HMS Holdings (HMSY) Q4 2016 Results - Earnings Call Transcript

| About: HMS Holdings (HMSY)

HMS Holdings Corp. (NASDAQ:HMSY)

Q4 2016 Earnings Call

February 24, 2017 8:30 am ET

Executives

Dennis Oakes - HMS Holdings Corp.

William C. Lucia - HMS Holdings Corp.

Jeffrey S. Sherman - HMS Holdings Corp.

Analysts

Ryan S. Daniels - William Blair & Co. LLC

Jamie Stockton - Wells Fargo Securities LLC

Mohan Naidu - Oppenheimer & Co., Inc.

David Howard Windley - Jefferies LLC

Robert Willoughby - Credit Suisse Securities (NYSE:USA) LLC

Matthew D. Gillmor, CFA - Robert W. Baird & Co., Inc.

Steven J. Valiquette - Bank of America Merrill Lynch

Shane Trow Svenpladsen - Avondale Partners LLC

Frank Sparacino - First Analysis Securities Corp.

Operator

Good day, ladies and gentlemen, and welcome to the HMS Q4 and Full-year 2016 Earnings Conference Call. At this time, all participants are in a listen-only mode. Later we will conduct a question-and-answer session and instructions will follow at that time. As a reminder, today's conference is being recorded.

I'd now like to introduce your host for this conference call Mr. Dennis Oakes.

Dennis Oakes - HMS Holdings Corp.

Thank you for joining the HMS fourth quarter and full-year 2016 earnings conference call. Joining me this morning are Bill Lucia, our Chairman and Chief Executive Officer; and Jeff Sherman, our Chief Financial Officer.

Earlier today, we distributed our fourth quarter and fiscal-year 2016 earnings release through our website, hms.com, under the Investor Relations tab. We also posted an investor slide presentation containing supplemental information, though we will not make specific reference to it in our prepared remarks. This call is being webcast and can be accessed via the Events and Presentations tab on our website, and a replay of the call will be posted later this morning.

Some of the information we will discuss on this call will consist of forward-looking statements, including without limitation to those related to revenue, operating income, operating margin and our future business outlook and expectations, such statements are based on the company's current expectations and actual events may differ materially from those expectations.

Likewise, our financial results in today's earning release reflect preliminary unaudited results, which are not final until our 10-K is filed. We refer you to the company's past filings with the SEC including our Annual Report on Form 10-K, and our quarterly reports on Form 10-Q, for important risk factors that could cause actual results to differ materially from those indicated in the company's projections or forward-looking statements.

All information discussed on this call is based on the information available to us as of today, February 24, 2017, and the company disclaims any intent or obligation to update any forward-looking statements as a result of developments occurring after today's call, except as required by law.

Finally, we may refer to certain non-GAAP measures during this call and on our earnings release and investor presentation – rather our investor presentation and earnings release do include a reconciliation of those measures to GAAP.

For the Q&A session, we ask that you limit your inquiries to one question and one follow-up, so we can get through the full queue in a timely fashion.

We're ready now to begin. Bill?

William C. Lucia - HMS Holdings Corp.

Thank you, Dennis. Good morning everyone, and thank you for joining our call. As we look back on the year just concluded, we are very pleased with our overall financial performance. Looking ahead to 2017 and beyond, we are excited and confident about the significant opportunities in front of us.

2016 was a year of solid growth and total revenue, operating income, and adjusted EPS. Adjusted EBITDA also increased. Overall profitability and margins improved and operating cash flow remained strong. In addition, we achieved a key strategic objective for the year by acquiring a care management platform in the third quarter.

Total company revenue last year was a record $496 million. Fourth quarter commercial health plan revenue of $64.3 million was the second quarterly record in a row and 23% higher than the average of the preceding eight quarters, so a very strong finish to the year, but not quite enough growth in the quarter to achieve our full-year target. We do see the Essette Care Management and care coordination platform as the foundation for a third major vertical.

In addition to our coordination of benefits and payment integrity products, it was designed and built from the ground up to serve as a care traffic controller, helping risk-bearing entities, identify, engaged and manage their at-risk populations.

Essette is currently at a web-based tool, but will soon be available as a full cloud and SaaS offering, along with our existing on-premise model. We plan a modest level of capital investment this year to scale the business. Have already made our first post-acquisition sales and have expressions of interest from several existing HMS customers. We also intend to internally develop or acquire additional products and services in this new area of focus.

We do recognize there are a number of large and well-funded players attempting to entire or expand their turf in the population health arena, which many view as a crowded field. What we are pursuing, in order to meet customer demand for more cost saving solutions is very different from most of those efforts for two reasons. First, this work is a natural extension of the product suite we have offered historically. And secondly, we intend to take full advantage of the vast HMS database, our proven proprietary algorithms and analytics capabilities to focus primarily on high utilizers, not broad populations. So focusing in on the highest risk members.

Now, macro forces have generally created a tailwind for our business in recent years and 2017 should be no exception. Employer-sponsored plans remain the largest source of health insurance, covering about half of the nation and their dependents. Employers are demanding more from their health plans, including greater cost containment and better health outcomes, not just the traditional network discounts and paying of claims. With less than 5% of our health plan revenue last year from product sales covering at-risk and administrative services only or ASO customers, we see this potential block of business as a substantial growth opportunity. Medicare enrollment and spending are expected to grow significantly over the balance of this decade, as baby boomers continue to age into their late 60s and retire. We are significantly underpenetrated with our health plan customers, compared to the work we do for the Medicaid populations. So we see significant upside opportunity to expand our Medicare Advantage presence over the next few years.

Studies of healthcare spending consistently show a steep upward trajectory over the next decade, with the CMS Office of the Actuary projecting growth at an average annual rate of 5.6% and representing almost 20% of gross domestic product by 2025. Within that spend, the top 5% of the population account for roughly 50% of healthcare expenditures. Not surprisingly, the aging U.S. population has a concentration of individuals with high-cost chronic conditions, often accompanied by multiple behavioral and medical comorbidities and expenses for the elderly and disabled are among the highest. Appropriately managing the health of high utilizers is critical to any effort to bend the healthcare cost curve and our new vertical helps to do just that. While an estimated 36 million individuals were enrolled in provider-sponsored health plans last year. Providers generally lack experience with many of the complexities of managing capitated risk. Additionally, most provider-owned plans have some level of contracted care, such as tertiary, outpatient rehab or specialty physician services. As a result, they should want to take advantage of the same type of cost containment and care management activities that other payers do. As more providers take on Medicare and Medicaid risk, we view this as a growth area for HMS.

And the shift to value-based payments for medical care is another area of potential interest. Though the pace of change and the long-term viability of these reimbursement methodologies is still unclear, we are currently working on small pilot projects with payers, so we are ready if and when these reimbursement changes gain traction.

In short, an aging population, growing numbers of individuals with chronic illness, employers focused on reducing their healthcare expenditures, providers taking on health plan risk and changing payment methodologies are generally acting as wind in our sales. The most significant headwind we face, which we see as more perceived than real, is the much talked about repeal and replace of the Affordable Care Act or ACA.

To be sure, the ongoing focus in Washington D.C. on potential changes to the ACA has raised concerns among investors, because of their exposure to the Medicaid program. Though a broad range of outcomes is still possible, we believe there is presently more likelihood that the collective action of Congress and the Trump administration will be relatively positive for our business rather than negative. That view is based on time I personally spent on Capitol Hill earlier this month, public comments by the Republican leadership and President Trump about preserving coverage; input we receive almost daily from our network in Washington and across the industry.

It is also important to note that estimate suggests up to 45% of individuals newly enrolled in Medicaid, following enactment of the ACA, would have qualified for coverage under the pre-ACA income criteria, further mitigating any downside risk of potential Congressional action affecting the expansion population. It may be several months before Congressional action crystallizes, but there do not presently appear to be any proposals to eliminate insurance coverage for individuals currently in Medicaid, which could garner majority support in the House and Senate, including for those who became eligible pursuant to ACA expansion. Other factors in play include opposition to any steps that would cause currently covered individuals to lose their health insurance by a number of key stakeholders, including the American Hospital Association, the American Medical Association and AARP.

Additionally, Republican governors who took advantage of expansion have been clear that they want to keep it, and some observers suggest that Republican governors who resisted expansion might be granted more generous Section 1115 waivers than those permitted by the Obama administration, actually resulting in Medicaid expansion beyond the current 31 states.

If federal reimbursement for the states for Medicaid were to move away from the current funding mechanism and be replaced by block grants or a per capita reimbursement, we believe states would be even more focused on preserving the dollars they receive.

Interestingly, their economic incentive could also be heightened by the fact that moneys recovered by states today must be returned to the federal government in the same proportion as the percentage reimbursement they receive for their Medicaid expenditures.

New reimbursement models may allow states to keep 100% of what they recover. In my meetings with members of Congress, both Republicans and then Democrats, I make the point that the existing Medicaid infrastructure is a well-tested mechanism for enrolling individuals and administering health insurance benefits. I urge them to think about utilizing Medicaid as they attempt to find a replacement for the troubled healthcare exchanges, which by the way and just as a reminder, we have no exposure to. Though I doubt many in Congress have considered this approach, there seem to be receptivity to the idea that we could potentially utilize the Medicaid railroad tracks and technology infrastructure that are already built to address the challenges of the individual market.

Finally, there appears to be a growing realization that designing and implementing any replacement for the current system could take many months, pushing the effective date of potential changes out as much as two years. In addition to a macro healthcare environment, which is generally very favorable for our traditional products and our expanding set of cost containment solutions, strong 2016 commercial sales activity strengthens our conviction that we can reach our 2017 growth targets. We added 17 million new commercial health plan lives last year, including a sale in the second quarter to a single customer for $15 million of their at-risk and ASO members. We also sold additional products to existing customers covering approximately 30 million of their members during 2016 as compared to about 13 million in the prior year. On top of the increased volume of health plan sales last year, the largest national plans continue to be the biggest buyers of our products. At year-end, they purchased about three times as many as the average health plan plus the balance of our customer base.

Product mix of new sales during 2016 was roughly 75% payment integrity and 25% coordination of benefits. We expect to continue selling PI solutions disproportionately in the year ahead as we are relatively underpenetrated compared to COB. As we have discussed on a number of occasions, closing new sales is only one of the many steps needed for revenue generation.

Efficient implementation of sold business is critical and continues to be an ongoing focus of our process improvement initiatives, particularly for the implementation of payment integrity business, which is significantly more complex than COB. We made substantial progress last year with a number of completed implementations increasing by nearly 25%, compared to the prior year and we expect progress to continue in 2017.

Jeff will now add his perspective on the quarter and provide the details of our 2017 guidance. Jeff.

Jeffrey S. Sherman - HMS Holdings Corp.

Thank you, Bill and good morning. I want to touch briefly on a few key indicators of our strong 2016 financial performance. Full-year operating income increased over 20% and full-year adjusted earnings were up 30% to $0.75 per diluted share. Our 12/31 balance sheet was stronger than when we began 2016 even after the third quarter acquisition and $20.5 million in share repurchases during the fourth quarter. That strengthening was a result of another solid year of operating cash flow approaching $90 million. Year-end cash of $176 million gives us plenty of dry powder to make needed investments in our growth and consider additional acquisitions and share repurchases during 2017.

As a reminder, these are not final numbers until our audit is complete and there are still a few open items before we can file our Form 10-K. In particular, we are working with our auditor to test our CMS reserve liability over the life of the contract, which was 2009 to 2016. As a result, it may require adjustments to any final numbers.

This testing is very complicated and labor-intensive. We are hoping to complete all open items by next Wednesday and trying to file our Form 10-K timely; if not, we may need to time accorded by the automatic extension provided by the SEC in these sorts of situations.

Turning now to the year ahead, we are projecting full-year annual revenue growth of 7% to 9%, based on the following components. High-teens commercial health plan growth and mid-single digit state government growth, which will be partially offset by declining Medicare RAC revenue of $6 million to $10 million compared to $19 million last year under the old contract and lower federal, excluding Medicare RAC, and other revenue of approximately $20 million compared to $23 million in 2016.

We expect full-year operating cash flow of $90 million to $110 million and full-year capital expenditures of approximately $28 million. The increase in CapEx compared to approximately $21 million last year will go through its implementation of big data solutions directly benefiting both revenue and margins, ongoing upgrades to our data security and IT infrastructure, and incremental investment in the Essette platform.

Finally, we expect full-year operating margin improvement of between 125 basis points and 150 basis points on 2016 base of 11.6% and an annual effective tax rate of approximately 37%. Given the leveragability of our operating model, we expect margins can continue to improve meaningfully over the next few years.

Each of the numbers above are for the full year and may not flow evenly throughout. A good example is first quarter revenue, which we expect will decline on the order of $8 million to $10 million from the fourth quarter level. In addition, we are expecting a very slow ramp for the new Medicare RAC program, which likely means little or no revenue until the second half of this year.

Achieving our health plan growth target is critical to achieving our overall objectives for 2017, so I want to briefly review the expected components of commercial growth for the year ahead. To begin with, we have the full-year benefit of new business implemented throughout 2016, which we estimate equates to a run rate in excess of $60 million per quarter.

Next is business sold during 2016 and scheduled for implementation throughout the coming year. We expect again to shorten – to both shorten the time from ink to green and to increase the total number of implementations completed resulting in earlier revenue generation.

Our fourth component of growth will be new sales we expect to close in the first half of 2017, such sales could be for totally new lives, but will more likely be related to sales of new products or the expanded application of currently-sold products to a broader population for an existing customer. In order to contribute to the current year revenue, sales were generally have to be closed over the next two to three months. We expect product yield improvements across all of our business to again contribute meaningfully to expanded revenues and higher margins in 2017.

Two other items should positively impact revenue growth, though both are outside of our control. First, we benefit by organic enrollment growth experienced by our customers across their employer and government lines of business, annual medical cost inflation is the other factor since our fees are generally structured as a percentage of dollars saved or recovered.

On a product basis, we expect greater year-over-year revenue growth in the payment integrity product line this year than last. We streamlined internal processes throughout 2016 to increase the production of new PI edits and to speed their adoption by our customers. During 2017, we will be operationalizing new data technologies, we expect will dramatically reduce the time for ingesting data and significantly increase our ability to analyze it rapidly.

Finally, our Six Sigma black belts were intensely focused last year on improving the yield and decreasing costs associated with our PI products. We expect to see the benefits of that yield improvement work reflected in higher PI revenue this year.

Our combined efforts to increase the number of PI edits, accelerate implementations and enhance product yield add to our confidence that year-over-year, PI revenue will grow at a faster pace in 2017. We also anticipate increased receptivity in the state government market to more broadly utilizing our payment integrity products, particularly under 23 existing Medicaid RAC contracts, so we intend to step up PI sales efforts with our state customers this year. This expected increase in activity is included in our view that state government revenue growth in 2017 will be mid-single digits, rather than the low-single digit base case growth we have spoken about previously.

In terms of share repurchases, we bought approximately 1.1 million shares in the fourth quarter at a total cost of about $20.5 million or $17.93 per share, which nearly exhausted the $75 million authorization granted by our board in August of 2015. Total purchases to-date under that program include 5.9 million shares at an average price of $11.95 per share.

Bill will now have closing remarks and then we'll be ready for questions. Bill?

William C. Lucia - HMS Holdings Corp.

Thanks, Jeff. I want to conclude this morning with the discussion of our key strategic objectives for 2017. They fall in the four broad categories. Managing big data, innovation, new product development and capital deployment, all targeted of course to improving overall growth and profitability.

We intend to utilize technology and automation to create a more nimble business environment and to identify additional revenue opportunities within our current service delivery model. Doing so is both a recognition of the tremendous big data assets we have and a realization that available tools can exponentially improve processes and results.

The planned implementation this year at our Hadoop data lake, which we tested during the latter part of last year, is a good example. Combined with our plans for robotic process automation, which is also underway, we aim to continue streamlining processes, which we expect will lead to increased innovation, quicker speed to market and higher margins. Buy versus build is a constant consideration as we pursue innovation and an important factor in evaluating acquisition opportunities. Innovation is also a strategic focus internally, particularly with regard to product development.

A recent example is the launch in early January of a member health profile product designed to help Medicaid payers identify individuals with chronic illnesses and comorbidities or substance abuse at the time of enrollment rather than waiting months for claims to trickle in and members obtaining care in the highest cost settings.

The key innovation involved in this and other products under development is data aggregation across geographies and payers. To supplement our internal product development efforts, we're working collaboratively with customers to refine and expand our product suite and to develop new approaches to fit their cost containment needs.

Listening to customers is key to productive and lasting relationships, but also a helpful source of intelligence about the evolving needs of payers in a market where complexity is the norm and cost pressures are never ending.

A final area of strategic focus for 2017 is maintaining a strong balance sheet and prudently pursuing acquisitions, which remains our top priority for capital deployment. We're actively evaluating a robust pipeline of companies to add to our core expertise, expand our data analytics capabilities or further augment the Essette Care Management product suite.

Beyond the good strategic plan, our ability to succeed in a competitive and ever-changing healthcare marketplace is highly dependent upon the hard work and ongoing dedication of the entire HMS workforce.

I am extremely grateful to all of my colleagues across the country for their contributions during 2016, and the effort I know will be forthcoming to achieve our goals in the year ahead. Given the fluidity of the current environment, there will be most likely unexpected changes as 2017 progresses. I believe, however, that we are well-positioned to overcome obstacles, which may reasonably arise because we have a well-constructed strategic plan, a proven business model, a realistic sense of where our growth will come from, and how to achieve it, a cohesive executive team with the range of skills and the commitment needed to execute our business objectives and a very able board of directors focused on the pursuit of long-term top and bottom-line growth in order to enhance shareholder value. For all of these reasons, I am very enthusiastic about the year ahead.

Operator, we are now ready for the first question.

Question-and-Answer Session

Operator

Our first question comes from Ryan Daniels with William Blair.

Ryan S. Daniels - William Blair & Co. LLC

Yeah. Good morning guys. Thanks for taking the questions. Bill, one for you, given the relationships you have with some many plans particularly on the managed Medicaid business, can you talk a little bit about what the hurdle has been to getting more penetration into the ASO and at-risk business, which you discussed as being very lowly penetrated and then same question on the Medicare Advantage business, I'm curious if it's – they already have products that you need to develop new solutions, if it's a sales force investment, just any color there on how you are going to penetrate that?

William C. Lucia - HMS Holdings Corp.

Thank you, Ryan. Yeah, I think, well, not all of our – if we take a step back, not all of our Medicaid plans are in commercial at-risk either, right, some are Medicaid-only plans, in fact a large portion of our plans are Medicaid only. Then there are government-only plans, which are Medicaid and Medicare and those we have a – are starting to have a better penetration rate in pushing our Medicare Advantage opportunities, which are both program integrity and COB related.

And then lastly, which you started first with, which was the ASO business, I mean in reality the ASO business, the dollars that are recovered in ASO or saved, benefit the employer. They don't really benefit the plan. So I'm not saying that they are not interested in pursuing that, I'm just saying that's not their top priority, because it doesn't impact their bottom line.

With that said, we're seeing an increased demand from the employers, particularly through our relationships with benefit advisory firms to achieve better results for their clients and that push is impacting large commercial ASO plans, and we're just starting to see the benefit of that like the large group we signed in 2016 as well as this is the first time we've signed a third-party administrator, which of course is a processor and administrator for large employers.

So, we're just starting to see that. Again, I think, if you compare and contrast us to others, we started in Medicaid, we are slowly making our penetration to Medicare Advantage, and we've just begun the penetration into the ASO business, which I believe is – may take a little longer to fully realize, but it's a big opportunity, particularly as the employer's request better savings and more efficiency.

Ryan S. Daniels - William Blair & Co. LLC

Okay. That's very helpful color. And then as a follow-up, just curious if you can dive a little bit more into how you're going to invest in the sales team over the next year. I guess we saw a few years ago the investment you made in the commercial side and the benefit that's not having with varied (29:55) market growth there. And I want to focus more on the state side or Medicaid side, it sounds like there is some new products to sell there, it sounds like you're going to pursue more opportunities under your RAC contracts, but those are probably less RFP driven and more proactive sales. I'm curious, if you have the team built up there already or if that's going to be a key investment area and one that would yield through? Thanks.

William C. Lucia - HMS Holdings Corp.

So, we continue to invest in sales and I'll give you two areas where we're investing. So, we're investing in both sales, what I would call sales technicians or sales subject matter experts, to support the existing sales team. So when we're going out to talk about the care management solution or an integration of a member risk analytics and care management solution, we have a subject matter expert, who is really reporting into the sales team versus the delivery team. So, that's one of the areas in which we're making investments.

And the other is in the state side, our state business has traditionally been RFP driven, but once you win the RFP, there are opportunities in many states to either amend the contract or to just sell other opportunities in, and while we have a strong regional structure of account management staff that really kind of open the door from that perspective, we're adding a sales staff into the state government market this year to provide additional opportunities for penetration into the large customer base, and we see that as an opportunity particularly this year, because states are gearing up for changes that will come down the pike, whether they're block grants or per capita funding, it's going to impact their infrastructure, how they count things, and the recoveries and savings that they pursue. So we think it's a prime time to make that investment, and we've also invested in an advisory services group and have won some, what I would call, blanket consulting agreements that will also help states as they go through that process.

Ryan S. Daniels - William Blair & Co. LLC

Okay, great. Thank you so much.

Operator

Our next question comes from Jamie Stockton with Wells Fargo.

Jamie Stockton - Wells Fargo Securities LLC

Yes. Thanks for taking my questions. Bill, maybe just as far as the ACA repeal and replace distraction is concerned, can you talk about – when I think about repeal and replace, it's mostly going to impact the individual market, and potentially Medicaid, right? When you're going into these health plans trying to sell additional services and technology around ASO lives or full-risk lives that aren't in the individual and Medicaid buckets, is there a good reason for the plans to be that distracted by ACA repeal and replace, when you think about the ASO lives and kind of the full-risk lives that aren't in the individual market or the Medicaid bucket or is this something that is actually just kind of a minor distraction, because it's not that big of a deal for those buckets that you're hoping to more significantly penetrate going forward?

William C. Lucia - HMS Holdings Corp.

Yeah. That's a good question. First of all, as I'd mentioned on the prepared remarks, we don't have any exposure to the exchanges. And in fact, even the plans where we are doing some auditing of their commercial block of business, they have asked us not to audit the exchange lives, because those have been tied down to very, very narrow networks and because those networks are so narrow and have taken the discounts, they didn't want to audit those providers. But you're right, the largest health plans, so a lot of small plans aren't in the exchanges.

So the largest health plans that have been in the exchanges and have ASO business, really don't have, I would say, at least people who run their commercial line of business don't have the same concerns about what might happen with the ACA, particularly if they've made a decision to exit exchanges.

But sometimes decisions about auditing are made at a corporate level. So, the type of work we do could be driven by procurement, it could be driven by someone over cost containment that rise over each of the business lines, Medicaid, Medicare and commercial. And I think we've talked about this before, but as we enter the commercial market and have a more viable product, not only in our complex clinical audits, but our data mining, our hospital bill audits and our credit balance audits. As we bring that set of solutions to the ASO market, and the large plans that are in it or the third-party administrators, it's often not a zero-sum game, meaning they don't just hire one vendor. The larger plans hire multiple vendors, some based on specialties, some based on first pass or second pass on the claim. So we still think there is a lot of opportunity to come in, where we can come in as a second pass and find significant value behind others that we compete with. So you're right. I don't think they're as focused on it, but ultimately, there is some distraction at the plan level, not a lot, but some distraction at the plan level, particularly as they've got government risk in their business.

Jamie Stockton - Wells Fargo Securities LLC

Okay. That's great. And then, Jeff, maybe a quick follow-up on expenses. They came in relatively contained this quarter it felt like. I know, you guys had – you had made some investments last quarter, there is a little mix shift, it felt like, between some of the lines. Can you just give us a little more color on what's going on with the expense base and how we should think about it trending as we go through 2017?

Jeffrey S. Sherman - HMS Holdings Corp.

Sure. Yeah. So I think from a cost perspective, we had good performance in the fourth quarter and we saw sequential costs declining and saw costs down a fair amount from the fourth quarter of last year. So we have been making investments to help improve our efficiencies. We've talked about making investments in big data. We are making investments in robotic process automation as well and actually just improving processes, as I mentioned in my prepared remarks through some of our Black Belt Six Sigma and how we actually work the business.

So we do, as I said in my prepared remarks, we do see margins expanding next year, on the operating income line, 125 basis points to 150 basis points. So we do think we're going to continue to get operating leverage as we see expenses grow – as we see revenue grow. And from a trending perspective, as we see revenue growth, we'll see costs moving with that revenue growth, but we still think on both the COB and payment integrity product lines, incremental revenues going to come in at much higher margins than our overall margin. So I think we will continue to get leverage on the business as we move into 2017.

Jamie Stockton - Wells Fargo Securities LLC

Okay. Thank you.

Operator

Our next question comes from Mohan Naidu with Oppenheimer.

Mohan Naidu - Oppenheimer & Co., Inc.

Thanks for taking my questions. Bill, going back to your comments about the federal reimbursement model changes for Medicaid, what is your perception around like – how likely is that change is going to come, and how are the discussions going on around the block grants or capitalized models, and anything that you have been talking to your state contracts right now about these changes?

William C. Lucia - HMS Holdings Corp.

Well, let me take the last part first. And yes, we have been talking to our state clients, in fact that's why we've been pursuing what – and states call the blanket consulting agreements, because we believe there is going to be a lot of opportunity that help states figure out, how do you operate in a new reimbursement model. Now, to add a little color to it, obviously, today, they get what's called a federal matching rate or an FMAP, and it's based on the level of poverty in the state. So, it may range from a high of 80% in the State of Mississippi. So when we do recoveries for them, 80% of the dollars go back to the feds versus to about a 50% match rate in California.

When you go into a block grant where you're looking at taking – so let's take the Paul Ryan plan, where you're taking last year – the federal fiscal year 2016 as a baseline and maybe adding some color (39:27) to that, you're looking at that as your base line in growing a grant or a per capita payment to the Medicaid agency and saying with that and minor adjustments each year, that's what you're going to live with. What that means is, they have to live with the smaller pool of dollars versus this – you know this – this FMAP that could increase and increase in a relatively uncapped way. And then Medicaid – the feds reimburse states very differently based on system development, use of clinicians, administrative work, there's many different categories, it's very complex and there's a whole field of consultants that help states maximize that.

That could all go away based on the fact that you're just going to get a block grant or a per capita grant, and you're going to have to live under a tighter framework in terms of costs. Now think about that cost pressure and what it's going to do to the states and their need to recover or save as much money as possible, we think is very positive for us, not only to advise them through it, but to help them further fight fraud waste and abuse. We have an administration at the federal level, who has really said that is our target, so you never know there may even be incentives to states to invest in fraud, analytics and then lastly that pressure is not going to just sit with the state, that pressure is going to push hard on the Medicaid plans and that push is typically making them do more work and fighting hard to justify their rates.

So all of that pressure on the system is good and it pushes more opportunity for HMS. I can't tell you what – I don't have a crystal ball to tell you they're going to do block grants or some combination of per capita funding or how they're going to change this, and how long it will take them to do it, because today's system is very complex, but I see that pressure on the system as a positive for HMS.

Jeffrey S. Sherman - HMS Holdings Corp.

And this is Jeff, the only thing I would add is, with that pressure in our contingency fee, pricing approach, we see that as generating more opportunity for us to help them save money for their programs in a relatively low risk way.

Mohan Naidu - Oppenheimer & Co., Inc.

Yeah. That's great color. Thank you very much, guys. Maybe Jeff, a real quick one for you. Looking at the commercial one, can you elaborate a little bit on where the shortfall came in and also the single customer that you signed on with 15 million lives, is that customer live now and revenue generating?

Jeffrey S. Sherman - HMS Holdings Corp.

Yeah. So, the customer is live, but obviously with a large block of lives like that, Mohan, it is being rolled out over time by groups. So, it is live, but we're continuing to expect to see revenue growth from that as we go through 2017. So, as we talked upon on our third quarter call, we needed about $10 million of sequential growth to reach our full-year growth target. And we did have good visibility in the quarter from a number of implementations that were scheduled and we did expect a usual year-end push for our customers for additional savings.

So, looking back at the quarter, we had about a $1 million of implementation scheduled in the quarter which did push out. Some of that would be in Q1, some of that could even go into the second quarter. And we did have some year-end projects that we had identified pretty significant savings for our customers. They were related to new edits, not previously worked So we didn't see – we didn't receive final approval from several customers to proceed before yearend. And then finally the last thing impacting is, we did have a large national customer, they did pause some PI auditing in the quarter, due to concerns about year-end ratings from their provider network. So at a high level, these three item – these items were the principal contributors to the roughly the $5 million difference from where we've ended up to our guidance range.

Mohan Naidu - Oppenheimer & Co., Inc.

Got it. Thank you very much for taking my question.

Operator

Our next question comes from Dave Windley with Jefferies.

David Howard Windley - Jefferies LLC

Hi. Good morning. Thanks for taking my questions. I hadn't heard the company mention Medicaid RAC for quite a while and in your prepared remarks you referenced that in the context of ramping up your activity into states. Could you may be talk about this – I'm sure you don't want to go into great detail, but talk about the status of Medicaid RAC as it relates to being a, say, a fertile seedbed for you to launch that kind of stepped up sales effort?

William C. Lucia - HMS Holdings Corp.

Well, I think, Dave, that's a good question. States initially – I'd say about half of our clients felt that Medicaid RAC was a must do, because the federal government pushed the requirement on them. I think the other half of the state said, actually this is a pretty good tool for us to use. We have other contractors that do other things on a cost-plus basis and utilization management, which of course HMS does as well in some states. But they viewed it as an opportunity to create fiscal results and augment their existing investigators. So, we're out now spending a lot more time with those states that have a real vested interest in improving and really increasing their recoveries and increasing their fraud identification to fit more opportunities under the Medicaid RAC umbrella.

So, we think the states will use Medicaid RAC a little more broadly in the future and that's why we're ramping up both our sales activity into that space, but also our discussions and dialogue with states about how that contract vehicle may be used. So, that's really the approach.

States have the same, I'd say, provider reaction that other federal government had when short stay auditing was done. So, you're not going to see states primarily doing short-stay audits or audits related to questioning provider judgment from a clinical perspective, but they have the same issues when it comes to DRG or ATC or other types of coding irregularities and they have the same issues related to data mining and/or potential frauds.

So, we think this is a good time to engage with both state Medicaid agencies and (46:35) and the other governing agencies in Medicaid to utilize those contracts.

Jeffrey S. Sherman - HMS Holdings Corp.

And we are continuing to ramp up just our PI edit development and so there could be some state-specific edits where we're focused on developing that will help drive more state revenue as well.

David Howard Windley - Jefferies LLC

And in terms of the catalyst, I guess, your point about states looking to use this vehicle more, has there been a change in regulation, some stimulus from the feds or is it perhaps just the uncertainty around perhaps going to block grant or per capita that is stimulating this thought process on the part of the states?

William C. Lucia - HMS Holdings Corp.

Well, there has been lots of public debate up until the end of the last administration. And the Center for Program Integrity at CMS has been brought to Congressional enquiries for – it seems like almost every other week, pressure on improving payment integrity and attacking fraud and abuse in both the Medicare and Medicaid programs. So it's not that pressure does not trickle down to the states. We think there's going to be increased pressure ultimately when all of the new administration, the deputy directors, all of the people are put in place, there's going to be increased scrutiny at the federal and state level on program integrity, particularly around fraud and abuse but also around these overpayments, but you're still ramping, I mean 12% in Medicare, sub-10% in Medicaid.

So we think that that is going to continue to increase and we've been investing in, what we call, edit development, but it's really refining and improving your algorithms and applying them to the state Medicaid programs, which as a reminder, still have in many cases the highest cost members. They are managing the dual eligibles that are harder to coordinate and potentially have the higher opportunity for errors, because you're managing it through multiple programs.

So, I think we're going to – there hasn't been one single stimulus, I think it's multiple pressure that's been placed on the states and that will continue to be placed on the states, and there was this mega rule that came out in the summer for states to be much more vigilant about managing their managed care plan through this process, and assuring that they are identifying fraud, waste and abuse and reporting it up to the states.

Jeffrey S. Sherman - HMS Holdings Corp.

And then finally, I would just add, obviously, we've talked about Medicare RAC ramping up a little bit slower from this year versus last year, so we do have some incremental bandwidth just with our resources to focus more on the state market as well.

David Howard Windley - Jefferies LLC

Right. Okay if I could sneak one more. You mentioned provider-sponsored plans or PSPs and that does seem like a ripe customer target for your care management capabilities, if you can garner their attention, would your pricing to, I guess, thinking also that those PSPs would be on average smaller from a membership standpoint than some of your – certainly than your big national plans that are purchasing a lot from you. I guess, I'm curious if the pricing to that market scales relative to their size or would your pricing in the care management model be more of a flat charge to a customer regardless of size? Thanks.

William C. Lucia - HMS Holdings Corp.

So, that's a good question. We price – first, we price to be competitive and win deals, but in reality the pricing model that was traditional for Essette in the care management platform was a perpetual license fee with a large license payment upfront, implementation fees and then maintenance, annual maintenance, typical software delivery model in a premise-based solution. We have started to migrate them to a SaaS-based solution, expect the next release to include a cloud-based solution. Many of those include an implementation fee and then a per-member per-month fee managed on the system. Sometimes it's a per-user. We, of course, are going to be flexible based on market, but we think there is opportunity in that market, I'd say about half of HMS – I mean half of the Essette clients that we assumed through the acquisition are providers that take risk and the other half are health plans.

We don't believe that just care management is applicable though to that marketplace. When you think some of the very large organizations that are providers taking risk or providers building – hospitals building health plans regionally, they need the same types of cost containment solutions that we traditionally offer, particularly if they're offering Medicaid, they're taking Medicaid risk. So we see that as a good opportunity both directly selling into them and then through partners.

Jeffrey S. Sherman - HMS Holdings Corp.

And generally, they have little to no infrastructure to actually do that work, so we do see that as a good opportunity.

David Howard Windley - Jefferies LLC

Great. Thank you.

Operator

Our next question comes from Robert Willoughby with Credit Suisse.

Robert Willoughby - Credit Suisse Securities (USA) LLC

Just a, excuse me, a quick one. Your DSO profile ticked higher into 2014, I guess, on the expansion in the Medicare business and I guess as it's come down that Medicare exposure to DSOs are back down, the cash is coming in nicely. But what's the new norm for a DSO, can you get back to historical levels or does that commercial book of business or any other change in a profile with assets whatever you have really kind of limit your ability to improve that metric further or do you see more room to run there?

William C. Lucia - HMS Holdings Corp.

Yeah. So, we've been in relatively stable range obviously for this year and have had good cash collections and good cash performance and we had a strong finish to the year with cash flow from ops of over $30 million. I think as commercial business grows and we are dealing with payment integrity work where you have to go – actually go back and get dollars back from providers. We do see that having an impact on DSO. So I think we've mitigated as we've seen our business shift to commercial, I think we've been able to mitigate that rise with improved focus on cash collections. But I think we're in a relatively stable range now and potentially additional incremental improvements in our cash collection process will probably continue to offset growth in the commercial business from a DSO standpoint.

Robert Willoughby - Credit Suisse Securities (USA) LLC

How much of the improvement that we've seen today was just simply mix and how much was something that you controlled through internal improvements?

William C. Lucia - HMS Holdings Corp.

I mean I would say, we've probably seen a five-day plus improvement in terms of just collection efforts.

Robert Willoughby - Credit Suisse Securities (USA) LLC

Okay.

William C. Lucia - HMS Holdings Corp.

And again continue to see that commercial growth drive DSOs the other way.

Robert Willoughby - Credit Suisse Securities (USA) LLC

Great. Thank you.

Operator

Our next question comes from Matthew Gillmor with Robert Baird.

Matthew D. Gillmor, CFA - Robert W. Baird & Co., Inc.

Hey, thanks for taking the question. I just had one left, which is on the commercial growth guidance for 2017. I think you mentioned that part of the outlook is based on some expected sales activity over the next two to three months, can you give us a sense for how much visibility you have on those contracts, are those negotiated and then just waiting to be signed or are those earlier on in the process? Thanks.

Jeffrey S. Sherman - HMS Holdings Corp.

So we track sales, Matt, and sales force and assign probabilities to those and so when we get above a 75% probability and moving into the 90% probability, we have a pretty good sense on completed sales. So, I'd say good visibility on sales we expect to happen over the next couple of months. As we said in our prepared remarks, as we are continuing to invest in big data technology, we do believe that that's going to continue to shrink that ink to green. The technology component, data ingestion, management of data interfacing with our clients is one of the biggest hurdles in terms of the whole ink to green process.

And so, we've certainly made a commitment, we're going to spend another $6 million or $7 million specifically on just big data investments that started in the second half of 2016 going into 2017. And as those investments, as we really start getting the ability to ingest massive amounts of data more efficiently, more effectively, we think that's going to help ink to green. So, meaning that we could even see some sales in the second quarter, as we improve that potentially generate revenue in 2017.

Matthew D. Gillmor, CFA - Robert W. Baird & Co., Inc.

Got it. Thanks, Jeff.

Operator

Our next question comes from Steve Valiquette with Bank of America.

Steven J. Valiquette - Bank of America Merrill Lynch

Hi. Thanks. Good morning, everybody. Thanks for taking the question. I guess when we think about the new business signings for the 2017, the way you factored that into guidance, I guess I was curious whether or not the way you're approaching revenue outlook for 2017, is this different than what you've done in the past or is this kind of standard operating procedure, the way you are sort of factoring in the potential new business signing, the business you already have, clearly 2017 is a little bit different year, different political environment? Is there any extra level of conservatism baked in the guidance on the revenue outlook, just rather curious to get your thoughts on how this year is kind of different on your approach to the revenue outlook versus what you've done in prior years? Thanks.

William C. Lucia - HMS Holdings Corp.

No, I would characterize it is very similar as we approached 2016. When you're dealing with multiple customers buying many products, which had differing implementation times, we always know as we do a budget we're going to have some pluses and minuses both in the COB and payment integrity side, and both in the state and commercial health plan marketplace.

So I think we look at – we have pretty discrete budget forecasting at a customer level, we obviously have some factor for new sales in there as well. And again, I would remind everyone, yield improvement continues to be an area we're focused on as well, which is just generating more revenue from our existing customer base, we continue to see that as a growth opportunity. Those investments in big data are going to help drive incremental yield improvement as well.

And that – if yield improvement for us is really all margin, there is no – very little incremental cost other than the technology investments I've spoken about. So once we make those investments, additional yield drive really has a very high margin. So I think all those items continue to be factored into our revenue forecasting and our guidance.

Steven J. Valiquette - Bank of America Merrill Lynch

Okay. And then just real quick, you touched on this as well. But should we assume again given the kind of increased uncertainty around the overall political environment. I got to believe that's probably dramatically increased the M&A pipeline opportunity that you're looking at right now. So maybe (58:39) a little higher that we could see potentially more aggressive M&A activity from you guys over the next one or two years versus what we've seen previously, is that kind of a safe blanket statement to make right now?

William C. Lucia - HMS Holdings Corp.

Well, I think we've talked about being very focused on M&A and it being a key user of our free cash flow and our significant liquidity. We have – also spoken about, we do expect to see consolidation occur over the next couple of years. Our largest customers are really have been telling us, they're going to – they want to deal with less vendors, they want to deal with less vendors from a complexity standpoint, they also want to deal with less vendors from a data security breach standpoint. And I think we're very well-positioned as we've got very strong core COB platform, we've got a growing PI platform. We have a new platform on risk bearing management and helping companies do that. So as that consolidation takes place, we're confident we're going to have a seat at the table, and then predicting when deals are going to happen is difficult, that's why we don't guide – include deals in our guidance, but we certainly continue to see a very active, robust pipeline, and expect to be making acquisitions that could either help our core business or our new growing business with the foundational acquisition we made with Essette.

Steven J. Valiquette - Bank of America Merrill Lynch

Okay, great. All right, thanks.

Operator

Our next question comes from Shane Svenpladsen with Avondale Partners.

Shane Trow Svenpladsen - Avondale Partners LLC

Good morning. Following up on your Medicaid RAC comments, how would you characterize the competitive environment in that market?

William C. Lucia - HMS Holdings Corp.

It's a good competitive environment for us, because we have so much domain expertise in Medicaid. We have seen a lot of people who have been in the market dropout. There is – we have about 23 contracts currently. We selectively rebid on them, primarily based on states who have an interest in pursuing – actually pursuing these savings versus them seeing it as a compliance issue with CMS. As the – we think we're going to continue to have a very strong footprint in the Medicaid RAC environment and we think this is the time to push the – move the needle when it comes to both bringing in the sales, little expanded sales team, and then pushing more of our focus on edit development, particularly when there is a lull in the Medicare RAC environment into Medicaid.

Jeffrey S. Sherman - HMS Holdings Corp.

And then, typically in the state marketplace versus the commercial marketplace, it's an RFP process, so vendors aren't typically stacked in the state contract, you win the RFP, you're the vendor doing the work.

Shane Trow Svenpladsen - Avondale Partners LLC

I appreciate that. That's helpful. And then just quickly, is there any update on the UPIC contract vehicle since you last spoke about it?

William C. Lucia - HMS Holdings Corp.

Yes. As everybody knows, we were one of seven companies selected last year to compete for what's about $2.5 billion over 10 years. The selection of us doesn't mean we're going to win something, but it does provide us an opportunity to both compete for the business and also be sort of pre-approved by CMS either as a primary contractor or a subcontractor. We have – there are five jurisdictions that are expected to be awarded over a period of about 12 months, that may take longer, sometimes it does particularly with the change in administration. There are – the first award was made last summer for jurisdiction one. We were not part of that bid. The second was announced in October for the northeast region and we are a sub-contractor in that bid, so we opted not to bid as primary, because we're an approved bidder, it's easier for the primary to get us approved as they go through their bidding. And then, the final past quarters were just released and proposals are due this month, and we expect that they'll start to announce those in April. We won't necessarily talk about what we bid on or whether we bid prime or so, but our goal is to be part of this.

I think the other part of these dollars that CMS has to spend is we may come up with a very unique strategic data aggregation project, considering the amount of Medicaid data we have, propose that to CMS, CMS might say, gee, that sounds great, we've got to put it out to the UPIC vendors, they put it out to the UPIC vendors and it's – so it's a little bit of a, I don't want to use the term hunting license because – but it is a little bit of that, it's an opportunity for us to propose new projects to CMS, and for CMS to say, these make absolute sense, let us put it out through the UPIC procurement process to the preapproved vendors. So that's sort of a current update on the UPIC, it is cost-plus business as everybody knows. So a little less from a margin perspective than our typical margin run rate.

Operator

Our last question comes from Frank Sparacino with First Analysis.

Frank Sparacino - First Analysis Securities Corp.

Hi, guys. I know we're running way over. Just a real quick, on the payment integrity side for 2017, I know you talked about an approved growth rate. Any color you can add there, I mean 2016 was obviously weaker than we had expected I think given the sales activity skewed toward the PI side. I would assume a material improvement in the gross rate there, but any thoughts?

Jeffrey S. Sherman - HMS Holdings Corp.

Yeah. So I think as we said in our prepared remarks, majority of our sales over the past year were more focused on payment integrity products. And it is more complex to implement than COB contracts. So it does take longer for them to be revenue producing, factors including client collaboration, the availability and prioritization of IT resources are critical factors in the process and it's also once PI contracts are in place, the revenue can be uneven from quarter-to-quarter. It is a category where as we find new edits and those get fixed over time you have to keep generating new edits.

So I think the resources we put into new edit development will be helpful in driving additional PI revenue in 2017. And then finally, as I said previously just the investments we're making both in implementation resources and in technology infrastructure and adjust data quickly, all are things that are going to help drive more payment integrity revenue growth in 2017 versus 2016.

Operator

And I'm not showing any further questions at this time.

William C. Lucia - HMS Holdings Corp.

All right. Well, I thank everybody for attending our call and look forward to speaking to you on our next quarterly conference call. Thank you.

Operator

Ladies and gentlemen, this does conclude today's presentation. You may now disconnect. And have a wonderful day.

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