quarterly growth numbers can be misleading quite frankly because there is -- both programs have different reasons and items and issues in terms of their ramping up. The RAC program itself, as we know and you could see it from the CMS public reporting numbers, is expanding rapidly. But quarter-to-quarter, it doesn't necessarily continue on a steady growth rate but it does over the year plan to have extensive expansion on that. And on the commercial side, that's again a portfolio of existing clients and growing, expanding them and a host of new ones. As Bill mentioned, we begin selling HDI products to our Medicaid managed care marketplace and we'll have implementations. And when those implementations come online, they will have a disproportionate effect in any given quarter. So please be cautious about applying any quarterly growth rates almost in any part of our business to a longer-term one. But the overall growth rate for that $95 million of HDI revenue is over 70% year-over-year, so very important.

Deepak Chaulagai - Dougherty & Company LLC, Research Division

And then the Medicaid growth, you gave good color last quarter on the slowdown in Medicaid growth overall, expense growth. Do you have any indication on what that was and how that might have tied to your Coordination of Benefits business?

William C. Lucia

Well, I mean, we just know that the growth in Medicaid expenditures and enrollment this year has been lower versus previous years. The good news is that -- CMS estimates are that, that will turn around and start to increase again in 2013. And of course, that also is in a state-by-state basis. So it's -- we have to look at that at a much more granular level. We also have the impact depending on the state of the shift of lives back and forth between managed care and then the new shift of lives from the dual eligibles, where we're starting to see an increase in expenditures coming from our managed care clients.

Deepak Chaulagai - Dougherty & Company LLC, Research Division

And final one, if I may. On the exchange opportunity, I know you have been working on a product there. Some states are farther along. Others are probably not. So are you working with multiple partners in that -- on that front from a market development perspective? Or are you just targeting 1 or 2? And how should we think about longer term? I know there is nothing in revenue for fiscal '12 and I'm assuming not much probably in the first half of fiscal '13, but how should we think about that overall opportunity and how you are approaching it?

William C. Lucia

Well, I think it would be hard to determine some metrics around the size of that opportunity. But let me give you some examples of how we are approaching it. We are going both directly to states so that they understand the value of our services in this -- in helping them automate their decision support processes for determining eligibility. There are tools available using HMS' eligibility systems that to be able to more rapidly make determinations or provide information to those who are making those determinations. So we're going directly to states to make sure they understand us as a thought leader in this market and are available to help them either in their exchange or quickly thereafter as an audit of the decisions that are made. That's a possibility. And then we are going to market with a number of partners to offer our services both in the exchange world or what's also commonly being procured at this point to prepare for exchanges is states doing a revamping of their eligibility determination systems overall. And so we're in a number of those bids as well. So I think by the end of the year, we'll be able to give a little more color about what this opportunity represents for HMS on a going forward basis. And we should probably start to see revenues from this in 2013.

Operator

And we will continue on to Richard Close with Avondale Partners.

Richard C. Close - Avondale Partners, LLC, Research Division

Is there any way you guys can break out what the ZPIC and MIC revenue was in the comparable period of second quarter of 2011?

Walter D. Hosp

Well, what we said, Richard, is that the MIC contracts were -- each of these areas was several million dollars, right? Though the ZPIC contract -- sorry, the MIC contracts were on an annualized basis on order of $4 million to $5 million and the ZPIC contracts that we had to let go were of a similar amount, a little bit higher. So you can just annualize those and spread them across the quarter because they are really cost-plus businesses.

Richard C. Close - Avondale Partners, LLC, Research Division

And so they didn't -- was there any revenue in the second quarter of 2012 on those?

Walter D. Hosp

No.

Richard C. Close - Avondale Partners, LLC, Research Division

Okay, so no revenue. And then just with respect to -- I think you said PI was flat year-over-year when you exclude those federal projects. Can we talk a little bit about that in terms of whether you think -- are you disappointed with the performance of PI? Obviously, you didn't have PI several years ago and it's a different business than the core Coordination of Benefits. I'm just trying to get a sense of whether that's living up to your expectations or just what your thoughts are on the Program Integrity.

Walter D. Hosp

Yes. Well, let me first talk about the numbers and then Bill may want to comment about the strategic directory of -- strategic projection of this area. First off, this bucket that we're talking about -- so this is non-federal Program Integrity. In 2011, total revenues were only $30 million in that bucket. So we're talking about a very -- a relatively small bucket, and we're talking about when there is quarterly changes to these numbers and it being implemented in lumpy sorts of pieces there. You're going to have quarterly numbers that, again, should not be extrapolated or assumed to be that, that is the -- at all indicative of the long-term growth potential of these businesses. So when you're using a $30 million base -- we're shifting the portfolio in that bucket or other areas like Employer Services and other items. So just be warned on that, that although these growth rates appear very low -- as I mentioned in my formal part of the speech here that we expect those growth rates to grow. And when we start getting Medicaid RAC revenue, starting to kick in, you're going to see, on the other hand, very high growth rates. And neither should those be extrapolated into sort of annual growth rates either. But that's the situation there. But maybe, I could turn to Bill to just talk about our strategic outlook related to Program Integrity.

William C. Lucia

Yes. I think the key message is that we had -- we can say we're disappointed that the RAC market didn't develop as quickly as possible because that's where we really see significant growth opportunity and ultimately, the commercial market as well. But in reality, it's the slowness of the RAC market that did not give us the significant growth rate this quarter. Now I'll tell you that with all of the new implementations that are going in and RAC being a somewhat cumulative-type project, meaning that it's not as automated as Coordination of Benefits, where it's running on a daily, weekly and monthly basis. In RAC we're presenting new audit findings and scenarios to states on a regular basis, but those projects may be millions of dollars of findings, they could be a couple of hundred thousand dollars of findings. And those go through an approval cycle which is different at every state. They do a -- we do a vetting with providers. There is a -- so it's a very lumpy process at this point, and I think that, that will start to smooth out in -- by mid-2013. But I think for the balance of this year, you'll see some lumpiness in that line.

Richard C. Close - Avondale Partners, LLC, Research Division

Okay. I'm going to try to hit the 5010 a little bit different. Walter, in the first quarter, you mentioned Coordination of Benefits, I think would've been up 12% to 15% if you were able to recognize the 5010 revenue, the $4 million to $6 million. What would the COB growth rate be this quarter, second quarter, if you were able to recognize all the 5010 revenue?

Walter D. Hosp

Very, very similar. So I've said in the comments before that the quarter COB grew 13%. And then again, if it's a $1 million to $2 million adjustment to that -- in that, you'd be back up at the 14%, 15% level.

Operator

And we will continue on. David Windley with Jefferies.

David H. Windley - Jefferies & Company, Inc., Research Division

So a couple. One is on Medicare RAC and the, I believe, mandated expansion to Part D as well as Part C. And I wondered how much visibility you have on that, when that will happen, and how that will happen.

William C. Lucia

Well, the current RAC contractors and the RAC contract that we and 3 other contractors have does not include Part D. We don't know when the additional procurements for other RACs will come out. There are other procurements that are coming out of CMS in the entire Medicare program as we speak, and we're opportunistically bidding on different procurements either at HDI or HMS. But the Part D claims will not be part of the existing Medicare RACs.

David H. Windley - Jefferies & Company, Inc., Research Division

Okay. And again, you -- so you really don't have visibility on the timing of when they would expand to Part D?

William C. Lucia

We don't, but we do know that because of the success of the Medicare RAC program, CMS is looking to both -- looking for ways to both improve upon it and expand that to other programs. And as you know, what the President's mandate to for all federal agencies to use contingency fee or performance-based contractors, we're seeing an uptick in procurements across all agencies.

David H. Windley - Jefferies & Company, Inc., Research Division

Okay. So a separate question then moving on. There is some -- I think some imbalance in your COB experience in terms of the revenue that you're -- the kind of the productivity of contracts by state, thinking about how much revenue you were able to generate, say, per covered life, per Medicaid life in a state. I'm just wondering what drives -- I assume it's products -- but what drives the fairly significant differences across states in terms of your revenue productivity and what you can do to bring the lower states up.

William C. Lucia

It's primarily scope. So it's the depth or breadth of products within Coordination of Benefits that the state has selected -- and I would mirror the same for managed care -- that has selected from HMS. And it's also, to a lesser degree but also important, the percentage of employer-sponsored insurance coverage that exists in a given state. So the first is the bigger issue, and that's scope. And every year, about -- we say that about 1/3 of our growth comes from upselling in existing customers. And so this year, like any other year, we are aggressively out trying to expand scope in each account. So that's one of the ways. And then the other way, of course, is just engineering our current services and making them more effective on a per-member, per-month basis.

David H. Windley - Jefferies & Company, Inc., Research Division

And the 1/3 of the growth, that's 1/3 of Coordination of Benefits growth? Just so I'm clear on that.

Walter D. Hosp

Yes.

William C. Lucia

Yes. 1/3 of Coordination of Benefits growth every year comes from upselling scope within an existing account.

Walter D. Hosp

So if it's 15% of growth in there, then it's roughly 5% upselling.

David H. Windley - Jefferies & Company, Inc., Research Division

Understood. The -- within the Medicare RAC business, we were looking at the prospect of appeals and saw an assessment or an estimate that the success rate on appeals is maybe 2% to 3%. I was wondering what your reserving posture is relative to the prospect for appeals and if that presents either a risk or an opportunity for income, if that -- if you're reserving higher than that 2% to 3% range of appeal success?

Walter D. Hosp

Yes. And that's -- so that's the CMS reported numbers, are the number of appeals out of total claim numbers. So it's the number of claims, not the dollar amounts that have gone through the process thus far. In our Medicare RAC revenues, the revenues we report are after a substantial reserve on the corrections that we make based upon historical experience with the appeals process. Now this is very much a laborious and very detailed calculation, separating out automated and complex clinical reviews into different product areas, looking at historical experience, and setting up reserves that are adequate to support projected levels of appeals. So is there an opportunity for any material changes to revenues by changing that reserve policy? The answer is no. In fact, changes to reserves would be very gradual over a time period because it's based upon, again, long data sets of experience and how those changes might happen. So even if it was improved dramatically in a quarter, it would be 1 data point on many that will go into our calculation for reserves. So we believe they're very adequate. So we sleep well at night in terms of not thinking we're going to have any exposure to that, but it's certainly not, in any way, shape or form, something that would provide a great deal of revenue variance particularly in any given quarter.

Operator

We'll now take our final question from Jamie Stockton with Wells Fargo.

Jamie Stockton - Wells Fargo Securities, LLC, Research Division

Maybe just real quick. It seems like during the quarter you leveraged compensation expense a fair amount. Could you just give us some color around what drove that? Was it the changing geographic concentration of your employee population, timing of hiring or maybe HDI? Are you able to leverage that technology already to help with the profitability of your core Program Integrity business?

Walter D. Hosp

Sure, Jamie. Yes. On every one of our line items, in general, we're able to -- over periods of time, obviously, have leverage. When you talk about compensation in particular and you're looking year-over-year, you do have to first x out HDI, which has higher margins in that line item there. But when you do that, you would still see the x [ph] HDI, as you point out, leverage in that line item. And part of that is ongoing efficiency programs and being introducing technology, et cetera, long-term projects that lead to leverage that shows up in the compensation line. But I would also say that in a quarter, we're growing so rapidly that to hire and maintain our staffing commensurate with our growth, you will have some quarters where, like this quarter, the revenue growth rate exceeds the expenditures and then you're going to have the flip side, and you may see that even more in the second half. So as a percentage of revenue, comp expenses could go up as we're going to be hiring many folks to staff the Medicaid RAC programs that we need to do. And in that quarter where we're not getting revenues for that, you'll see a change. So again, I know I sound like a broken record, but it's great to look at a quarter and look at standalone results, but you really have to look at multiple periods to get a true sense of where it's going. We do expect to leverage that line item each and every year -- maybe not as significant as we've done in this quarter.

Operator

Thank you. And ladies and gentlemen, that's all the time we have for questions today. I would now like to turn the conference back over to Mr. Bill Lucia for any additional or closing remarks.

William C. Lucia

Well, I'd like to thank everybody for attending our call today. We're very excited about the opportunities ahead of us at HMS, and we're looking forward to speaking to you again on our Quarter 3 conference call.

Operator

Thank you. Ladies and gentlemen, again, that does conclude today's conference. Thank you for your participation, and have a great weekend.

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