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Athenahealth Inc. (NASDAQ:ATHN)

Q1 2008 Earnings Call

May 6, 2008 16:30 am ET

Executives

Carl Byers - SVP and CFO

Jonathan Bush - Chairman and CEO

Analysts

Richard Close - Jefferies

Randall Stanicky - Goldman Sachs

Sean Wieland - Piper Jaffray

Corey Tobin - William Blair

Constantine Davides - JMP

Topher Orr - Thomas Weisel Partners

Leo Carpio - Caris & Company

Operator

Welcome to the Athenahealth Q1 2008 conference call. As a reminder, today's call is being recorded. At this time, I'd like to turn the call over to Carl Byers, Chief Financial Officer of Athenahealth. Please go ahead, sir.

Carl Byers

Good afternoon and thank you for joining us. With me on the call today is our Chairman and CEO, Jonathan Bush. Certain statements contained in this conference call maybe considered forward-looking as defined by the Private Securities Litigation Reform Act of 1995. In particular, any statements we make about our expectations for future financial and operational performance for the benefits of our service offerings.

Forward-looking statements may often be identified with words such as we expect, we anticipate, upcoming or similar indications of future expectations. These statements involve various risks and uncertainties that could cause our actual results to differ materially from those expressed in such forward-looking statements.

And these include the risks and uncertainties under the heading risk factors in our most recent annual report on Form 10-K and other periodic reports filed with the SEC and available on our investor relations website at www.Athenahealth.com and on the SEC's website at www.sec.gov.

Investors are cautioned not to place undue reliance on such forward-looking statements as there is no assurance that the matters contained in such statements will be achieved. The forward-looking statements we make on today's call are based on our beliefs and expectations as of today, May 6, 2008, only.

We do not undertake any obligation to revise or publicly update any forward-looking statements expressed in today's conference call.

Finally, please note that on today's call, we will refer to certain non-GAAP financial measures in which we exclude certain non-cash or non-recurring items from our financial results, as determined in accordance with GAAP.

We believe that in order to properly understand our short-term and long-term financial trends, investors may wish to consider the impact of these items as a supplement to financial performance measures, determined in accordance with GAAP.

Please refer to today's press release, announcing our first quarter 2008 financial and operating results, available on our website at investors.athenahealth.com for a reconciliation of these non-GAAP performance measures to our financial results, determined in accordance with GAAP.

With that, I'll now turn the call over to Jonathan Bush, who will discuss the highlights of the quarter, after which I will discuss the financial results.

Jonathan Bush

Thank you, Carl. Good afternoon everyone and thanks for listening. Athenahealth had an outstanding first quarter and we are delivering results ahead of where we thought we would be at this time. We had revenue of $29.8 million in the first quarter, representing growth of 36% over Q1 of 2007, comfortably above our long-term target model growth rate of 30%.

Similarly our adjusted gross margins in the first quarter were 57%, well ahead of our target model. In fact, it's at the low end of what we had in mind for 2011 gross margins. In profit, we achieved $0.09 per diluted share and adjusted net income.

But most importantly, we are making incredible headway in the market. In particular, I'm pleased to announce that we just signed MinuteClinic. This is an incredible new client for us. Owned by CVS Caremark, MinuteClinic is the largest operator of retail clinics in the United States, with over 500 clinics in 26 states, most of them located in CVS stores.

We expect all of these MinuteClinics to be live on AthenaNet by the end of the year, making them our single largest client. While I am pleased with these results, I am also pleased overall with the core drivers of performance that lie beneath them, because they will drive our future results.

In complex business services like ours, growing faster than planned can lead to strain on the inner core of the business. Thus, I am always watching the engagement level of our employees, the core financial results we are delivering to our clients and the level of satisfaction that those clients report back.

Employee engagement in Q1 was 3.8 out of 5 using the same framework I have described on prior earnings calls. This is a good performance. But as one step to move this number to the next level, we have named Leslie Locke as Athenahealth's Senior Vice President of People and Process.

I use days in A/R to measure our financial performance for clients. It was 46.5% in Q1, which is 1.5% better than it was in Q1 of '07 and approximately 30% better than the pre-Athena average reporting for clients according to our benchmark data.

I am pleased to see this metric moving in the right direction, and we have several initiatives in place to continue that progress. For example, to better serve retail clinics, we are upgrading the credit card, check and cash pay capabilities of our network to enhance our real-time estimation, adjudication and payment collection capabilities.

Finally, client satisfaction was 86%. Again, measured the same way we described in prior earnings calls. This was flat with Q1 '07 and can be improved. In order to take our client-facing operations to the next level, we have recently named Jody Blakeway as our new Senior Vice President of Client Services. Jody is a veteran of Procter & Gamble, AT&T Broadband and UPS and we have significant confidence in her ability to bring greater scale to our customer servicing functions.

Needless to say, I am extremely satisfied with the volume and balance of our sales efforts. Nevertheless, we continue to innovate. Our most recent such innovation is an exciting enhancement to our partnership with PSS World Medical. We have established a dedicated team of sales professionals who will work exclusively with the PSS sales force to deliver leads.

Other companies that distribute through PSS have had great success with this model and we are working very closely with PSS in the design of the group. Obviously, we expect this new team to push up performance of our already growing small group sales force. It will also push performance in our historic area of strength, the group practice segment.

Similarly, our access to the enterprise segment has experienced a notable increase. In addition to MinuteClinic, Eclipsys continues to help us on leads. Mostly though, we are seeing that our success with the Methodist Community Health Systems, Vanguard, the Rockford Clinic and others have given us a whole new level of access to the nation's large medical groups.

Looking forward, our new product development is also a source of great pride. Athena Clinicals is making solid progress with over 400 live providers and satisfactions amongst respondents to our survey of over 90%, which exceeds the average levels for our revenue cycle product.

Our unique approach to the EMR market that have actually outsourcing medical chartroom functions, rather than convincing medical groups to do it themselves with software is a disruptive, market changing strategy that we believe will win in the end.

In summary, Q1 was the single most validating quarter to date that we are indeed disrupting the old world software model and replacing it with a network that is actually able to sell results, not tools, and able to do so with conscience.

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

Carl Byers

Thank you, Jonathan. We were pleased to see strong revenue growth in Q1 2008 to $29.8 million, up 36% over the same period last year. This represents our 33rd consecutive quarter of organic revenue growth.

The Q1 growth rate exceeded the Q4 2007 growth rate, which in turn exceeded the Q3 2007 growth rate. We expect our growth rates to vary from time-to-time based on implementation timing, but the underlying trends are in a very favorable direction.

We also executed well in the quarter to produce adjusted earnings, which exclude the impact of stock-based compensation of $0.09 per diluted share. While no business goes in a straight line, our service-based business model provides much greater visibility and is more recurring in nature than is the case with traditional software businesses.

Our first quarter growth was driven by an increase in the number of physicians actively using our services to 9,810 in Q1 2008, up from 7,639 in Q1 of 2007. Total client collections posted to AthenaNet in the quarter were $797 million in Q1 2008, up from $606 million in Q1 of 2007.

As we always note, most of our revenue is tied directly to the collections of our clients, so we typically experience fluctuations that mirror the activity of the medical practices we serve. It is for this reason that we believe that year-over-year comparisons are more useful than sequential comparisons.

For example, historically our collections per physician and our revenue per physician have been relatively low in Q1 and relatively high in Q2. Given that the collections that follow the holiday period tend to be diminished and the collections that follow the start of the year tend to be more robust.

In Q1 2008, our business services revenue per physician was up 6% compared to Q1 of 2007. With regard to medical providers using our services, we are rolling one change and one additional metric.

First in light of the fact that retail clinics such as MinuteClinic, employ medical providers who are not physicians, we will begin to report the total medical provider count as well. To be clear, physicians are the largest subset of this medical provider count. In Q1 of 2008, our total medical provider count was 12,723, which was up from 9,827 in Q1 of 2007 and sequentially it was an increase from 12,118 in Q4 of 2007.

Second, we also will begin to share regularly with you our athenaClinicals' medical provider count, which at the end of Q1 2008 was 412, of which 291 were physicians. This represents a current cross-sell ratio of about 3% of our live provider base for this new service, meaning that we have a significant amount of untapped opportunity for athenaClinicals within our current client base.

As a reminder, our provider counts are activity-based metrics, by which I mean, this is the number of discreet providers for whom a medical claim was submitted. On the clinical side, this is the subset of those counts for which the clinical service was activated by period-end.

Our adjusted gross margin, which we define as the difference between total revenues and direct operating expense, divided by total revenue, excluding related stock-based compensation expense was 57.4% in Q1 of 2008, up 640 basis points compared to Q1 of 2007.

Improvements in gross margins in general are driven by automation, scale and increased effectiveness. Please note that our income statement presentation is based on categories of expense without a comprehensive cost of revenues line. Some expense associated with client service, such as components of depreciation and amortization is reported separately.

Regarding profitability, we experienced substantial improvement on the bottom line, delivering our third GAAP profitable quarter. We believe that when evaluating our profitability, it is most useful to look at EBITDA and net income adjusted for stock-based compensation expense. In Q1 2008, we delivered adjusted EBITDA of $4.0 million, which was 13.5% of revenue compared to what was about $700,000 in Q1 of 2007.

Our adjusted net income in the period was $3.1 million, which was up sharply from the same period last year when we had a net loss of $1.5 million. The adjusted net income amounted to $0.09 per diluted share.

This result included a charge of $419,000 associated with our withdrawn S-1 filing in the first quarter. So with the adjusted gross margin, adjusted EBITDA and adjusted net income levels, we have experienced significant margin improvement.

Having reviewed these results, I want to briefly cover stock-based compensation expense. We have always said that a useful way to look at any business is with such expense excluded, because equity events are reflected in share counts when relevant.

That said, our stock-based compensation expense increased significantly in Q1 2008, so I want to provide some color on that.

First, the company issued about 975,000 stock options in the first quarter. These were a combination of yearend grants, one-time milestone-based grants for four executives as described in our S-1, and grants to new hires.

These awards were anti-dilutive because they currently are underwater, but they did contribute about $850,000 toward our stock-based compensation charge in the first quarter.

Second, as described in our proxy statement, which we filed in late April, we have enacted an employee stock purchase program, which also creates stock-based compensation expense related to participation levels in the plan which was $18,000 in Q1 2008 for the one month that the plant was active in the period.

When added to the stock-based compensation expense for option grants and prior period grants, the total stock-based compensation expense in Q1 of 2008 was $1.26 million. Given the impact of yearend and the milestone-based grants, we expect such increases in stock-based compensation expense to be uncommon. However, because stock-based compensation expense is spread over time, these higher levels of expense will persist.

As I discussed in the last earnings call, general, and administrative expense associated with our ramp up of operations in Maine is anticipated to negatively impact margins in the short run and then to help with margins around the end of the year, due to the lower cost of operations there.

That expectation remains the case. Our ramp up is proceeding on schedule and we believe that Maine will contribute meaningfully to our operational capabilities and to our expense profile around yearend.

Beyond the impact of our ramp up in Maine, we also expect to see increased spending in our operations in anticipation of a higher rate of revenue growth around yearend. Between the MinuteClinic, Community Health Systems and other client wins, we have the opportunity to generate significantly increased revenue in the last quarter of this year.

We always caution that implementation is truly the last stage of the sales cycle and that implementation schedules are inherently flexible, that implementation may take longer than planned, especially for large accounts and that our contracts are usually cancelable at will.

That being said, as implementations proceed, we expect to experience ramp up costs associated with these opportunities, which will impact margins, since we expense sales and implementation efforts as they happen, but begin to recognize revenue only once it is live.

This tradeoff is a substantial positive for the business, but as is always the case in this business model, the time sequence will be that incremental costs come before related growth, revenue and profit.

We anticipate that the return on these investments will be significant in Q4 of 2008 and will be reflected in our growth rate and in our profitability at that time. We believe that these near-term investments will more than pay for themselves on a full year 2008 basis.

Finally, in looking at our balance sheet, the most significant event in Q1 was our purchase of the Maine facility, which was completed in February at a purchase price of $6.1 million. In addition, we paid out a large portion of deferred compensation in Q1 based on yearend performance pay.

At the end of Q1, our balance sheet included $66.5 million of cash and short-term investments, compared to $71.9 million at the end of Q4. Our balance sheet also had $1.7 million of restricted cash and $1.7 million of debt.

With that, we will be happy to take any questions you may have.

Question-and-Answer Session

Operator

Thank you. (Operator Instructions). And we'll take our first question from Richard Close, Jefferies.

Richard Close - Jefferies

Yes. Congratulations on a good quarter. Carl, real quick, on the stock comp, you say you are expecting that to continue going forward. And is that essentially the $1.2 million? Use that sort of as a rule of thumb, or back out the 150,000 that you mentioned?

Carl Byers

Richard, I think the best way to look at it is within the context of the accounting rules around 123R. I'm sure you're familiar with the fact that when we issue an option, we use the Black-Scholes pricing model. All of this is disclosed and the details are on our Q, which should be on file now, if not now, then shortly.

You have to use the volatility assumption and a bunch of other assumptions to determine the value of an option, even if it's underwater. So for example, in Q1, there was about $18 of value per stock option. It then gets spread over the expected service period.

So with any company, stock-based compensation is persistent. In the sense, that once you start amortizing that cost, it will be there until it's been amortized. So in that sense, the stock-based compensation can only go up in the short run.

That being said, I would also point out that level of stock option grants in Q1 was highly unusual in the sense that, A, more options were granted in Q1 than all of last year. B, it included a substantial number of one-time grants that were, as shown in the S-1, based on a milestone, which was the profitability of the company.

And the compensation committee does have guidelines about the total number of options it will issue in a given year. Its target is between 2% and 3% of the diluted share base and so a lot of the option grants for this year, essentially, are now done. In using that math, they would exclude the one-time grants that were disclosed in the S-1.

So there will certainly be additional option grants this year. It'll be at a much lower volume. Those will add incrementally to the stock compensation expense. But just given the way the rules work those expenses should persist.

I think our view is that the number of shares is reflected in the share count on a diluted basis under GAAP, using the treasury stock method and that's the better way to look at the business, is the adjusted earnings against the diluted share count. And on that basis, as I said, in Q1 it was a $0.09 quarter.

Richard Close - Jefferies

All right, I think I got all that. I was curious if we could talk a little bit about maybe some ratios that you guys might use. Have you guys ever used it like the physicians in a backlog as a percentage of the physicians live on the network?

And if you have, I would assume that ratio has trended up considerably over the last six months, obviously with community the MinuteClinic there, any comments in and around that?

Carl Byers

Sure. I can comment on that, Richard. First of all, what's unusual about MinuteClinic is that there are no physicians. As a retail clinic, they employ nurse practitioners, they have over 500 locations. We intend to implement all of them at one time later this year, at the end of the year.

And so that's the reason we've started to disclose a medical provider count in addition to the physician count. Because you will see those providers in the medical provider count only, so that's the first thing.

Second of all, it is absolutely the case that the backlog of business that is queued up to go live has grown significantly and we believe will grow significantly in the short-term. That is the reason why we're trying to be very clear here, whereas we don't provide specific earnings guidance, we do think it's important to tell you what trends we're seeing in the business.

And the trend we're seeing is that those backlogs, as you put it, are increasing because of very recent contracting activity. We do expect contracting activity to increase further, still, and the net impact of that will be in our best estimation, significant revenue growth in Q4 of this year and obviously subsequent to that.

So in that sense we are planning on that assumption; i.e. building in capacity both at the G&A level, in terms of our infrastructure and at the direct operating expense level to make sure we have the professional services and account management and other resources we need to properly serve those new clients.

Richard Close - Jefferies

Okay, and then just one final question. With respect to the professional services side, do you guys feel completely comfortable with, I guess, a surge on your backlog that you guys can effectively implement those physicians or those providers in that backlog? Do you have a high level of confidence, I guess, over the next several quarters?

Jonathan Bush

Richard, I'll take this. It's Jonathan. I think we have a huge amount of confidence. We are blessed, at some level, by the fact that MinuteClinic, which represents obviously a significant bolus of all of our usual rapid growth, is going as one single go-live and is using their own proprietary nurse practitioner EMR on the front-end.

And so the account management and professional services strain they represent is significantly less, but certainly client-facing, so no, we're fine with the swelling in the backlog that we're experiencing. But there's no question that this means that client-facing areas are our current area of highest priority innovation.

So during the last year, we talked to you on the road show in the last quarter, talked about the improvement we mad in electronic remittance rates and a lot of the claim-related operating indicators that we were so proud of.

I think the current work is around account management and professional services, not for this year, but for out years. I think that we can do what we signed up for this year even though we continue to have just a terrific year.

Richard Close - Jefferies

Okay, great. Thank you.

Operator

And next we'll hear from Randall Stanicky, Goldman Sachs.

Randall Stanicky - Goldman Sachs

Great, and thanks very much for the questions. I just have a couple. First, I'm sorry if I missed it. Did you talk about the revenue per medical provider from the MinuteClinic additions?

Carl Byers

We did not give a client-specific number for those guys. But let me just characterize a little bit what their business looks like, which should give you a sense. As I mentioned, they use nurse practitioners in their delivery model across the 500 plus clinics that they have in operation today. I should note that the number of clinics in operation is growing and it is their strategic intent to continue to grow the footprint of the MinuteClinic.

The one way to look at it is both headcount and full-time equivalent count of nurse practitioners and the way they describe their business, typically there may be about four nurse practitioners per site and the full-time equivalent ratio is about two. And so if you look at on that basis, 500 clinics is about 1,000 nurse practitioners worth of work.

I also should point out that we always have commented on the seasonality of our regular physician business. The retail clinic market has a different seasonality pattern that is much more pronounced. The flu season is a big deal for retail clinics and so Q4 is absolutely the monster quarter in that world.

It's a much more product-based clinic, if you will, camp forms, school physicals, flu shots, et, cetera. And so it's very important to any retail clinic to have a highly scalable service delivery platform and that's why we think we're just a perfect fit for that sector, which is emerging.

Randall Stanicky - Goldman Sachs

And you guys capture all that growth and as they build out their footprint, I would assume under your current contract?

Jonathan Bush

Yes, absolutely.

Randall Stanicky - Goldman Sachs

Okay. That's great. And actually I just had one more. As you think about it, I think you referenced 3% on the clinical offering in terms of current cross-sell. How do you guys think as you talk to your current customer base about the ramp in that number and ultimately I guess where can that number go as you guys continue to work on that cross-sell?

Carl Byers

I think there's no limit to the height of it. One of the key elements in the value proposition that's missing today that will be there in the coming years is new streams of revenue for our clients to be obtained through performing disease management services and participating in pay-for-performance programs, which today are pretty anemic in terms of the total dollars available.

That being said, we designed athenaClinicals to drop a significant amount of cash onto the bottom line, even if there was no performance-based revenue to be obtained ever. The way we do that, of course, is that we outsource all of the chartroom functions. The fax machine literally doesn't ring at the doctor's office anymore, it rings at our data center and all of the trafficking of orders and results is handled by Athena.

That business model works really well. It is a much more complicated one to build product against and to deliver against, compared with just the screens and menus, et, cetera associated with the EMR, kind of clinical documentation of the encounter on a laptop, which is the extent of most EMR functionality.

So it can go all the way through to the moon, Randall, and we have been working on getting it to where it can handle that, where we can handle that kind of growth. And I think we're getting there.

I think that we really, I mentioned during the formal part of this call that our client satisfaction across the clinical space is now higher than our average client satisfaction across the collector base, which is something that collector satisfaction level is one of our most valuable assets.

So I think we're poised for real growth here and I don't think there are any -- there are very little in the way of subsets of our customer base that would not qualify. That if we consider to be not part of the addressable market.

Randall Stanicky - Goldman Sachs

Thanks very much guys.

Operator

Next we move to Sean Wieland from Piper Jaffray.

Sean Wieland - Piper Jaffray

Hi. Thanks guys. So again just help me get my head wrapped around this MinuteClinic deal. I'm gathering that it's, first, congratulations on the deal. It sounds exciting. If I gather correctly, it does not include Clinicals and it is priced as your other deals as a percentage of collections. Is that accurate?

Jonathan Bush

That is correct. There are minimums, but yes. Basically materially it'll act as a percentage of collections deal, the way the rest of our business does.

Sean Wieland - Piper Jaffray

And given the size of the deal, I mean, can we talk, or give us some direction as to how much it was discounted? Just so we can try to figure out how to price this into our model?

Jonathan Bush

I would say that our margin projections internally are that we haven't changed our model in terms of what we expect to get out of the account. As I mentioned earlier, in answer to another question, we are going to market with them in a manner that is actually convenient for us.

So the intensity of the strain on our professional services group and on our account management group is significantly lower on a per provider or per dollar of revenue basis than we have had in other situations.

And once you neutralize that, the difference in pricing, there's still a little discount. These guys are extraordinarily decisive, extraordinarily large, just really important customers for us. But net-net, we certainly don't think that what comes out the other end of the money machine actually looks different.

Sean Wieland - Piper Jaffray

Okay. So aside from the size of the opportunity, what else is going to be different? What differentiates this from, I mean, is there going to be portability of data from one MinuteClinic to the next? Have you worked through some of that?

Jonathan Bush

Of course there's portability of data across all customer base, the customers in our base. There are 18 million records that can be accessed from anywhere in the country on AthenaNet.

But more specifically, in terms of this margin point I've made, the front-end users, those 1,000 STE nurse practitioners, 2,000 nurse practitioners, will not be on AthenaNet. They will be on a kind of cash register-esque, very narrowly sort of task designed a medical record product that MinuteClinic maintains.

And so all of their use challenges get directed to MinuteClinic to take care of, whereas, typically issues of frontline personnel with using the system would go directly to Athena.

And similarly with account management, the local site management is not referring to Athena for guidance or support. MinuteClinic has actually a very sophisticated management team that doesn't need our advice on how to run a clinic the way our average customer does. Does that get at your question, Sean?

Sean Wieland - Piper Jaffray

Yeah. I think so. The second part of my question is on Clinicals, you're starting to give us some metrics on that, which is great. How is the reception among the new sales prospects that you're talking to now? How is the reception towards Clinicals and the attachment rate going?

Jonathan Bush

I would say our sales force is still focused and I can't say I'm totally depressed about this, on getting that collector deal, no matter what. And they don't want to slow the process down to include large committees of physicians in order to get the 50% upside.

It's a little bit like the real estate brokers challenge. He sure would like to get your house sold a little higher, but mostly he really, really wants to get your house sold and move on to the next house.

And I think that that dynamic is there. It's got to be expunged overtime from our sales force. But given the newness of the product, I'm not in a huge rush to force that. I want it to emerge as this very disruptive type of technology grows up on its own. So we're on first generation.

We're only on version nine I guess now of the EMR and for Athena that's very young, because obviously we can do very rapid deployment of releases compared to the software world. So that's new and I don't feel like forcing it on them.

It's a part of every single collector sale, not every single though, I think we actually measured that. And 85% of our collector sales included a Clinicals pitch and due diligence around Clinicals basically so that the prospect can preserve the option to upgrade to Clinicals when they want.

So I think it's doing well for us. But our sales guys aren't insisting on getting it. And they're not getting it too terribly often. We have a decent volume, but not huge.

Sean Wieland - Piper Jaffray

Okay. Last question, Carl, I know you don't provide guidance, but I'm going to ask you anyway. I mean, your comments on the investment to get ready for MinuteClinic is going to pay off in Q4 '08. I mean, how much of a sequential increase in expenses should we model into Q2 and Q3 to account for MinuteClinic?

Carl Byers

Sure. I mean, I won't give you a specific number, except to say we would expect the margins to be compressed a bit in Q2 and to some extent in Q3. Both at the gross margin line, as we ramp up some professional services and account management capacity, and at the EBITDA line because of G&A.

Now our G&A was higher in Q1 in part due to the S-1 write down that I mentioned, which obviously wouldn't recur. And there are some G&A costs that are somewhat seasonal when the year turns over, and they do dissipate after Q1.

That being said, underneath that, we will have some ramp up, some significant ramp up in Q2, of G&A associated with our Maine operations. And so I think the way I would look at that is you should see some margin compression at the gross margin and at the EBITDA margin line, so that we can have just a very much higher growth rate and profitability level in Q4.

Jonathan Bush

Let me tag off of that, Sean, to make sure my point is emphasized here that as you think about the model for us, you keep in mind. We've said during the road show and all throughout, this is a disruptive technology that needs to be in every doctor's office in the country.

And we are not going to micromanage net income at the expense of market share growth too, too tightly. We're not going to swing wildly and get people nervous, but our goal when we very favorably, on sale, is to take some of that and invest it in expanding our growth engine.

And so in addition to the obvious infrastructure necessary to support outsized growth, I think we will always look to see if there are ways of accelerating our investment in the growth engine itself, in the size of the sales force and the amount of online advertising we do.

And even in the tightness and simplicity and ease-of-use of the product itself, to make it easier to insert. So those are things that I would also caution you to keep in mind. If you see us way out growing on revenue, you should hope to see us investing more in growth as well.

Sean Wieland - Piper Jaffray

Okay. Will Q2 and Q3 remain profitable?

Carl Byers

You mean on a total profitability base? Absolutely. Yes.

Sean Wieland - Piper Jaffray

Okay, just wanted to make sure.

Carl Byers

And when I say margin compression, I mean that the number goes down a little bit. I don't mean that it disappears.

Sean Wieland - Piper Jaffray

I'm just making sure.

Jonathan Bush

Carl doesn't give guidance, but he's prone to take guidance by being sure he's aware of what guidance others are giving.

Sean Wieland - Piper Jaffray

Okay. All right, thank you very much.

Operator

Next we'll move to Corey Tobin from William Blair.

Corey Tobin - William Blair

Hi. Great quarter, guys. Just a follow-up on Sean's question, then. So was there anything in the quarter that would be more sort of one-time in nature or unsustainable for the gross margins outside of the investment you mentioned here in Maine coming forward and then with MinuteClinic. But was there anything else that drove the exceptional year-over-year improvement in gross margins in Q1?

Carl Byers

The main thing that drove the improvement in gross margins is the performance of the operations at Athenahealth. So let's be really clear about that. The business model, the ability to remove work because we're getting claims paid the first time, our ability to automate, those are the heart of our business model and because we can price to value, we generate significant gross margins.

We do not expect any aspect of that to change. So we don't want to snatch defeat from the jaws of victory here, the performance in Q1 is a credit to our clients and to our service team and our business model and there's nothing about that that was one-time in nature at the gross margin level.

That being said, we've just told you that our growth rate at the end of the year should, and we believe will increase. And as a result, we need to be prepared for that. And that's the reason we are setting expectations that in the professional services area and in the account management, we need to make sure we have invest some of that in capacity.

Jonathan Bush

Maybe I should add, just we're characterizing adjustments that you might look into on the margin here. Things at the core are going absolutely as well as we could have hoped and so it would be very hard for us to mess this up, where you would actually see a loss. That's way beyond the realm of the kind of characterization we're trying to give you here.

Corey Tobin - William Blair

Okay. And so, Jon, just to sort of round off on that and tie it back to your comments from earlier, I mean your margins have typically sort of stir-stepped up and then stayed at that level, have gone higher.

Absent the incremental investments that you're speaking about here, is it safe to assume that the 57% or so that we saw this quarter is the new sort of baseline level to think about going forward?

Jonathan Bush

Well, the first thing I want to make sure is clear is, on the revenue line and on the expense line, direct operating expense, there are seasonal elements that are relevant. And when we provided our five-year target of 57% to 59%, those were full year numbers. And so I would let history be the guide that there can be some variation on the margin.

That being said, we do not see any reason why we cannot repeat that level of performance in the future. But we also will be making these incremental investments and we do expect them to cause some modest margin compression at the gross margin line and also at the EBITDA line.

Corey Tobin - William Blair

Excellent. Great, and then finally just switching gears quickly. In terms of customer renewals, any deviation from the very high renewal rates you've seen in the past?

Jonathan Bush

We do not have a deviation that we can see. We do not do a complete study of that every quarter, we do a thorough look about twice a year. And we have remained steady at that 97% at the account level renewal rate.

Corey Tobin - William Blair

Excellent. Congrats again, thanks.

Jonathan Bush

Thank you.

Operator

And next, we move to Constantine Davides from JMP.

Constantine Davides - JMP

Thanks. Congratulations on the quarter, guys. Just a quick follow-up on the MinuteClinic. Can you just talk about the length of that sales cycle? And maybe just give us an idea of what other types of vendors you were competing against there for that opportunity?

Jonathan Bush

Like all of our customers, this is a one-year evergreen type of contract. They can let us go any time they see fit. In addition, on the second part of your -- but we hope that they'll behave like the other customers and renew at a similar rate.

In addition, regarding competition, I did get a look at the RFP, that started this process. Our business development folks have been talking with Nancy Brown, our Business Development folk, has been with them for over a year. The RFP process though is very short and very decisive and really didn't seem to me to be answerable by a software vendor.

So it was very specifically about a network that could change what happened at the front desk of all of the different locations, both with internal planning and with external events. So if payers change the game, they want all of those front desks to change the way they operate instantly.

And more importantly in a sort of a sophisticated marketing company like CVS, as they invent different ways of packaging healthcare services to be attractive to the consumer, different discounts, different extras you get for free, they want that instantly to be available and talked about and delivered upon across this incredibly broad network.

I mean there are 500 MinuteClinic, but these guys are used to dealing with over 6,000 CVS stores. They want to be able to roll out special offers in these clinics in a very nimble and dynamic way. And so I'm not sure how a software company would even bid on this.

So we didn't know of any. I'm sure they could have made anything work. These are very innovative guys. But my sense was, from my glance even at the first paragraph, of that RFP was that these were guys that were past the software model before they showed up with and RFP.

Constantine Davides - JMP

Okay, okay. That's helpful. And then on the Q4 call you noted that you looked at a couple, or at least one strategic opportunity. And it just seems like every week there's a deal announced in this space. And are you finding it difficult to find some attractively priced opportunities right now?

Jonathan Bush

Well, price often comes up in these conversations.

Constantine Davides - JMP

Yes.

Jonathan Bush

And so of course that's part of it. And the most important screen on our acquisition is that nothing about that company would get in the way of our ability to bring on and digest and serve at the current satisfaction performance levels of the core business.

It's running like a bat out of hell and we don't want to risk any kind of wrinkles, having our core ops guys having to go subsidize or deal with or fix companies that have kind of digestive troubles deep inside.

That being said, that leaves an enormous subset of ideas for us and we're working away on those kinds of things. I mean, I think no wine before its time and when things are going well as they are for us. But certainly you're not done hearing from us on those kinds of ideas.

Constantine Davides - JMP

Okay. And, Carl, one quick housekeeping item, what was the headcount for the quarter?

Carl Byers

Sure. One second. The headcount at the end of Q1 was 633. And in the direct service area, that number was 385, which was compared to 379 at the end of Q1 of '07.

Constantine Davides - JMP

All right, guys, thanks. Congratulations on the quarter.

Carl Byers

Thank you.

Operator

And next we'll go to Topher Orr with Thomas Weisel Partners.

Topher Orr - Thomas Weisel Partners

Yeah, thanks. Hey guys. Just a quick question here, going to active medical providers. I was wondering if you could give us the Q3 and the Q2 '07 for that?

Carl Byers

Sure. In terms of the full provider count, and again to clarify, this includes the MDs that we provided previously. The total providers on AthenaNet, I'll start at Q1 of '07, 9,827. Q2, 10,515. Q3, 11,510 and then I mentioned Q4 was 12,118, Q1, 12,723.

Topher Orr - Thomas Weisel Partners

Great, thank you very much. And going forward, are you still going to be breaking out the physician live count as well as medical providers? Or is it just going to be medical provider going forward?

Carl Byers

Yeah. We will do, but we will do both going forward. We're trying to balance being useful with the numbers versus confusing people with too many of them. But we absolutely will not pull back on any of the numbers we've shared previously.

Topher Orr - Thomas Weisel Partners

Great, all right. Thanks.

Operator

(Operator Instructions). And we'll move to Leo Carpio with Caris & Company.

Leo Carpio - Caris & Company

Hi, good afternoon, gentlemen, just a couple of quick questions going back to the MinuteClinics. Now that you have MinuteClinic and a few of these hospital deals, any particular in terms of future prospects or areas you're focusing on in the future? Or is it more just hospital penetration, more of these clinics that you're going to focus on? Or any other subsegments within the provider network you're going to look at?

Carl Byers

Well as I mentioned in the formal part of this call, all three of our core segments are going very well. So we have this unique ability to sell to, contract with, install and support these small practices, the one, two, three doc practices that represent over a third of all doctors in the country, no one else can do that.

So we're very happy with that and growing it like mad. I drew your attention to the number of sales folks that we're adding there, doubling since the IPO. The medical group practice segment, the group practice segment, the four to 50 doc segment has been where we've always been, and that remains at the current pace, at the pace of expansion that we expected.

But I also mentioned that in the enterprise space, and we would include kind of mega corporate type deals like MinuteClinic, CVS to be in that category. I mentioned that our level of access there has expanded significantly. So we are actually able to be in conversations that we would not have been considered for even six months ago, today.

Rather than get more complex than that, I would lump those types of deals into the enterprise segment and say that net-net the breadth and depth of our access in the enterprise segment is much higher.

Leo Carpio - Caris & Company

Okay. And then a little housekeeping item, what was your first pass claims adjudication rate in the quarter?

Jonathan Bush

The first pass rate in the quarter was 92%.

Leo Carpio - Caris & Company

All right, thanks. That's all my questions.

Carl Byers

Thanks, guys.

Jonathan Bush

One thing I do want to just add about the MinuteClinics, since there have been a lot of questions about it, is I want to emphasize that this deal took place in April and so in terms this is a Q1 call, and so as we give you information about how we're looking at the business, we're trying to look forward to the end of the year, as we talk about our growth rates.

I did mention growth rates do tend to bounce around, if you look at our company historically. So in our business, nothing happens until a client goes live. We're trying to give you some of the trends and leading indicators that we see, so you can think through where Athena may be at the end of the year. But these are very much leading indicators of growth down the road, growth that we're willing to spend in the short-term to make sure that it's serviced properly.

Operator

And that concludes the question-and-answer session. I'll turn it back over to our speakers for closing remarks.

Carl Byers

No closing remarks. So I guess we're all set, and I thank you all very much for your attention. We look forward to speaking with you next quarter, if not sooner.

Operator

That concludes today's conference. We appreciate your participation. You may now disconnect.

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Source: Athenahealth, Inc. Q1 2008 Earnings Call Transcript
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