HealthStream, Inc. (HSTM) CEO Robert Frist on Q3 2019 Results - Earnings Call Transcript

Oct. 22, 2019 3:52 PM ETHealthStream, Inc. (HSTM)
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HealthStream, Inc. (NASDAQ:HSTM) Q3 2019 Earnings Conference Call October 22, 2019 9:00 AM ET

Company Participants

Mollie Condra - Vice President, Investor Relations and Communications

Robert Frist - Chief Executive Officer and Chairman

Scotty Roberts - Chief Financial Officer and Senior Vice President

Conference Call Participants

Ryan Daniels - William Blair

Matt Hewitt - Craig-Hallum Capital

Richard Close - Canaccord Genuity

Frank Sparacino - First Analysis


Ladies and gentlemen, thank you for standing by, and welcome to the HealthStream, Incorporated Third Quarter 2019 Earnings Conference Call. At this time, all participants are in a listen-only mode. After the speaker presentation, there will be a question-and-answer session. [Operator Instructions] Please be advised that today's conference is being recorded. [Operator Instructions]

I would now like to hand the confidence to your speaker today, Mollie Condra, Vice President Investor Relations and Communications. Please go-ahead madam.

Mollie Condra

Thank you, and good morning. Thank you for joining us today to discuss our third quarter 2019 results. Also, in the conference call with me are Robert A. Frist, Jr., CEO and Chairman of HealthStream; and Scotty Roberts, CFO and Senior Vice President.

I would also like to start by reminding you that this conference call may contain forward-looking statements regarding future events and the future performance of HealthStream that involve risks and uncertainties that could cause the actual results to differ materially from those projected in the forward-looking statements.

Information concerning these risks and other factors that could cause the results to differ materially from those forward-looking statements are contained in the company's filings with the SEC, including Forms 10-K and 10-Q.

So, at this time, I’ll turn the call over to Bobby Frist.

Robert Frist

Thank you, Mollie. Good morning everyone. Welcome to our third quarter 2019 earnings call. Our third quarter performance was in line with expectations with our expectations and revenues were up 4% over the same quarter last year. Adjusted EBITDA up 3% over the same quarter last year. Supported by strong cash flows from operations and a record-low days sales outstanding we ended the third quarter with a cash balance of approximately 173 million, so strong balance sheet.

In a minute, Scotty will elaborate more fully on financial results, so I’m going to dive into some of the operational updates. To start today, I want to provide with updates with regards to three business transitions that we introduced and discussed in previous calls. All three transitions are designed to move us towards being a higher margin, more profitable company in the coming years.

We’re about nine months into what I described as a 36-month journey. So, we’re about nine months and we’re about 25% through these migrations and I’m pleased to report we’re making steady progress on all of these transitions.

During the quarter, for example, we contracted 48 new accounts for our new resuscitation offering. We increased new Verity platform subscriptions by 50% over the last quarter, and we added approximately 434,000 hStream subscriptions and support of our SaaS to PaaS migration or strategy. If we continue to progress on these three transitions, we expect to cross the 60% gross margin level at this time in 2020. So, we’re kind of excited that we expect to see some of those transitions start to playoff in the gross margin line by the middle of next year.

So, let's look at each one in a little more detail. First, we have transitioned our sales and marketing efforts from the legacy resuscitation products to our new resuscitation offering, which includes the American Red Cross Resuscitation Suite program and Innosonian Skills program launched earlier this year.

Since there are no new sales of the legacy resuscitation products, we expect revenue from those legacy products to continue declining sequentially each quarter through year-end 2019 and throughout 2020. So, we’re projecting sequential declines in revenues throughout 2020 on the legacy resuscitation products.

Specifically, we anticipate revenues from legacy products to decline an additional 800,000 in the fourth quarter to approximately 12.6 million. This is a little bit lower than we had thought last quarter, but our new forecast puts us at about 12.6 million on legacy resuscitation products. We anticipate revenues from our legacy resuscitation products to be zero in the first quarter of 2021.

As a reminder, the new Red Cross Resuscitation Suite program is comprised of basic life support, advanced life support and pediatric advanced life support competency driven development curriculum. It brings an updated highly adaptive competency-based solutions to healthcare professionals. It offers certification to healthcare professionals successfully demonstrating proficiency of life-saving resuscitation knowledge and skills. In fact, the program is live for several accounts and the first healthcare professionals have achieved certification through the program.

I'm pleased to report strong sales momentum of our new resuscitation offering. And just looking back at the history of launch, we announced on January 15th of this year and in that first quarter, we had six new accounts during that launch quarter. In the second quarter, we had 15 new accounts, so an additional 15 accounts and we just announced 48 additional account in the third quarter.

Together, through the first nine months of the year, therefore, these 69 accounts totaled over 22.3 million in contact order value signed for our new resuscitation offering. These new contacts are from a mix of hospitals and healthcare facilities from across the continuum of care, including new and transitioning customers. We're not expecting material financial contributions for 2019 from these contracts because many of these customers are running off their legacy resuscitation product licenses.

We have a solid sales pipeline and encouraged by the market's reception to the new resuscitation offering that we believe is more innovative, more effective and more cost-efficient than legacy solutions. To support that, we've approved and are recruiting new sales representatives specifically in this solution area. So, that’s an area of investment for us.

Second transition involves adoption and migration to our new SaaS-based Verity platform. In the first quarter of 2018, we announced the launch of Verity, our new SaaS-based platform for managing credentialing and privileging in health organizations. As of the end of the third quarter 2019, new customer accounts for the Verity platform grew over 50% to approximate 155 contracted customers. This rate means that on average, over four new customers per week were contracted during the third quarter.

So, it’s an exciting time as we filled our building momentum around the new technology platform, both signing customers to migrate and our brand-new customers. So, the 155 customers are a nice balance of customers migrating and brand new, and they're also taking advantage of the privileging technologies that are built into the platform. Given the high quality of the new platform and our history of successfully migrating existing customers to improve solutions, we anticipate continued progress in terms of new sales and migrations of legacy customers.

So, the migration journey is one that requires several years to fully accomplish. The third – and I want to talk about the third transition that we’ve talked about. The third transition involves our customers upgrading to the hStream platform, which is essential technology working behind the machines that powers all activity in the HealthStream ecosystem. Again, it’s an evolving technology platform and it’s nascent, but effective and active and some of our new solutions are directly powered by the new hStream technology.

In the third quarter, we added approximately 434,000 hStream subscriptions bringing our cumulative total up to approximately 2.78 million subscriptions at the end of the third quarter. That's up from 2.34 million contracted subscriptions at the end of the second quarter of 2019. The HealthStream platform and service committees are enabling new functionality even in some of our most established applications such as the HealthStream Learning system.

HealthStream Learning center customers who have upgraded to hStream now enjoy an advanced manager interface known as MyTeam. Initial reception to the upgrade continues to be positive and has exceeded our expectations with over 81,000 managers across 700 organizations actively using the new MyTeam technology. And again, MyTeam is an extension of capabilities of the old HealthStream Learning center.

So, when a customer upgrades to hStream, they get new capabilities in their older legacy applications, the HealthStream Learning center. So, it’s an exciting way and upgrade path for the HealthStream Learning center when customers adopt MyTeam. So, we expect to see continued adoption of hStream over the next couple of years and we’re excited about the progress in the last two quarters, specifically.

I want to remind everyone that these three business transitions, we’ve described them as multi-year journeys. We don't want anyone to have the perception or concept that these will be done or finished in the next six months. In fact, I opened by saying that we’re kind of nine months into a 36-month transition, and each one may take a little plus or minus 36 months, but we think we'll see financial benefits to these migrations over the course of the coming years, and be it through the bulk of these three transitions within 36 months.

Again, we’re nine months into of the 36-month journey. Again, it’s a characterization, it’s not precise, but we want you to all understand that these are not short-term migrations, these are things that are going to take us a couple years to work our way through. But again, we’re encouraged by the early returns.

As we announced in September, our Board of Directors appointed Scotty Roberts as CFO and Senior Vice President following his service as our Interim CFO since February. So, we’re excited to have him serving as the company’s CFO. He’s an exceptionally talented and competent executive. He brings 17 years of experience at HealthStream in public, financial reporting and all operations, including accounting and finance. Scotty makes a strong addition to the company's executive team serving as our top financial leader.

At this time, I’ll turn it over to Scotty to provide a more detailed look into the financial metrics for the third quarter of 2019. He’s also going to give us a little bit of a outlook for the rest of the year in his guidance.

Scotty Roberts

Thanks, Bobby, and good morning. As a reminder, the discussion of our financial results today are for continuing operations only and comparisons are against the prior-year third quarter unless [Technical Difficulty]. Our financial highlights for the third quarter are as follows. Revenues were up 4% to 62.5 million. Operating income was down 20% to 3.7 million. Income from continuing operations was up 14% to 3.5 million. Our EPS from continuing operations were $0.11 per diluted share, compared to $0.09 per diluted share in the prior year. And adjusted EBITDA from continuing operations was up 3% to 11.5 million.

Now, let’s review our results in more detail. Revenues from our Workforce Solutions segment totaled 51 million for the third quarter and were up 4% over the prior year. During the quarter, we experienced organic growth in our platform and content subscription revenues, and our topline also benefited from the Providigm acquisition. These improvements were partially offset by an expected decline from the legacy resuscitation business.

The legacy resuscitation revenues decreased by 10% or 1.6 million and were 13.4 million, compared to 15 million in the prior year. Through the first nine months of this year, we’ve recognized $46.3 million of revenues from these products with a year-over-year growth rate of 14%.

One of our opportunities for backfilling the declining revenue from the legacy products is by marketing and selling our new resuscitation offering. Since of the launch of the new resuscitation offering in January of this year, we’ve sold over 22 million of total contract value with most contracts averaging five years in length.

Revenues from other Workforce products grew organically by 5%. This growth rate excludes revenues from the legacy resuscitation products and the Providigm acquisition and the Providigm acquisition brought 1.9 million of revenues in during the quarter.

Revenues from our Provider Solution segment were 11.4 million and grew by 6%. Revenue growth is primarily coming from sales of the new Verity platform subscriptions and professional services for client implementations. Compared to last year, Provider Solutions license and subscription revenues were up 1.1 million or 13% while Professional Services revenues were down 500,000 or 22%.

Our gross margins improved to 59.4%, compared to 58.1% in the prior year. This improvement occurred because of the declining revenue from the low-margin legacy resuscitation products, which is being replaced by contributions from some of our other higher margin products. As we look out over the next year, we anticipate our gross margins should begin to show improvement over historical levels, which over the past three years have ranged between 57% and 59%.

We believe there are three key drivers that can improve our gross margin profile, which are centered around the transition areas Bobby mentioned. The first opportunity for margin improvement is from the decline in lower margin legacy resuscitation products and our ability to convert customers to our new resuscitation offering. Second is the adoption of the new Verity platform solution; and the third is our continued growth of hStream. We are successful with these transitions as we have been over 2019 to-date. We anticipate our gross margins to improve to 60% by this time in 2020.

Our operating expenses, excluding cost of revenues, were up 11% across the following categories. Product development expenses increased by 9%; sales and marketing expenses increased by 5%; depreciation and amortization increased by 19%; and G&A expenses increased by 11%. The higher operating expenses compared to last year are due to growth in staffing levels, which were up 12%, the incremental operating expenses from the Providigm acquisition, as well as higher depreciation associated with the relocation of our corporate office earlier this year. Although operating income declined by 20%, our adjusted EBITDA grew by 3% to $11.5 million from $11.1 million in the prior third quarter.

Now, let’s review the balance sheet and cash flows. Our cash and investment balances increased by 11 million and ended the quarter at approximately 173 million and our working capital was 123 million. Cash flows from operations improved to 52.5 million year-to-date compared to 29.8 million year-to-date in the prior year, an increase of 76%. This increase resulted from improved cash collections and lower DSO, and incremental cash flows generated from operations. Our DSO for the third quarter was a record low of 40 days, compared 46 days in the prior year.

For capital deployment, we incurred 3.1 million of capital expenditures during the quarter, which brings our capital expenditures for the year to approximately 27 million. As a matter of practice, we maintain an active business development pipeline as indicated by the Providigm acquisition and two minority investments we completed earlier this year. We ended the quarter with a strong balance sheet and access to capital, including 173 million in cash and investments and 50 million line of credit facility, which support our business development activities.

Now, let’s turn to our financial guidance. We anticipate that consolidated revenues will range between 252 million and 256 million with revenues from the Workforce Solution segment ranging between 207 million and 210 million and revenues from the Provider Solution segment ranging between 45 million and 46 million.

We are increasing our operating income guidance range to be 12.5 million to 14 million and our non-GAAP operating income guidance range to be 14.7 million to 16.2 million, which excludes the $2.2 million stock grant expense incurred during the second quarter. We anticipate that capital expenditures will approximate 33 million for the year and the annual effective income tax rate to range between 23% and 25%. This guidance does not include the impact of any other acquisitions that we may complete during 2019.

That concludes my comments, and I will now turn the call back over to Bobby.

Robert Frist

Thank you, Scotty. Before we go into Q&A, I’d like to make a few closing remarks. One thing that’s interesting that’s happening actually today and yesterday is there is a unique convergence of the three business transitions that we mentioned earlier in the script. In Philadelphia, at the National Association of Medical Staff Services, or NAMSS conference, we’re demonstrating some new – an innovative new technology that integrates several pieces of our story.

It’s the automated integration of the Red Cross certification with hospitals and medical staff credentialing records through the new Verity platform is being demonstrated. So, now, when healthcare professionals successfully complete the Red Cross certification requirements, the record of their certification is transferred automatically through an integration with their Verity credentialing system. That saves the medical staff officers' hours of time and paperwork.

The bridge between our Workforce development platform and our Provider Solutions business segments is made possible via hStream. The hStream technology, for example, is used to login to the program and into the manikins, and so, when certification is complete, that transaction results in an issue of a credential, which is automatically transferred into the new Verity platform.

And again, the long history of this is that these medical staff officers and credentialing officers would have to research and acquire that data in very manual processes, even sometimes asking for a faxed copy of the credential to enter into the credentialing system, and now we’re demonstrating it live on the exhibit floor today as someone completes the physical certification on the manikin, the certificate pops up and shows in the Verity platforms.

So, it’s a very exciting leverage of the hStream technology platform as its used to login to the – into some of the manikins, a flowing of the credential from essentially the learning network into the credentialing platform of Verity and its being demonstrated at the NAMSS conference for the medical staff services. That's where the credentialing process is managed. So, it’s really an interesting bridge that incorporates many elements of what’s new and exciting about HealthStream and I think it's being well-received on the floor as the exhibit for today.

As a reminder, at the first year, we announced that our addressable market now includes approximately 10.5 million employees. These are healthcare professionals, which comprised of approximately 5.2 million employees in acute care space and 5.3 million employees more broadly defined continuum of care market. We define the continuum of care as ambulatory services, including physician offices; health and human services, including behavioral health facilities; and post-acute care, including skilled nursing facilities.

With an expanded market comes greater growth opportunities. For example, we announced a new strategic alliance with Medline in October. With over 23,000 employees, Medline is a global healthcare distributor and solution provider that’s particularly well-positioned across the continuum of care with a strong foothold in the post-acute care space.

Through our new alliance with Medline, the companies will champion and expand HealthStream’s specialized workforce development programs, including a compliance essentials program and professional development program, and these programs drive clinical development and meet compliance requirements in those clinical settings.

We’ve already seen a number of new opportunities created and the first contracts have been signed as a result of our new Medline partnership. So, we’re excited to have them help us take these solutions into the continuum markets as we’ve defined them.

In the fourth quarter, on November 12 and 13, we’ll welcome clients of our Provider Solutions to [Thrive 2019], which is the second annual Verity National User Group Conference. This event will be held in Scottsdale, Arizona, where clients can connect, learn and collaborate with peers, thought leaders and the Verity team. Special learning opportunities are also offered in the pre-conference on November 11. We look forward to this exciting event, which will kick-off in about three weeks from now and where we anticipate over 300 clients will be in attendance.

In May, we launched our new corporate social responsibility program, which we call Streaming Good. This program was developed and launched by employees. It’s from the ground up, and we’re excited about the opportunities to contribute to the communities we work and – we serve and we work within.

For our first year, we are focused on supporting the American Cancer Society, and I’m pleased to report that last week we held an exciting event for this worthy cause. HealthStream hosted a relay for life event in Nashville, outside of our new Capitol View corporate office to raise funds and awareness for the American Cancer Society.

Company-wide, employees are participating in Streaming Good and it's gratifying to start to see the positive impact this program is having in our local communities and on behalf of American Cancer Society. So, I want to congratulate all employees and encourage all of our nearly 850 employees to be actively involved with these programs, and our new social responsibility program. We couldn’t be more excited about our initial events.

At this time, I’d like turn over for questions from the investor community.

Question-and-Answer Session


Thank you. [Operator Instructions] Our first question comes from Ryan Daniels with William Blair. Your line is now open.

Ryan Daniels

Yes, good morning, guys. Thanks for taking the question. Bobby, a follow-up for you on the legacy resuscitation solutions, have you had the opportunity to look back at those clients that are running off the legacy solution, let’s say over the next 12 months and to determine how many of those are actually converting to the new HealthStream solution versus perhaps reopening with the legacy? So, kind of what’s your sales conversions or sales capture rate as those clients roll-off?

Robert Frist

Yes, Ryan, we haven’t reported that. We’re – the blend of the 48 new accounts in the fourth quarter was a nice mix. It’s fairly well-balanced from a conversion to brand new account, so we felt really good about that. And of course, our team is acutely aware of and watching, all customers [indiscernible] make sure we’re in the hunt, but we have not disclosed our conversion rate, and I don’t think that’s necessarily a helping metric for the competitive dynamic. Remember, we do maintain partnerships with both entities and we want to represent and sell and market the American Red Cross Resuscitation Suite program, but we also need to maintain a healthy relationship with the legacy partner, our QR partners as well.

Ryan Daniels

Okay, that’s fair. And then, I know the last quarter of the year had some requirements, CMS mandated, and I think they kick in November, the requirements or participation for nursing homes. So, that in tandem with the new Medline partnership, do you expect kind of a [indiscernible] of new contract signings over the next month or so to meet that demand? Or is much of that already been put in place because the conditions of participation actually start in a few weeks?

Scotty Roberts

This is Scotty. I think our expectation of that is most of the customers that have adopted the abacus product have done that in the past couple of years, and some of the changes in regulation, you know, although they were mandated by the government, some of the penalties enforcements won’t kick in for another year or so. And so, I think this gives us a little more runway to kind of approach customers to try to picture our products for them, but I don’t think there will be [indiscernible] that you indicated that will occur.

Ryan Daniels

Okay. And then, just any thoughts on capital deployment? I know, you know, the balance sheet is very healthy especially with the low DSOs and with, you know, the strong free cash flow building up again, so any thoughts on potential uses of cash going forward as it reaches, you know, nearly $200 million here towards year-end? Thanks.

Robert Frist

Yes. I mean we’re constantly examining that and we tried to communicate even in the script that we maintain an active pipeline of all sorts, including minority investments and acquisitions. We did complete one acquisition earlier in the year and we're trying to team up. We have made a few bids on acquisitions where we weren’t prevailing better. So, we also kind of we know our limits. And again, it's an active program that we’re investing in to find opportunities for inorganic growth.

Also, organic growth though minority investments, content development, our deployment of capital increase. As we just finished our five-year plan with our Board, we’re increasing our capital allocations towards a content development and program development. So, we’re pretty excited about that. We’ve gotten great results where we’ve chosen to invest in a fully kind of vertically integrated product where we have platform content and data and we own all three pieces.

Ryan Daniels


Robert Frist

So, we probably see a slight uptick in investment, capital employment and to, what I guess I’ll call content or program development. There’s a lot of solutions we’re building, for example, around the resuscitation suite that are complementary to the programs that we’ve built or that Red Cross has built. So, we’re excited about that as well. And so, overall, we’re going to do our best to thoughtfully deploy the capital and have an active pipeline, minority investments, M&A activity and increased capital investment into content and programming.

Ryan Daniels

Okay, great. Thanks for the color.


Thank you. And our next question comes from Matt Hewitt with Craig-Hallum Capital. Your line is now open.

Matt Hewitt

Good morning. Thank you for taking the questions.

Robert Frist

Good morning.

Scotty Roberts

Good morning.

Matt Hewitt

Just a couple of follow-ups. First, regarding the long-term care market, I mean your relationship with Medline, how are those facilities currently attempting to meet the new regulations – the requirements for participation regulations? Is that something that some of these facilities are trying to do internally? Or, you know, obviously I would think that the Verity platform is a much simpler way, but what other options do they have out there?

Robert Frist

Well, to the Providigm platform, which is the Abacus platform, that is really the – the acquisition we made at Providigm and came with the Abacus platform, which is kind of a long-standing market leader in helping them prepare for all form of mandate and quality audit process and quality management. And what’s happening is there’s some increased regulation around relating not just staff competency, which is one of the business hypotheses under which we acquire Providigm. And what we’re seeing now is we’re combining our content bundles like Medline, for example, helps us position the Abacus platform and these new content bundles together into these – into this vertical. And so, they're very prominent in the vertical.

These are products that help them differentiate their overall product offering to those organizations, and they’ve helped us over the years to position them. And now, they have a more complete tool kit that help introduce to the market. What they do otherwise? I guess a lot of pen and paper. There are a few competing products for the Abacus platform that are offered by competitors of Medline, for example.

There are competing educational products offered by competitors of HealthStream into the market, and there's a lot of kind of traditional pen and paper that needs to be displaced and made more efficient as well. So, you know, a typical competitive landscape, but we’re really proud to be aligned with Medline. We think they're the strongest in the market and they’re going to help us carry these solutions, which we think are also the strongest in the market to these customers.

Matt Hewitt

Understood. Okay. And then, shifting gears, regarding the legacy resuscitation program, so as those roll-off, you enter 2021 I think you had said you’ll at zero for the legacy revenues at that point. How will the access fees be accounted for? Because there's going to be some customers that still are going to be using the legacy platform, but, you know, RQI is going to be basically paying you a legacy – a access fee, if you will, will that be accounted for in another bucket? Or is your saying zero, but essentially there's going to be some revenue there? Just help us understand that a little bit.

Scotty Roberts

Yes, sure. It's another bucket, and so, we’ve communicated, you know, approximately [50 out of 60 million] revenue from the legacy products at its own, you know based on its own legacy contracts and wind down agreement, and so, that's that 59 million winding down. We announced the RQI partners agreement, which is a separate revenue stream, which is the access fees where they do the sales and marketing and we’ll facilitate the connectivity and that will be growing, but it will be dependent upon kind of customer choice and their own success selling and contracting with hospitals that are on our learning platform, for example.

And so, the sequence of events would be that a customer is using our learning platform and enjoying the benefits of that, they want to maintain their older, what we would call, legacy solution, but they want to maintain that, so they contract for that with RQI partners. And then, our ops teams will help make sure that it works for the customer and the RQI partners organization would pay us an access fee, which would show up in revenue and its – but it’d be very low because it is a subset of the contract, right. So, we’re no longer contracting for the products, we no longer sell the products; we no longer market the products. That’s all on the access partner, as we call it now, the RQI partners.

Matt Hewitt

Okay. That’s very helpful. Thank you. Maybe one last one and then I’ll hop back into queue. Regarding your hStream subscriptions, you launched the product in Q3 of 2018 and its ramped very, very quickly. Its almost 60% of the last fully implemented and contracted subscriber numbers for the way you reported that previously. How quickly do you get that other 40%? Is that going to ramp on in the next year? Or do you expect that rate of conversion to maybe be slow as you get, you know, closer to that 100%?

Robert Frist

Yes. It should. First of all, as I’ve articulated, each of the three transitions I think are kind of 36-month transitions and they are kind of arbitrarily picked, you know, January 1 as a start date even though something started before that and some will go a little longer than 36 months, but just to characterize all the three, I think the bulk of the migrations, transitions, and movements will be completed within 36 months, and again, starting January 1 of 2019. So, we’re nine months in to the 36-month transitions. So, I would say that couple years are left and whether, you know, 100,000 migrator or 434,000 as in this quarter, its largely dependent on when these accounts are coming up for renewal. And so, if you have a couple of big enterprise, accounts coming up for renewal might be a high number.

If it's a bunch of smaller accounts coming up for renewal on the old platforms, it would be a lower number. And then, to the extent that we do renew them, you know, they’ll account into the hStream subscriptions where they are upgrading their old contracts and include hStream and other product sets from us. And remember as well that, you know, contracting for this kind of new operating system is kind of step one, and then, receiving benefits and capabilities from it is step two, and some of the most tangible and obvious benefits are for customers that choose to stay with and renew our learning platform as well.

They get this upgrade to MyTeam. There are other benefits that we can roll out with hStream and we’ll be articulating them in the coming months and quarters to both customers and to the market. But that’s how we’re achieving this migration. You remember that average contracts are kind of three plus years. And so, a third of the accounts will come up for renewal each year, some would enter longer term renewals in that. So, again, I think about 24 more months and we’ll be to the bulk of these migrations.

Matt Hewitt

Understood. Alright, thank you very much.


Thank you. And our next question comes from Richard Close with Canaccord Genuity. Your line is now open.

Richard Close

Great. Thanks for the questions. Just a little bit on gross margins, obviously, you’re targeting, based on your statements, 60% by the middle of next year. As you think about the transitions here, what you think margins will be, you know, out maybe two or three years? Have you thought about that in terms of like what may be a long-term target is considering these transitions?

Robert Frist

Okay, Richard. Now, you know, that I’ve never guided beyond a year, but this is one that I think I can touch on because there’s kind of a natural follow-up from the roll-off of the resuscitation products and the growth in the newer Red Cross Resuscitation Suite program, and our new resuscitation product set. So, I think I can say that, you know, by this time next year, we’ll feel like we’ll cross across that 60% of the gross margin level. My expectation is sustainably. And then, as the legacy products drop off even faster by Q1 2021, we think we’d see a much more aggressive move up in the gross margins.

And so, just for now – just for now, I'll ballpark and say that, you know, we should cross through 65% gross margins against approximation, its long run, and so we'll caveat with all that, but it is this natural migration of the switch out of the legacy revenues for the new that gives me the confidence to say that – in addition to the other migration that we’ve talk about and the SaaS to PaaS past strategy and the Verity migrations, all those together, you know, I think, you know, we’ll be looking at 65% kind of gross margins by Q1 of 2021, and with even some upside to that into the future. But all this – I'll leave it at that for now to give you a little bit more sense for the way we’re thinking about it. You know 60% by the third quarter next year, 65% by the first quarter or so of 2021.

Richard Close

Okay. That's great. Thanks for that insight there. And then, with respect to the most recent quarter, and then in the updated guidance with respect to operating expenses, I think on all the line items you did considerably better than what we were forecasting, and just any thoughts there in terms of, you know, may be how you’re trending in terms of product development, sales and marketing, and then the G&A in terms of – are there – were there anything as really to call out that, you know, maybe you didn't do as much hiring or, you know, things along those lines that led to the better operating expenses in the quarter?

Robert Frist

Yes. Let's talk about that a little bit. That’s a good question. So, we’re just talking about that before the call started actually, and we had a very ambitious hiring plan. We did end up adding a net new about 80 plus employees in the year, so we did grow our workforce, a good chunk of that, maybe a third of that or so was through the acquisition of Providigm, but there was also some organic net new hiring of probably 50 or so people across the rest of the company. So, we did achieve some really good growth as we had planned to in our headcount.

However, in our modeling, and then, in our guidance, we had assumed even higher levels. And so, we were not able to hire to our desired outcome and that resulted in lower expenses than we had, and therefore, kind of outsized earnings in Q3 to what we had hoped. So, had we been able hire everyone we had hoped to? We probably would have had a little lower earnings in this existing quarter. And so, I think probably the single biggest variable is setting our hiring expectation internally, and then, how close do we get to achieving them. And I would say, this year, we underachieved.

We’re not aggressively trying to correct that, meaning, I didn't tell our teams go out and get five [head hunting] firms and get all these positions filled. So, we’re kind of fighting the national battle for talent in our market, including national, which is heating up and we’re doing it diligently, but were not overinvesting like treating a huge cause of rapid recruiting. We’re taking our time trying to get the right people, and I think we’re doing well at that. But the net effect is, yes, we’re behind kind of where we thought we would be from a headcount standpoint and that has been a persistent story now for probably a year. But I don’t want to you to get the sense that we’re not growing our headcount.

We did add – in technology, we did add. In sales, net new adds in sales and net new adds in almost every are of the company. So, we’re getting things done, but I’m – we're not – we haven’t yet, you know, ripped the cords and said, look, fill all these jobs instantly, and as you know, that cost a lot of money to do that through recruiters. So, we’re kind of more – we’re doing our best organic recruiting, and that's resulting in a little bit lower forecast, and therefore, higher operating income in Q3.

We’re going to do our best in the fourth quarter to authorize lots of project work and contracts to make up for that deficit in hiring so that we can deploy capital and cash and expenses in the product development, product design, things that are [expansible] and some things capitalized. So, we’re going to try to [amp] up Q4 a bit to simply invest the money we would have invested in headcount and don’t know if we’ll be able to fully offset the hiring shortfall. Again, it's important to know that we did add a net new 80 employees, so we’re not shrinking the employee headcount, but we did – we were more aggressive earlier in the year in our expectations for hiring.

Richard Close

Okay. And about a year ago, you talked about a transition to, I believe it was Azure and AWS. Any updates there in terms of where you stand in that process maybe the positives associated with that that you think you’ll accrue? And then, maybe an update on the expenses associated with that? Is that coming in lower than anticipated or, you know, above expectations?

Robert Frist

It's about at expectations. You know, I think it's going to take – I think I’d characterize that as a 24-month migration as well or 27 months. If I had to think of – or like describe another migration, this one is more at hand and it's managed with a thorough process. But as our PaaS strategy grows, we’re increasingly moving all the applications up into those two environments you mentioned, the Azure and AWS, and that does [indiscernible] duplicative cost where our legacy platform, HLC is all a SaaS, you know, it’s a great architecture, but it's hosted in managed hosting environment and a couple of Tier 1 data centers across the country.

And so, we are having duplicate costs, but I would say, we’re going to bear those duplicative cost for the next – and I’ll go ahead just to align this with the other two migrations because you know, there are hundreds and hundreds and hundreds of HealthStream managed servers in these Tier 1 data centers and it’s going to take us time to get each of our applications moved and we’re not in any particular hurry because it's a good, stable growing model and platform. And again, a lot of the new platform technologies are being built. And so, we don't have all the functionality in the new platform to just switch some of the legacy platforms over.

And so, I guess I would say that they’re at our budgeted expectations for cost in the model, nothing exceptionally the way, and that we’re going to take our time probably next 27 months. So, I’m going to give us the same time line as the other three transitions to get us over to the cloud fully.

Again, all of our access to be clear. Our SaaS applications that our webhosted and delivered, multi-tenant architecture, so they are modern architectures, but as far as the actual hosting environment, managed hosting versus outsourced hosting to AWS and Azure, the Microsoft platform. We are going to take our time on that and manage those cost.

Now, to your point though, if you look out 30 months from now, if – when those migrations are complete, we will have a lower cost structure, because there is a – I think some of our server facilities have over 300, 400, 500 servers in them that would go away and the capitals who refresh them would also go away, but let’s call that a 27 month journey as well.

Richard Close

Okay, and would that be included in that sort of 65% type of gross margin or is that a [indiscernible]?

Robert Frist

Yes. Those costs are in our thinking as we look out and as I mentioned since a 27 month migration, those kind of duplicative costs are in our assumptions and we still think we can see a move to cross the 60% threshold by this time next year and then a more rapid move by Q1, Q2 of the next year to touch that 65% area. So, we will touch the cost.

Richard Close

Great. Thanks.


Thank you. [Operator Instructions] Our next question comes from Frank Sparacino with First Analysis. Your line is now open.

Frank Sparacino

Hi, guys. Just one from me on the talent side of things given we haven’t talked too much about that recently Bobby. You know, I see there is some new money in start-ups coming into the space on the hiring side, but any thoughts just in terms where you are at today in terms of the talent portfolio products and your thoughts going forward there Bobby in terms of the market opportunity and how you sort of balance that maybe with some of the other initiatives you have?

Robert Frist

Yes, thanks. We haven’t talked about it a lot. I would say, Globally I would say, we are retrenching to what we are best at, that would be a fair characterization, the learning and development dimensions, tools like our checklist tool have been good winners, we put those in the talent management bucket. The learning center with its refreshed MyTeam and the new kind of initiative management capabilities we have been building into the platform, we are really excited about.

Probably a slight move away from some of the other areas like compensation, like the full talent suite, yes and so, probably deemphasis on what I would call the secondary and tertiary components of talent management and a doubling down on what I will call performance management and learning. And then, even within learning there is new innovations coming and we are right on top of them around for example, using video-based education and training and providing new products that give the capabilities to manage. Essentially your own kind of YouTube for your health system and tied into your learnings platform and so we have some exciting momentum around this new video-based platform that is connected to our learning platform.

And so, overall our characterization would be, we are kind of doubling down on what the core is. From our perspective, it is kind of learning and performance management. We are probably moving away from the secondary and tertiary services like compensation management and recruiting, for example the ATS moves we made several years ago, probably deemphasizing those overall and then the emerging technologies like the new video-based platform really excited about. So, we think we can continue to differentiate ourselves and what I’ll call learning development and performance management.

Frank Sparacino

Thank you.


Thank you. I am not showing any further questions at this time. I would now like to turn the call back over to Robert Frist for any further remarks.

Robert Frist

Well, thank you everyone for participating. Congratulations to the employees on their great efforts for our social responsibility program and helping raise over $20,000 for the American Cancer Society, a great, great effort there. We look forward to reporting to all investors on the three key transitions again next quarter. Actually, it will be sometime before to gather again around February. And we are proud, that we’ve made good progress on each of the three key transitions and migrations we talked about. I guess we identified a fourth, is the move into these full Cloud hosted solutions as almost a fourth transition to think about. Thank you all. Look forward to our next report.


Ladies and gentlemen, this concludes today’s conference call. Thank you for participating, you may now disconnect.

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