Hanger Orthopedic Group, Inc. Q2 2008 Earnings Call Transcript

Aug.24.08 | About: Hanger, Inc. (HNGR)

Hanger Orthopedic Group, Inc. (HGR) Q2 2008 Earnings Call July 30, 2008 9:00 AM ET

Executives

Thomas F. Kirk - President and Chief Executive Officer

George E. McHenry - Executive Vice President, Chief Financial Officer and Secretary

Kenneth J. Abod - Vice President, Treasurer and Director of Investor Relations

Analysts

Lawrence Solow - CJS Securities

Adam Feinstein - Lehman Brothers

Dawn Brock - JP Morgan

Mike Petusky - Noble Research

Greg Williams - Sidoti & Company

[Ameritt Magville] - WCM Investment Management

Operator

Welcome everyone to the Hanger second quarter Earnings conference call. (Operator Instructions) Mr. Kirk, you may begin your conference.

Thomas F. Kirk

I am Tom Kirk, President and CEO, and I’m joined with George McHenry this morning, who is our EVP and CFO, and Ken Abod, who is our Vice President and Treasurer, and Director of Investor Relations. I’d like to welcome you all to Hanger Orthopedic Group’s discussion of our second quarter results. But before getting started, let me take a few moments just to review with you our declaration on forward-looking statements.

During this call, management will make forward-looking statements relating to the company's results of operations. The United States Private Securities Litigation Reform Act of 1995 provides a Safe Harbor for certain forward-looking statements. Statements relating to future results of operations, in this document, reflect the views of management. However, various risks, uncertainties, and contingencies could cause actual results or performance to differ materially from those expressed in, or implied by, these statements including the company's ability to enter into and derive benefits from managed care contracts, the demand for the company's orthotic and prosthetic services and products, and the other factors identified in the company's periodic reports on Form 10-K and Form 10-Q filed with the Securities and Exchange Commission under the Securities Exchange Act of 1934.

The company disclaims any intent or obligation to update publicly these forward-looking statements, whether as a result of new information, future events or otherwise. So that out of the way, I think there’s a few noteworthy points from this quarter. And let me just briefly touch on those and then I’m going to turn it over to George McHenry to talk more about our financial results, and I’ll join back in to provide a little color later on.

As the total entity, our sales grew by 13% and net income was up by 57%, making this the 10th quarter where we have met or exceeded first call estimates. Due to our people’s dedication and the investments we’ve made in prior years, all four of our operating units exceeded their performance targets. I’ll have more to say about the reasons for this in a little bit later in the call.

As a result of this performance and other actions initiated during this year, we have increased our full year sales guidance range by $10 million and our full year EPS range by $0.05 per diluted share, yielding earnings growth of 25% to 28% compared to last year.

And finally, our strong common stock performance triggered an acceleration of the preferred stock dividend, which will translate into the conversion of the preferred stock into common, thereby simplifying our capital structure as well as providing other benefits.

Now, I’m going to turn it over to George who’ll describe this event in detail, in addition to reviewing all of our financial results.

George E. McHenry

I’d like to talk about the preferred stock conversion and the dividend acceleration first to get that out of the way as it impacts the proforma EPS.

In late June, the company stock price hit a milestone which accelerated the payment of dividends on our preferred stock through May 26, 2011. Stock is owned by [Inaudible] Management. It was paid in the form of a pick dividend on the preferred. Now, most important part of this milestone for us is this event allows Hanger to immediately convert the preferred to common stock. And we have notified the whole of our intention to convert.

While the acceleration did add almost 700,000 shares to the calculation of EPS, it eliminated the payment of cash dividends and a conversion both simplified and strengthens the company’s balance sheet.

Hanger exceeded first call estimates by a nickel, including the extra shares. For GAAP purposes, the entire pick dividend is included in the quarter’s calculations of EPS and the first six months. So, you’ll see that in our filings when we make those in a week or so. For the purpose of my performance discussion, I will use proforma EPA, assuming the additional 700,000 shares I just mentioned were outstanding at the beginning of the year. We believe the proforma calculation represents some more meaningful measures as it does measure the long-term impact on EPS of the conversion. And the company has already acted to convert the preferred.

Turning to the results for the quarter, sales increased by $20.8 million or 13%. Our patient care centers had a great quarter reporting same center sales increase of 8.9% or $12.7 million of that total. For the quarter, SPS had a strong quarter as well, reporting a $3.2 million or 20.6% increase. Acquired entities accounted for $4.9 million of the sales increase.

Cost of goods sold as a percentage of sales decreased by a half of a percentage point to 48.7% compared to the prior year. Labor costs increased by $2.1 million in the current quarter due principally to a slight increase in headcount and the impact of merit increases and an increase in commissions. As a percentage of sales, however, labor costs decreased by 1% to 18.2% of sales through the sales increase.

Material costs increased by $7.2 million compared to the same quarter last year. Approximately $6.3 million of that increase was due to the $20.8 million increase in sales and $900,000 was due to a combination of a slight change in mix and increased rate costs.

SG&A increased by $7.6 million in Q2 due principally to a $2.6 million increase of the accrual for incentive compensation, due both to increased sales volume and timing of the accrual. $1.8 million of the increase was personnel costs, primarily related to healthcare and benefits. $1.4 million due to acquisitions. $800,000 related to merit increases year-over-year. An additional $600,000 was invested in our in-growth strategy and we have $1 million increase that was mostly professional fees and some other costs.

EBITDA, as a result of these changes, was $25.7 million, a $4 million or 18.4% increase compared to the prior year. And as due to the factors I just mentioned, EBITDA margins increased by 70 basis points from 13.5% to 14.2% this year. So, we showed excellent leverage on our fixed costs.

Interest was $1.1 million less than last year due principally to the impact of lower variable interest rates. Due to both our improved results for the trailing twelve quarters and the reduction in interest, our total leverage is calculated under the terms of our term B loan outstanding at 3.97 times trailing EBITDA. As such the first time in some time we’ve been under four times levered.

Income taxes, the provisions for the quarter was 40% of pre-taxed income. As a result of all this, our EPS for the quarter was $0.25 compared to $0.17 in 2007. That’s a 47% increase. Keep in mind in evaluating our performance that our proforma EPS calculation used on average over 500,000 more shares than used by analysts in their estimates. Cap EPS, which includes the dividends that I mentioned previously, was $0.11.

For the first six months, our sales increased by $34.6 million or 11.4%. Top sales in our patient care centers increased 6.7% or $18.2 million for the year. SDS outside sales increased by $6.7 million or 23.5%, compared to last year. And acquisitions accounted for $9.1 million of the sales increase.

Cost of goods sold, as a percentage of sales, decreased for the first six months by four-tenths of a point, principally due to decreased labor costs which is relatively fixed. Our labor costs in dollars increased by $4.6 million due to a combination of increased healthcare costs and the impact of the sales increased on some variable costs like commissions.

Material costs increased by $11.2 million versus 2007. Approximately $10 million of that increase was attributable to the sales increase and of $1.1 million was due to the combination of mix and inflation.

SG&A increased for the first six months by $12.6 million and that’s due to $2.9 million from acquisitions; a $2.8 million increase in the accrual for incentive compensation for the same reasons I previously discussed when I talked about the quarter; $1.6 million due to merit increases; $2.8 million in personnel costs, principally healthcare and benefits; $2 million invested on our Linkia gross strategies; $800,000 in advertising; $300,000 in other costs such as professional fees, bank and credit card fees, all of which was offset by $1.1 million decrease in our bad debt cost.

EBITDA at $44.1 million increased by $6.2 million, or 16.4% compared to the prior year. And our leverage for the first six months increased by 60 basis points which is at the high-end of our internal expectations.

Interest was $2.2 million lower than last year, again, due to the impact of lower variable interest rates. From income taxes, we recorded at provision of $7.7 million for the first six months compared to $4.9 million provision last year. Effective tax rate was 40% compared to 41.5% last year.

Moving on to our balance sheet. Our AR decreased by $1.4 million since 12/31/07 despite the $3-4 million increase in sales. And our DSOs decreased by 5 days from 57 days to 52 days this year. At the same time, our bad debt expense dropped to 2.3% compared to 2.9% last year. And the quality of our receivables, which we measure based on our over 120 days old receivables, was really good. Our percentage of 120-day old receivables was 12.2%, which is the lowest it has ever been. So, we’ve excellent quality of receivables. We’re collecting well as evidenced by our DSOs dropping and our bad debt expense at the same time has dropped. So, very good results there.

Inventory decreased by $1.3 million to $83.5 million compared to last year in balance as the 12/31 balance of $82.2 million. Inventory balance makes sense compared to all our other business trench.

CapEx for the second quarter was $4.7 million compared to $5 million last year. For the first six months, our CapEx was $7.8 million compared to $9.1 million. Both of those numbers are in line with our expectations and we still expect to spend about between $19 and $21 million for CapEx for the year. So, we should have slightly higher expense CapEx in the second half.

Cash flow from operations was $20 million compared to $18 million in the prior year. A $2 million increase. For the first six months, cash flow from operations was $12.6 million compared to $20 million last year. The decrease, as we mentioned when we talked about first quarter, was due principally to a fluctuation in advance payments on our practitioners. It’s kind of a compensation plan, which were impacted by the improved performance in 2007. So, that impacted our first quarter payments. We still expect to show $30-35 million in cash flow from operations in 2008.

Tom Kirk already talked about guidance. As he mentioned, we’re moving up the range of our expectations relative to sales by $10 million to a range of $680-690. We’re adding a nickel to our range for EPS and seasonality between $0.80-0.82. So we have moved that up by a dime this year. And we are, in essence, reaffirming guidance for the second half and you should note that we are absorbing the extra shares when we affirm our guidance that we just talked about in terms of that acceleration of the preferred. So, we are really moving up our guidance slightly when you consider that factor.

That’s the end of my comments on the quarter in the year. I’m going to turn the call over to Tom Kirk to talk about some more color on the results.

Thomas F. Kirk

Let’s take a few moments and talk about the business drivers from an operations perspective. At first, HPO, our patient care division, achieved $12.7 million in increase in sales, or 8.9% same center sales growth for the quarter. It’s an outstanding performance and the performance is principally attributable to three factors.

The first is price. On January 1, 2008, we received a 2.7% CPIU increase, which on this first year, will impact about 35% of our book of business. This combined with last year’s increase, which you’ll remember, was 4.3%, translates to about 2% of the 8.9% in same store sales growth. Now, the balance of the growth is attributable to two other factors. The first of which is volume and the second of which is mix. Let’s take a look at the drivers on that end of the business.

And the reason that we were able to see some additional translation is that on that 4.3% that we received last year as we’ve told you previously, it takes about three years for that to roll all the way through of our book of business. So, it’s the second year of picking up on some of that. Okay, back to the volume and mix issues.

First, we continue to see improvement in our Linkia book of business. And let me remind you again that HPO is the primary vehicle for the delivery of most of the services under our Linkia contracts. On an overall basis, the revenue from the Linkia designated contracts for this quarter was up 16% compared to the comparable quarter last year. And on a year-to-date basis, they are up 12%. So, that’s a very nice increase in revenue that is flowing through Linkia from the preferred and the exclusive contracts. And most of that is, as I said, goes to HPO and results in an increase in volume for us.

Second factor is our continued emphasis on our high-performing products such as our microprocessor prosthetic hands, knees and feet components. For this quarter, the revenue from the delivery of these products is up about 30% compared to the comparable quarter last year. Now, year-to-date, the figure is also up about 30%. So, you can do the math and see that we’re running about 30% first quarter and second quarter and these products not only provide additional functionality to our patients but they also help us in improving our margins in taking a look at our revenue.

The third are our patient evaluation clinics. And if you recall, this is the methodology that we use to ensure that our patients come back in a timely visit schedule so that we can check their fit and functionality. And for this quarter, those clinics have produced approximately 10% more revenue compared to last year and almost 40% more revenue for the year. Now, you also recall that these clinics performed very strongly in the first quarter of this year on a comparable basis and that’s because they really got off to a rather slow start in 2007. So, the comp was not as difficult. I would say that year-to-date that 40% they’re performing now in line with normal projections.

And the fourth area are our sales, marketing and public relations efforts by our practitioners and all of those that support them in identifying local opportunities in their business communities and the system in implementing these activities to translate plans into results. Basically, this is the blocking and tackling at the grassroots efforts that enables us to compete and to take market share and increase our volume.

One of the things I want to announce was to our legislative fronts. Some interesting activities have gone on in this arena. We continue to support the Amputee Coalition of America on educating state legislatures on the issues involved with reimbursement caps and how these deprived patients of quality care enduing them to lower levels of mobility.

Recently, Louisiana became the 11th state to pass parody and there are 29 others that have introduced parody legislations. On the federal level, a bill was introduced into the House for national prosthetic parody and the bill is expected shortly in the Senate.

In mid-July, the Congress passed the Medicare Improvements for Patients and Providers Act of 2008, better known as MIPPA. One of the features of this bill was that competitive bidding for DME suppliers was delayed by 18 months, providing additional time for CMS to review the process. Even more significant was the fact that OMP was not viewed as part of DME and therefore did not have to bear the cost of delaying the competitive bidding taxes. We’re very pleased with that and we work very hard to ensure that the legislatures understood the difference between OMP and DME.

And also in early July, the Department of Labor Statistics posted that the CPIU increase over the last 12 months was 5%. This should be the fee schedule increase that we see next year absent any definitive legislative actions to not implement that fee schedule update. So, we think we’ve got some good visibility out to 2009 on that front.

Now, let’s turn our attention to SPS. Their outside sales were up approximately $3.2 million, almost 21% compared to the second quarter of last year. And this is excluding the SureFit business, which we purchased in the beginning of July of last year. Their success is in continuing to build their core business by focusing on three major areas.

First, is continuing the leveraging of the location provided by the new warehouse which was opened in early July of ‘07. It’s in Pennsylvania and this provides the great conduit in the Northeast market. Second is their superior customer service and training, which has really been the emphasis for their gaining some new large customers during the quarter. And third is the addition of some new products into the portfolio, some of which they have on a sole distributor basis.

Just want to make a few comments on SureFit. You remember that this acquisition, as I mentioned, was made last year in the beginning of July, and it really is opening up a new entry into the podiatry market with some custom design foot orthotics. We are in the process of integrating SureFit into the Hanger family, which has included improvements in their work flow, their management schemes and in their sales force. And their sales are up about 5% over the comparable quarter last year.

Now, let’s turn our attention to Linkia. Linkia continues its dual mission of A) building its share of key healthcare company’s book of business and B) negotiating a fair price for the services provided by the providers within its network.

The network consists of Hanger patient care centers and independent providers. And by the way, the independent providers has now grown to 301 as of today. As I mentioned earlier, Linkia continues to increase their business as a provider-network management company, as insurance companies recognize the Linkia value and terms of their network. In addition, Linkia is exploring other dimensions of service that they could incorporate into their model. And on the marketing side, they are continuing their discussions and negotiations with key national and large regional healthcare management companies, as well as, the firms in the workman’s compensation segment.

And last but not least, Innovative Neurotronics. They had another successful quarter almost as good as the first quarter, which you recall, contains a feature on the Good Morning, America with WalkAide. So, that gave it a tremendous push. We’re continuing to complete our clinical studies and we still expect to file for coverage and reimbursement on a schedule to hopefully have resolution of coverage and reimbursement by the end of 2008 or early 2009.

And finally, a few words on acquisitions and our other developmental projects. We are continuing to pursue our strategic acquisition program. With respect to OMP, we are looking for kinds of candidates that have strategic value to us in the form of location, quality practitioners and/or favorable products and service mix. And on the development front, we’ve made some progress preparing to move our developmental projects into commercialization later this year.

So, in closing, the results of the quarter demonstrates improvement over the first quarter of last year in terms of sales but we also improved our leverage of fixed costs by about 70 basis points. And when George reviewed the SG&A categories for you, that actually contained some one-time costs that we expect that we go through the year to continue to see improvements on this metrics. But we also recognized that the environment in which we operate continues to contain challenges and this is why we’re stepping up our efforts on revenue generation. We’re continuing to invest in our development companies and some developmental projects and why we’re continuing to insist on stringent cost management so that we can leverage our fixed costs.

Thank you very much. That concludes my comments. I’d like to open it up to any questions.

Question and Answer Session

Operator

(Operator Instructions)

Your first question comes from the line of Larry Solow with CJS Securities.

Lawrence Solow - CJS Securities

I asked this question last quarter. I’ll throw it out to you again. You see any impact at all from the economy and maybe does the Linkia growth, or maybe providers maybe turning more to Linkia because of kind of tightening financial fiscal environment? Would that have any impact?

Thomas F. Kirk

I think there’s two sides to this. There’s the revenue and the cost side. Our the revenue side, we’ve not seen any impact. We monitor this closely. We are under-represented as you know, in some of what I will call the classic industrial heartbeat of America in Michigan, etc. But we continue to see the opportunity to use their scale in size to grow our revenue through all those mechanisms that we spoke about. And Linkia, certainly I think, has provided an opportunity for the insurance companies to manage their administrative costs and also Linkia, as you know, provides high quality; it measures customer satisfaction. So, it’s just a good deal all the way around. So, from that perspective, as opposed to the economic or the economy perspective, I think Linkia has a good value proposition. So, haven’t seen any negatives and we continue to watch that very closely.

The other portion of the economy that I alluded to would be on the cost side. We’re recognizing that inflation seems to be going up. And certainly anything to do with energy, although that seems to have mitigated a little bit in the last few days, but we’re seeing fuel surcharges and some increases from some of our suppliers on the material side but we’re doing our best to manage through those, consolidate our buy wherever we can, and try to use all the tools that our scale will give us in order to manage through that. Nothing disastrous at all as evidenced from our results but it’s something that we are looking at everyday, really, Larry.

Lawrence Solow - CJS Securities

Okay, and then in terms of WalkAide, you had spoken that there was some publication expected, I guess, from your earlier results out of Alberta. Is that still scheduled for some time this year?

Thomas F. Kirk

Yes, it is. The inventor has put together some research. He’s got several research projects that have concluded. He has submitted those drafts. One is on the physical side; one is on the thing called neuroplasticity, in terms of enhancing brain activity to actually have the brain re-train so it can do the job that the damaged part no longer is capable of providing. They are into magazines. Our understanding that the magazines have made a few comments back and he’s cleaning those up. So, we would expect that this year, as you’ve suggested, that we’re going to see those publications out on the market.

Lawrence Solow - CJS Securities

Okay, then last, I know you had kind of a sort of a mid- to longer-term target on your leverage of bringing your EBITDA down to four times now that you’re kind just below four. Can we expect that to kind of continue to fall, maybe even towards 3.5 or lower?

George E. McHenry

Well, if you add up from four’s, another half is a pretty big chunk. We think we can keep it down under four, overtime, operate it down to 3.5 times. It would probably be an ‘09 event but we feel good about our leverage right now.

Operator

Your next question comes from the line of Adam Feinstein with Lehman Brothers.

Adam Feinstein - Lehman Brothers

I guess just first, you may be just clearly showing big revenue growth here is the best seems the revenue growth you guys have reported in over a decade and that it’s certainly a very strong quarter. So, I know in your own guidance you’re being conservative in thinking more of a 4 or 5% going forward. But for the growth to really continue at these higher levels, what are some of the things that would need to happen? Again, just trying to understand it in terms of what led to the upside here. You talked about all of the programs and initiatives you have in place but just curious to get your thoughts as you think about the ability to sustain this accelerated revenue growth. What are some of the things you would need to happen?

Thomas F. Kirk

As you’ve picked up on, there really is no one silver bullet that we attribute to the sales growth. It’s sort of a potpourri of a number of the ongoing projects that we’ve had for some time. But I think in direct answer to your question of what’s going to allow us to actually go a bit higher than the 4-6% that we’ve had out there, I think there’s three things.

1) Linkia’s got outstanding performance for the quarter. 16% is really off the charts. It’s almost double what they’ve had over the last three years. So, what’s happening there is that the insurance companies are continuing to reduce their network and bringing business into the Linkia shop through their network management. So, I think that’s the first thing that the insurance companies have to remain dedicated and continue to see the value administratively and quality-wise. And certainly, we are working with them on a weekly basis to make sure that we understand their needs and we’re capable of providing that kind of service.

The second thing: We’ve, again, reported strong performance on our high-end high-tech products at 30%. If you would’ve asked that at the beginning of the year relative to what we achieved last year, would we see that kind of growth? I think the overall average response would have been not nearly as strong as we have been able to demonstrate. And I think what’s happening there is insurance companies are recognizing that microprocessors componentry is here to stay. Certainly, it’s not experimental. Manufacturers have stepped up. They’ve begun a number of clinical studies so that they can statistically demonstrate the efficacy of this device. The use of our proprietary pallet, which is a patient evaluation tool, that we put all the patients through now, has been accepted by the insurance companies. And actually some of the insurance companies have licensed us on non-royalty basis. So, their insisting that all patients receive this and those that qualify on their scores are getting the devices. So, I think what we’re seeing is an acceptance of the high-tech products as a very efficient modality, in a way, through life cycle costing to deferred cost. So, we continue to reinforce that with all of our payers.

And last but not least, I think it’s the basic blocking and tackling that’s going on at the grassroots level, of being able to use our scale in size to go in and convince people that we’ve got the range of skills, we’ve got the range of technology. And therefore, whether they want it better, whether they want it faster or whether they want it at the right economic value, that Hanger is the group that can provide that. Now, that’s breaking pattern to care and breaking all kinds of relationships. And that is one of the biggest reasons that we’ve been able to increase volume and of course, the more successful we are there, the more that helps Linkia. So, it’s a combination of all three of those things that we’ve got to keep a focus on in order to sustain this growth above the 4-6% that we expected.

Adam Feinstein - Lehman Brothers

I guess just as we think about just the cost of leverage and, obviously, margins are moving the right way, G&A expense in the quarter down to 37.1%. You’re showing big improvement there. But looking back when G&A used to be in the 36% level back in 2003. So, just curious, as you think about longer-term goal, do you think there’s the potential to the extent revenue is growing at these higher levels that you get the G&A levered so you can get back to 36% type of number over time?

George E. McHenry

I think over time, Adam, that we can move towards that. When you recognize the fact that we have made some substantial investments that affects our SG&A and things like the WalkAide and the clinical trials will be concluding soon, that cost will go away. We’re getting price increases and that helps us with our leverage. And good comp growth comparable to what you saw in 2001, ‘02, and ‘03. And if you remember back then, it took us three years to get to that number. And I think we’re moving towards that but it’s going take probably another year and a half to move towards those kinds of levels.

Adam Feinstein - Lehman Brothers

Before, there was a question about the impact from the economy. Just wanted to follow up. What sort of co-pay do the patients typically have in terms of a typical managed care type of patient? Just any commentary there as we think about that.

George E. McHenry

On average, Adam, it’s about 20%. Sometimes the patients actually have backup insurance, supplemental insurance, that will handle that. Sometimes, they have to come out-of-pocket for that. Certainly, as we have discussed, and historically, patients do need this care. This is their mobility. It’s often not discretionary. Now, they do have some discretion around timing and they can delay. And that’s why our patient evaluation clinics are so important, to make sure that their devices stay in tune. If it needs any maintenance we can get that done. But as you’re probably suspecting there, that’s the area of vulnerability. If somebody doesn’t have the co-pay, then how are they going to get this done? We haven’t seen any weakness in that area. It is something we watch and certainly, we watch our repair and maintenance codes to see if they’re going up relative to historic levels so that we can monitor those kinds of trends. But we haven’t seen anything that leads us to believe that, that economy is going to impact our ability to try and make sure that they get the right device and the right service.

Operator

Your next question comes from the line of Dawn Brock with JP Morgan .

Dawn Brock - JP Morgan

So, I guess I wanted to see if we can dig a little bit more into WalkAide. It sounds great that you appeared to be getting the literature that you need by the end of the year. Can you just go into the timeline again for us in just where you sit with it and when we can kind of expect this to really take off?

Thomas F. Kirk

I think there’s probably three pieces. There’s the clinical trials. Then there’s all the filings that utilize the data coming out of the clinical trials. And then there is the government’s decision-making process once they receive the applications. As we’ve said before, we absolutely need to demonstrate the efficacy of the device. We can all see it empirically and Good Morning, America was certainly a great anecdotal piece of evidence as to how the device works but the government needs statistics. So, we have been running clinical trials at a number of highly regarded rehabilitation in hospitals and university settings around the country. And those trials are scheduled to be completed in late August. And by complete, I mean that we think we will have put through a sufficient number of people so that when we do the statistics, the sample size will be large enough to give us significance.

There’s no doubt that we will probably continue measuring other variables to demonstrate more effectively the overall case for WalkAide. But once we get what we consider to be the statistically relevant sample size, what we will do then is take all those results and by the way, we’re monitoring these things. A lot of the patients have already completed the trials and we have the data. Each patient generates almost 75 pages of data throughout their entire experience here. So we, along with an outside consultant that we are working with, are monitoring that data to diagnose any trends. And obviously, to begin to formulate opinions on just how well the device works on a number of metrics.

By working, we talk about avoiding some bad things. We talk about avoiding some costs and we’ve talked about improvement of quality of life. So, as the data continues to come in, it is continuing to validate and verify what we’ve seen on our early results. And we are then taking that data as it’s coming in, formulating opinions and beginning to say what would a high quality research document report really look like? So, we’re building those outlines and we’re working with the principal investigators in the universities to make sure that we’re doing that in real time. And when that data’s finished, we will complete those research reports and they will be submitted by the principal investigators to the appropriate magazines for peer review.

At the same time, in working with, and that should be occurring at the latter part of the Summer, early Fall where we’ve got those things compiled. We’re working with our outside consultants to put together the necessary applications to CMS on two fronts. And the first will be what we call coverage. And that is nothing more than the device. That is the job from an efficacy perspective that it’s supposed to do. And the second front will be from reimbursement, with a suggested reimbursement amount that is based upon a health economic study, which is all those things that I mentioned. So, we’ll be putting those applications together. And then once they are complete and the peer reviews articles are out, we will be submitting all of this to Medicare. And we may choose to do this on a regional basis or we may choose to do it on a national basis, whichever gives us the best strategy for moving forward. And it’s our expectation that we’ll be able to make those applications by the latter part of this year. And then we’re into the government cycle. Now, the good news is with coverage and reimbursement, it’s not an annual event as it is with coding, that you can submit these things and the government has about a 90-day time payable that they operate on and they will review them. They have the opportunity to ask immediate questions or to delay a decision until they get that information. But we would hope, and based on experience and what our consultants are telling us, that within about 90 days after we’ve submitted this that we will have a decision from the government. And so, that’s our overall timetable and that’s why we say we hope to have resolution by the end of the year or early 2009, as all of those pieces come together.

And then once the government would come out with coverage and reimbursement decision, we obviously would take those and go to work with an independent insurance companies and try to demonstrate the efficacy to them. There is nothing that is preventing us from once we get the evidence to beginning to work with the independent insurance company and the Veteran’s Administration to begin preliminary discussions and start talking to them. We don’t necessarily have to wait until Medicare renders its decision. So, we’re trying to really parallel-process here on a number of tracks.

Dawn Brock - JP Morgan

Is it correct, and I thought that we saw this about a month and a half or two months ago, that you actually did get a preliminary coverage determination?

Thomas E. Kirk

What we received was a preliminary code designation. We had been applying for very specific L-code designation and Medicare came back, and rather than a miscellaneous code, they gave us a very specific E-code designation. And some subtle differences between an E and a L-code would suffice to say that this was a major step forward because the descriptor on this specific E-code designated the device as a functional electrical stimulation device geared for the others that were out there, like TENS units, they were therapeutic instead of functional. So, the government did recognize the uniqueness of the device in the functional area, which means one restores functionality whereas the other’s therapeutic that tries to rehab and builds strength. So, that was a major step forward to give us that designation. But since no one had filed for coverage, which is demonstration of efficacy, there were those little tag lines on there that there was a national decision not to reimburse because nobody has provided any information on coverage. So, that’s why we’re so laser-like focused on getting these studies done. But what we’ve received was the code, but coverage and reimbursements are still out there until we get our clinical trials submitted.

Dawn Brock - JP Morgan

And my next question is on cost of materials. Can you just run through with us how you’re mitigating and/or what you’re seeing as far as fuel charges on freight. I know that it’s going to be in both divisions but it doesn’t look like it really impacted you all that much in the quarter.

George E. McHenry

If you look at our margins, our margins stood wide but it’s principally because of leverage that we got in our labor. We were up about four-tenths of a point in terms of our com rate for the first six months. And that’s principally due to the impact of the fuel surcharges on our air freight and our ground freight. Air freight I believe, was up about 30% and ground freight’s up about 8%. So, it has had an impact on us but it happens to be expected. Going forward, we are somewhat protected in that a lot of our large vendors are doing business with us through contracts and we have set pricing. That gives us some protection for this year. We will see higher freight cost continue but that has mitigated somewhat. The search in low prices has slow down a little bit but we still expect to be able to continue to lever our results despite that and get some leverage out of SG&A going forward. And we believe we can continue to lever the labor component because that is, other than the commissions piece, that’s pretty fixed. So, we think we can mitigate it with the sales growth and with the pricing component of that sales growth as well.

Dawn Brock - JP Morgan

George, maybe you can just go into a little bit more on the labor side. You know, a couple of years ago, there’s a lot of competition. I think there was a lot more concern over some of the practitioners being able to kind of get [inaudible {45:54}], go hang up their own shingle, possibly put the pricing in jeopardy in the local and regional markets. That doesn’t seem to be as much the case anymore. Is that true?

Thomas F. Kirk

Well, we still have the same conditions. The barrier, the entry, are indeed low so that someone can go out and hang up their shingle. And from time to time, that does happen. I think what we’re seeing and our understanding, just been talking to some of the folks that we encounter in the primary mechanisms again, is our acquisition program, is that the regulatory complexities of what’s going on are really a huge distraction from the clinical side of the business, which most of these people got into because they wanted to be good practitioners. So, as a result, I think people are taking the time to say if this is what I really want to do is to go out and get into the economic and regulatory fray of trying to compete and survive in this world on a day-to-day basis. And so we have had some people come to us and saying, “Look, buy me out. I’ve just had it. I don’t want to deal with the complexities. I don’t want to deal with the uncertainties. I really just want to take care of patients.” So, while that trend is still apparent, some people just don’t want to put up with the hassle. I think that’s number one.

Number two, I think this economic environment is a bit frightening to folks. Certainly, if they have to go out and get any kind of loans on their business, that’s not the easiest thing to do today, particularly in lieu of the fact that they don’t have the scale in size. We are very grateful to SPS in terms of their ability. They’re really the purchasing [inaudible 47:40}] to HPO and their ability to use their scale and the staff that they have is so experienced that they can really manage the cost, as George has just talked about. Whereas, the single practitioner, he doesn’t have the time to go through three or four different books and try to compare and price shop so he can get the best deals in the faith of the environment that he’s in. So, I think the complexities of going out on your own these days, particularly as a small entrepreneur, make it extraordinarily difficult.

Now, having said all that, we have still have some people leave that they’re contingent that life is getting a little more difficult to be the small entrepreneur out there and that is working in our favor.

Operator

Your next question comes from Mike Petusky with Noble Research.

Mike Petusky - Noble Research

What I really want to find out about is raccoons from whether you can leverage what you’re doing there and rabbits and squirrels, but I’ll save that for maybe a 2 or 3 hour phone call with George one day.

Thomas F. Kirk

We’ve done a great job in going from dolphins to raccoons.

Mike Petusky - Noble Research

First thing, and I’ll just follow up on the previous question in terms of guys going independent, with the difficulty and materials cost rising and all the rest, are you guys seeing more guys willing to sell their businesses to you? I mean what are you seeing on the acquisition front?

Thomas F. Kirk

I’d say it’s increased a bit. And remember for couple of years, we got out of the business of acquiring when we were in the freeze. We decided to let’s just stay focused on what we were doing. And particularly, we didn’t want to be using evaluation techniques in the absence of knowing what the fee schedule increases were. So, I think we have re-established ourselves over the last couple of years and that, as a result, has started to have more people approach us. Incidentally, rarely do we go out and call anyone up. I mean we certainly have a short list of the folks that we would like but we have found that people come to us through our relationships. So, I would say the answer to your question is yes, for two reasons.

One is we’ve re-established ourselves out there but then secondly, we’ll be some of the complexities of doing business today. So, there are more people knocking at the door but as I alluded to in my comments, we’re really focused on what makes good strategic sense to us. And there are folks that knock on the door but frankly don’t fit with our plans so we’re not very aggressive nor sometimes do we event got interest and we just be candid with them.

Mike Petusky - Noble Research

One revolving around WalkAide. Have you guys find any additional agreements internationally, and if not, can you just kind of give us as a reminder of where you guys have signed agreements?

Thomas F. Kirk

We haven’t signed any new ones. We still have seven distributor ships and then a joint commercialization agreement in Japan. And those agreements are in Canada. Several of the countries are in Europe and a couple of locations actually in Mid-East. So, what we’ve done is take the time. When we get overseas, there’s a language change and trying to support our folks, meaning our new distributors and dealers, that’s our primary care. And that’s what we’re really going for. So, we’ve taken the time to develop the brochures to support them, to give them the training to make sure that they certainly know what the device is all about, and they can support the local practitioners over there. So, we have really been focusing on developing those.

We’ve put a lot of time in with our partner Teijin in Japan and have received almost the equivalent of what we would call the FDA certification in Japan. Teijin did that but we worked closely with them. So, we’re making progress. Anytime we go into the highly regulated countries, they almost have the same kind of hurdles that we do in terms of FDA as well as their equivalent of Medicare. So, we’re taking this one step at a time but it is paying off and we’re moving devices over in that direction as well.

But we have a lot of applications from folks that are anxious. We’ve got a Director of our International Sales and he spends a lot of time outside the country in trying to recruit and to select the people that are making the right call points. So, that business is coming up but it takes, as you can imagine, a little foundation work to get it there.

Mike Petusky - Noble Research

In terms of Japan and what you’re doing with Teijin, I assume that your sense is revenue’s still at least a couple 2 or 3 years away?

George E. McHenry

That’s correct.

Mike Petusky - Noble Research

And last one, I’m pretty sure I’ve heard you say that what’s been put out there by CMS is a 5% cost of living update. That’s correct, right?

Thomas F. Kirk

That is right. Yes.

Mike Petusky - Noble Research

In terms of the election and the laying down to Congress and administration for that matter, does that make it more likely, less likely, that Congress will come in at the last minute and make a change or try to take some of that back, or reverse it? Do you guys have any sense of that?

Thomas F. Kirk

Well, I wish we did have a crystal ball. Just as a personal opinion, the legislation that was just passed to MIPPA was extraordinarily complex and has a lot of politicking going on because the doctors were involved. Competitive bidding was involved. And my personal opinion is that, that’s probably the last piece of healthcare legislation that we’re going to see under this current administration. And actually, you know, the overrode the President’s veto on that. So, I think all eyes are going to turn to the election and they’re not going to be thinking about new kinds of healthcare legislations. It gives me some comfort around that our fee schedule increase, and as you know, it’s by law we’re scheduled to get it unless there are some overate action taken. I just don’t see the Constitution of the Congress of getting back into healthcare debate at this point, in terms of trying to save or enhance budget or other kinds of characteristics. I think they’re going to be willing to say, “Let’s let that ride onto the backs of the new Congress. We’ve satisfied the doctors, which was the pressing issue. We’ve satisfied the complaints and the DME folks, which was the other pressing issue. We’re going to let that monkey ride on somebody else’s back,” I think. So, I think we’re in good shape but I’ll always have to put the caveat. Who knows when you’re dealing with the legislatures.

Operator

Your next question comes from Greg Williams with Sidoti.

Greg Williams - Sidoti & Company

Just had a quick question back on the WalkAide. After your trials, you can choose to go to CMS regionally or nationally. Just wondering in that process, does CMS already have the dollars budget for new products in ‘09 pipeline or should they approve WalkAide to have to find the funding and cut elsewhere?

Thomas F. Kirk

I don’t profess to be an expert, Greg, on understanding the funding mechanisms for CMS but I don’t think that they develop a bottom up kind of budget in terms of adding up all the things that they’re willing to pay for, and they’re fore saying that’s the total amount, I think they do a topside on this. And so, I don’t think they go through that granularity in deciding whether to approve or to fund something. I think their job and the reviewers that encodes its uniqueness in coverage, its efficacy, and in reimbursements healthcare and health cost economics. And I think they let the budgeting go to the other guys sitting down inside the beltway. So, I don’t they’re looking at this from that perspective.

If you satisfy by law, if you satisfy those three criteria on those three dimensions, you get code coverage and reimbursement, and it’s up to someone else to figure out then if there’s sufficient money to handle it or are there other things that perhaps are less qualified on code coverage and reimbursements that they don’t need, haven’t demonstrated, therefore it’s going to be a factor in consuming funds. So, I don’t get the sense at all that they adjudication process is bias by how much funding is available.

Greg Williams - Sidoti & Company

. I don’t know if I missed it but did you mention how much in WalkAide sales you have this quarter?

Thomas F. Kirk

We alluded to it, if you remember last time, I think we mentioned we have $3.2 million in enterprise sales and we were not quite as strong as that we got up close to $3 million this time.

Greg Williams - Sidoti & Company

Can we just talk about the near-record DSO levels? What are you doing there, prescreen patients or more aggressive collections? And how do we look at that with DSOs going forward?

George E. McHenry

Well, Greg, really nothing has changed but what we found is that when it comes to collections, we just have good systems and process is the most important thing. We have a good process. We haven’t really changed anything. Basically, what we do is like what happens in any doctor’s office when you go in to get care. We collect our deductibles when we deliver the device and when you look at the device itself, the other 80% that either Medicare or a commercial payer is paying for. 90-plus percent of those devices are pre-approved. So, there’s really no reason why we shouldn’t collect. Our real exposure is on the copay and as long as we continue to do a good job and our people become more and more comfortable with the process, they’re able to collect because the value to the patient is there. When we have trouble is when we let the collection go to after the device is delivered. So, we try to avoid that where ever possible.

On the DSOs, 52 days is one day higher than we were at the end of Q1, which was a good result in Q1. With a lower sales, we usually see slightly lower DSOs. We think low 50’s and possibly high 40’s is where our DSOs will stay, given our current level of technology on the system side. But we are working on a new billing system. That’s probably a year and a half away that we think could enable us to bring that down lower because we’ll be able to do more electronic billing. But for now, we think high 40’s or low 50’s is a very good result, especially with the 2.3% bad debt expense.

Operator

Your next question comes from [Ameritt Magville] with WCM.

[Ameritt Magville] - WCM Investment Management

Mine was more of an accounting question. George, I think you mentioned that you have some accruals in the period for incentive comp and I remember last year you had a big sequential increase in the fourth quarter of 2007 for incentive and variable comp and bonuses. So, are you approaching that accounting differently? Should we see a more smooth SG&A this year or if performance is good, will there be a similar bump up in that fourth quarter?

George E. McHenry

I think you’ll see a more smooth accrual this year and the reason is the discretionary poll, and that was about half of the catch up last year, that doesn’t get accrued unless we meet our internal goals. And given our EPS performance, we’re able to accrue that according to our policy. And we shouldn’t see a catch up on that in the fourth quarter.

Operator

At this time, there are no further questions.

Thomas F. Kirk

Well, I’d like to thank you all for joining us and particularly those that asked questions, for taking the time to do the work to understand the company. We look forward to the challenges in the second half of the year and look forward to joining you after our third quarter. Thank you very much and have a good day.

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Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited.

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