Hanger Inc (HNGR) 2004 Q2 法說會逐字稿

Good morning, my name is DeShanta, and I'll be your conference facilitator. At this time I'd like to welcome everyone to the Hanger Orthopedic Group second-quarter earnings conference call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will will be a question-and-answer period. [Caller instructions]. Thank you. Tom Kirk, President and Chief Operating Officer, you may begin.

Good morning. I'd like to thank you all for being with us today on the review of our second quarter earnings. With me this morning is George McHenry, who is our Executive Vice-President and Chief Financial Officer; and Jason Owens, who is our Treasurer and Director of Investor Relations. I'll be hosting the call this morning, Van Sabel, our Chairman and Chief Executive Officer, is on an airplane right now returning from a business trip, and he couldn't move that flight so he certainly is aware of what's going on and joins us in spirit.

Last night Hanger released its second-quarter earnings announcement. Overall the results demonstrated a continued decline in our same center sales due to both the slowing in our prosthetic unit growth and continued pressure on reimbursement, which has impacted our margins. Costs have also increased due to normal inflationary pressures on salaries and operating costs and the Company continues to incur expenses due to new regulations like Sarbanes-Oxley and HIPAA, as well as investment in our new billing system and the cost of efforts to drive sales. George will go into the explanations on some of these financial details a little bit later in the call. I'm going to start off by providing an update on our West Hempstead situation. You'll recall that on June 14 an employee from our West Hempstead, Long Island practice went to the New York City media with allegations of billing discrepancies. On June 18, the Company announced that on June 17, the day before, the audit committee of the Company's Board of Directors had engaged the law firm of McDermott, Will, and Emory to serve as independent counsel to the committee and to conduct an independent investigation of these allegations. Also on June 18, the Company reported that the U.S. Attorney's Office for the Eastern District of New York subpoenaed records of the Company regarding various billing activities and locations. And that on June 17, the Securities and Exchange Commission had commenced a informal inquiry into this matter. We are cooperating with all of these regulatory authorities, and based on the preliminary results of the independent investigation, management believes that any billing discrepancies are likely to be primarily at the West Hempstead patient care center and based on the preliminary results of this investigation, management does not believe that the resolution of the matters raised by the allegations will have a materially adverse effect on our financial statements.

The sales of our West Hempstead facility for the years ended 12-31-02, 03, and for the 6 months ended June 30, 2004, were $1.6 million, $1.9 million, and $0.9 million, respectively, or 4/10ths of a percent of our overall net sales. In addition, on June 25, 2004, the Company announced that substantially similar class actions on behalf of certain shareholders of the Company had been filed against the Company in certain of its key executive officers and directors in the U.S. District Court for the Eastern District of New York and the U.S. District Court for the Eastern District of Virginia. The complaints in these cases repeat the above referenced employee allegations of misconduct at West Hempstead. We have reacted quickly and in a responsible manner to the allegations in New York. Management will continue to do whatever is necessary to determine the facts and cooperate with all of the agencies involved. Regarding the resolution of the West Hempstead investigation, it should be noted that the regulatory agencies have not yet reviewed the records that they have requested, and additional regulatory inquiries may be raised relating to the Company's billing activities at other locations. No assurance can be given that the final results of the regulatory agency's inquiries will be consistent with the results to date, or that any discrepancies identified during the ongoing regulatory review will not have a material adverse effect on the Company's financial statements.

Now with that, I'm going to turn it over to George McHenry, our Chief Financial Officer. George is going to discuss some of the financials, then Jason Owen will discuss some of the situations with our bank. And then I'll wrap it up with a discussion of some of our operating activities. Thank you. George?

Thank you, Tom. Thank you for joining us today. First, before I get into the quarter and the first 6 months I'd like to just give some color on the extension of our filing and the restatement that we reported last night.

When we first extended our filing last week and postponed our earnings release, because we got a late start on the close in our normal review, really because of the detail that attention that we had to put to the West Hempstead situation, then we also had to deal with an accounting issue that came to light as a result of better information provided for the first time by our new billing and collections system, OPS. We, as of then of June, had virtually all of our practices on the same platform for the first time and that gave us better visibility of our receivables. And showed us that we had an issue with receivables that were uncollectible. When we extended our 10-Q filing, we were required to file a 12(b)25 which also required an earnings estimate since we would have a material change over the same quarter in the prior year. At that point in time, we were still determining if the issue we were addressing was a change in estimate or a prior period adjustment, and we had not yet completed the work necessary if it was a prior period adjustment to determine which periods it applied to and to do the necessary materiality test required by Sab 99 [ph]. Therefore, the most conservative treatment at the time we filed the extension request was to include the entire adjustment and the results for the quarter, and that gave rise to the estimate of 2.5 million of pretax earnings that was in that filing. After a significant amount of work last week, we determined that the adjustment was a -- was not a correction of an estimate or an adjustment to an estimate, but a prior period adjustment, and since it was too material to the current quarter, prior periods had to be restated, hence the change in reported earnings that we released last night.

Now I'd like to get into an analysis of the quarter. Net sales for the quarter increased by 6.2 million or 4.5% to 145.1 million from 138.9 million from the prior year's comparable quarter. The sales growth was primarily the result of a 1.4 million or 15.5% increase in sales at the Company's distribution segment, and a 7.5 million or 5.2% increase from acquired practices. As Tom mentioned earlier, these increases were offset by 2.1 million or 1.6% decline in same-center sales at the Company's OMP practices, which was a result of the combination in a decline of prosthetic sales and continued pressure on reimbursement. Gross profit for the second quarter of 2004 was 73.2 million or 50.4% of sales, compared to 73.5 million or 52.9% of net sales in the second quarter of last year. Decline resulted from a 1.8% increase in material cost as a percentage of sales and continued -- combined really with a continued pressure on reimbursement that I just mentioned when I analyzed the sales. The Company is also experiencing a sales mix change toward orthotic goods, which have a higher cost of materials, and this is also impacting our material costs and the margin is adversely affect -- this is also adversely affecting our gross margins because the orthotic devices, as I mentioned, have higher cost of materials. Labor costs increased by 7/10 of a percent compared to the prior year. Modest salary increases and the fixed nature of the expense compared to decline in same center sales drove the increase there as a percentage of sales. Selling, general and administrative expenses for the quarter were 9.6 million higher than the previous year. The increase was primarily driven by a $2.5 million increase in variable compensation due to our practitioners, 1.8 million in expenses related to acquired practices, about half a million dollars was Sarbanes-Oxley 404 compliance work, and then the balance of the increase was the result of normal inflationary increases in expenses such as salaries and rent. We had a liability insurance increase. We also invested in increased headcount in marketing, corporate development, internal audit, either drive sales or required by statutory requirements, and that was -- that was really why the balance of the SG&A increased. The sales decline in combination with the increase in SG&A expenses resulted in a 10.6 million decrease in income from operations in the second quarter. Net income in the second quarter decreased to $3.2 million or approximately 10 cents per diluted share.

For the 6 months, net sales for the 6 months ended June 30, increased by 11.7 million or 4.4% to $276.7 million from 265.1 million in the prior year. The sales growth was primarily the result of a 2.4 million or 14.3% increase in sales at the distribution segment, a $13.2 million or 4.8% increase from acquired practices, and then that increase was offset by a 3 million or 1.2% decline in same center sales for the same reasons I discussed when I made my comments on the quarter. Gross profit for the first 6 months of 2004 was 139.4 million or 50.4% of net sales, compared to 139 million or 52.4% of net sales in the prior year. Gross profit for the first half is impacted by a lesser degree by the same factors affecting the quarter. SG&A increased for the following reasons. There was a 3.7 million in expenses at acquired practices, 1.2 million in Sarbanes-Oxley 404 work. e had $1.2 million increase in the cost of general liability insurance; $1 million in travel, training and setup costs related to our new OPS system as well as the roll out of Insignia; and about $1 million in selling expense as well with the balance made up of the inflation-based cost increases that I mentioned before in salaries and rent and some increase in headcount. These changes resulted in a 13.1 million decline in income from operations in the first 6 months of 2004 to 29.8 million versus 42.9 million in the prior year. Net income for the first 6 months of 2004 was 7.6 million or approximately 25 cents per diluted share, compared to 14.5 million or 54 cents last year.

On our balance sheet, our cash position was $1.2 million at the end of June, due to revolver payments totaling approximately 13.5 million in the quarter, so we paid down our revolver to roughly $40.5 million at the end of the second quarter. Accounts receivable was approximately $113 million, and our DSOs stayed pretty steady at about 75 days. The inventory increased to 63.1 million due to higher cost of materials, the inventory turns remain constant at 2.5 times. The presentation of our long-term capital structure has been altered this quarter to conform with GAAP due to the fact that we had not yet obtained a waiver or an amendment to our loan agreement, and Jason will get into that in a second. On a cash flow -- our cash flow from operations increased almost $20 million in the first quarter, when you compare it to the prior year. So we had strong cash flow and that ties into the reason why we had 13.5 million to pay down the revolver during the quarter. And for the year we're at 4.7 million, which is 13.7 million less than last year. That's due to primarily to about an $8.5 million tax refund that we collected in the first half of last year, so those numbers are fairly comparable. CapEx for the quarter was 6.1 million and 10.8 million for the year.

I'm going to turn the call over to Jason who will give you update date on the situation with our banks.

Good morning, everyone. I want to spend just a couple of minutes, and walk through where we are currently with the bank group and what the expected timing is. As you all know, as we've reported, the Company is in violation of its total leverage covenant test as it relates to the revolving credit facility and the term loan B. We had a preliminary call with the bank group last Friday to discuss certain timing events and we have scheduled a conference call for tomorrow afternoon to go through the performance of the Company and the detailed amendment request that's forthcoming. We would expect resolution of this matter before the Labor Day weekend, and that would give us access back to our revolver. As it relates to liquidity currently, the Company as of Friday had approximately $18 million on the balance sheet in cash. We had a bond payment that went out on Monday, yesterday, of $10.3 million, and that satisfied the interest requirement on the senior notes. That was paid to the bond trustee yesterday morning. Our balance as of today is approximately 18 million -- or excuse me, $8 million, and we expect to have significant or sufficient liquidity to operate the Company until we reach an agreement with the bank group. As most of you know, our liquidity constraints are typically the first week of every month as large rent checks and other vendor payments go out and we tend to accumulate cash on the back half of every month. With that I'd like to turn it back over to Tom to go into some more discussion of our operations.

Thank you, Jason. I'd like to spend a few minutes discussing operations from sales down through some of the activities that we currently have underway and we will be pushing on as we go through the balance of this year and into next year.

As George has mentioned, our sales went from 138.9 million to roughly 145 million or up $6 million, that's a 4.5% increase. There's 2 pieces to this. SPS accounts for about 22% of this increase. Their improvement is due to market penetration of some of their existing product lines, caused by extensive sales and marketing activities. They've really been out promoting the products that they sell and displacing other vendors. And the second reason is they've broadened their product portfolio and they're now distributing a line of a well-established supplier, excellent reputation which was add in the first quarter of this year, so on a year-over-year basis it's adding to their overall sales growth. The second piece of the sales line is our patient care business. Within patient care there's really 2 sources. The first was acquisitions, which added about $7.5 million. Now these acquisitions were made in the second half of '03 and throughout the first half of '04, so they're reporting in this year where we did not have them available last year. And the second influence within our patient care business is our same-store sales growth. And this is as we've reported for this quarter, a negative 1.6%. You'll recall that in the second half of '03, we decided not to continue certain relationships and contracts with third-party payers that were offered for renewal because they were offered at a deeply discounted reimbursement level, and we felt that that was not consistent with our short-term, nor our long-term objectives.

These contracts provided revenue during the second quarter of last year, and their absence this year is one of the reasons for some our negative statistic. Some of the other contributions to the negative same-store sales growth were first off looking at our patient base. Some of the personal health economics of our patients are causing them to have differences in their insurance coverage and certainly even changes within their specific benefit plan coverage. These are benefit design changes in the form of copayments and higher reimbursements, and what that's really forcing them to do is to use their own finances to make their own payments to a larger extent than they did in the past. We continue to believe that O&P is lower on the food chain in terms of their overall healthcare than some of their other more pressing healthcare needs. The second thing that we note on some of the same-store sales growth is that this sales pressure seems to be focused on some regions more than another. These regions are primarily in the midwest where certain states are not enjoying the same levels of economic recovery in job creation.

Matter of fact, if we look at some of these regions which are certainly very popular even during presidential election and we see that they are a focus for job creation, that if these regions were even flat, and we're talking about 4 states here, sort of in the industrial midwest, if they were flat compared with last year, the overall division will be flat as well, so we recognize that we have to really redouble our efforts in this area and go after trying to get some additional business in those states. The third reason for the negative same-store sales growth performance is our overall reimbursement levels. As George had mentioned before, we are seeing pressure on our reimbursement and that's coming in the forms of 2 different ways. First off, federal government has put a freeze on our CPI increase. Had that been allowed to flow through this year, we understand that it would have been slightly greater than 3%. Nevertheless, it continues to apply pressure in the form of margin compression. And we also know that certain entities out there at the state and federal levels are continuing to reevaluate specific codes. Now this is part of the ebb and flow that normally goes on within the business, but when you have the absence of having any sort of a relief valve, these things become particularly onerous as they go through and understand the economics of the particular product line and where they have changed as they have the ability to come in and insist upon lower reimbursement levels. And as we've mentioned before, some of the third-party payers, particularly the in the negotiation period last year became particularly aggressive because they've bulked up on size and were trying to exert some of their rights through volume purchasing. Net-net this third reason for the negative same-store sales growth is one of reimbursement pressure. And last but not least, the fourth reason is we are in a competitive business and we can't lose sight of that. We know that while we are the largest in the industry, and we'll talk about the advantages and how they can come into play -- that we are competing against good-quality individual mom-and-pop stores out there that have very strong relationships and at the same time, some of our suppliers have become more aggressive in employing direct sales mechanisms by going directly to the referral sources. All of these factors have combined to yield this negative for this quarter 1.6% same sales growth for the first half of the year to negative 1.2%.

I'm going to continue down the P&L, but I want to return to the sales situation at the end of the discussion here. In terms of cost of goods sold, as George had mentioned, increased on a percentage basis from roughly 47 to 49.6% or about a 2.5% change due to 2 primary factors. Labor costs are up due to some modest salary increases. We're evaluating productivity measures that we can use to try and better control that, and at the same time, our materials are up 1.8% due to a mix change. We have seen our ratio of orthotics increase, which we know orthotics carries a higher ratio of materials to sales. We're redoubling our efforts in our best value materials program to better manage our material costs to work with our vendors and to work with our practitioners in terms of overall usage of materials. And finally I should note that some of the more recent acquisitions that we've made are not fully integrated into all of our processes, both from a labor and materials point of view. These 2 events of sales, cost of goods sold have attributed to the fall off of our gross margin from about 53% to about 50.4%. But let's go back now to the real focus of the Company, which is building sales for our patient care division. We've known for some time that the major benefit of this Company was scale and size, and we worked a couple years ago in making sure that we put in all of our fundamental processes and got those right. We're now working to make sure that we can use our scale and size to attract new high volume business, which will not only provide more revenue, but also to leverage our fixed cost of labor and administration in our patient care centers. In order to maximize this labor potential, we recognize that we had to improve our patient treatment processes to allow our practitioners the maximum time to devote to the patient flow. In other words, capacity.

One of the answers was Insignia. We've talked about Insignia in the past. It's our proprietary laser scanning system that's used in conjunction with a comprehensive fabrication strategy of national and regional and even local fab centers. We've determined, based on our studies and some others in the industry that using such a system has demonstrated reductions in patient processing time and improvements in accuracy and it really sets us up for improvements in our patient flow. Also to reduce the administrative burden and the number of platforms in our billing and cash application systems, we developed and installed the new billing and collection system called OPS, and George has referenced that before. This has been installed in all but a few of our patient care centers, and will be totally in place by September 30. Regarding our Insignia, we now have trained 260 practitioners, and we are still on schedule to have 300 or more trained by the end of this year, and we believe that these 2 technological advances in systems and in patient processing are going to greatly enhance our capacity and our ability to provide high valued service to clients. So how do we use that? Who are these clients? We announced the formation of a new subsidiary called Linkia. Linkia is in the business of contracting with third-party payers, and it really is first managed care network for the orthotics and prosthetics industry, and in exchange for those national contracts, we offer clean and efficient front end as well as very high quality clinical care to these third-party payers. Last quarter we announced a contract with United Healthcare, and we are in the transition and the ramping up stage on that contract. We expect to see the benefit of that contract through the tail end and the latter part of this year and into next year. And at the same time we're continuing to negotiate with other large national third-party payers even as we speak.

Another area where we expect to get benefit and we've been making investments apparent from the SG&A line is in business development. These are marketing and salespeople that are out in all of our markets and regions. We are now fully staffed in terms of managers and directors. Some of the regions are reporting improved results and others are coming up to speed. The goal is to use this team to capture sales and share by working with our practitioners out in the field and identifying ways that we can satisfy our referral sources' needs. Understanding where we can create value, understanding how we can help them be successful. The third area that we've been working on is a national contracts team. This team is now staffed. It is fully in place. It is regionalized across the country. What this team does is to continuously review and analyze all of our regional and local contracts, with the goal in mind of ensuring that we have current, most favorable nation-type terms and conditions, and we are seeing slight improvement in some of the prices on these contracts where we've gone back and worked with some of these third-party payers. The fourth area that we're going after to try and improve sales is by upgrading our sales tools and continuously offering an outstanding product line of devices to improve patient functionality. We have recently put in and negotiated a deal with a third-party vendor where we're going to have a one-stop electronic store in front for the furnishing of all of our promotional materials, all of our educational materials so that each of our practitioners out there, each of our sales folks can go to this site electronically, pull down the devices they need and have quick and efficient delivery so that these things can be on hand, be current, and be effective tools in demonstrating our ability to provide value to our customers. And at the same time, we recognize the need to continuously push back the envelope on technology. We continue to be one of the leaders in advancing the microprocessor devices, as well as working with some new devices, and currently we're working with a vendor on a vacuum socket system we're currently training practitioners on how to install the system and how to provide better patient benefits, higher price point product.

And we also have some additional products in our prosthetics and orthotics pipeline and in the area of orthotics we designated that as an area for specific improvement several quarters ago. We've been spending money in that area and have brought in a new director of orthotics, we've been putting on patient evaluation clinics in orthotics, and it's beginning to pay some benefits with increased sales. Last but not least, the area that we think is going to provide benefit to the Company in sales is continuing our human resource and development efforts. This is a business about people and for people. We've recently put on another phase in our market leader training in terms of leadership and better management skills. We brought a group of approximately 30 of our new managers from all ranks of the Company together to better educate them and new manager workshops, and we continuously are out teaching enrolling through the Company by bringing in critical job skills such as how to better utilize computers for the electronic and digital age. All that work is ongoing and will make us more efficient, will provide benefits. We recognize that these are trying times and they've got very challenging conditions. We believe we're making the changes to exploit our market share and our scale. These investments that we're making are requiring us to spend funds, we knew that in the beginning, we also have some additional spending that we're going through right now from the regulatory side. We think that they're setting us up to have the processes for the future as well as meeting the requirements of all the regulatory bodies and most importantly our customers and patients. Thank you. At this time we'll open it up for any questions.

[Caller Instructions]. Your first question comes from Harry Rokhoff [ph] of Deutsche Bank.

Yeah, good morning. Just to summarize in terms of the top line, which really is -- what you focused on what I think is most important. It is a very difficult environment. You've initiated multiple revenue initiatives to drive revenue. But this quarter just given the disappointment in the sales mix and maybe some volume decline in your prosthetic business is really what sort of surprised, may have surprised you a little bit in this quarter. Is that fair or --

Well, we knew last quarter when we started looking a bit into the future that some of these programs were going to take several quarters before they grabbed hold. We certainly were pleased with the increase in sales on the orthotics. We had invested in that area, certainly the change in mix commensurate with the change in materials cost was one that we, as I've said, we're going to redouble our efforts in our materials cost area to make sure the best value comes into play, but I think it points out the need for the programs, Harry, that we -- that we've just outlined, and we are investing in those, and we're going to be evaluating their impact over the coming quarters.

In terms of volume that you've seen, I know it's still very early, but, you know, in July, has there been any, you know, improvement or continuation of sort of the weak volume?

We have -- the second, third quarters are typically sort of strong. Summertime is affected by vacation. It's a little too soon for us to be making any forecasts on how the third quarter's going to come out. As we typically see on these things, whether it's a short month or in July you have the holiday, and you really can't make any prognostication until we get to the end of the quarter.

It is fair to say, though, that we don't expect third quarter to be dramatically different from second in terms of what we're seeing from a same center sales perspective. We do expect to see some improvement in fourth quarter related to the effort we've made on national contracts. We think third quarter will be too soon to see anything from that based on what we know today but -- and then in '05 we expect it to really pickup. But we expect a fairly similar third quarter and, you know, there's other things going on like the hurricane didn't help us in Florida which is a pretty big market for us that's been doing fairly well. Closed a few practices for us. But that's pretty much how we see it today.

And then just turning to the expenses, the cost of service, to me it didn't sound -- it sounded like that the growth error, the margin compression was really just normal margin compression associated with rising expenses given in your shift in mix.

Yeah, it is. When we look at the material cost we really feel the increased material cost was tied into both the mix and the pressure that we're seeing on reimbursement at the time, at the present time. The labor and cost of sales is really under good control. It's only risen slightly but when you have that pressure on sales, it makes it rise as a percentage of sales. So you're absolutely correct with regard to that question.

And then in the SG&A, I mean, there is a fairly large increase sequentially and both sequentially and year-over-year. I know you've done some revenue initiatives. How much, you know, is there that's associated with the revenue initiatives that -- investments for the future?

Well, -

- in dollar amount?

If you -- we have -- because there's a number of areas that that affects. Salaries in the headcount, we've got about 750,000 that's tied into marketing, corporate development, product development, efforts that we have. We've got, -- we spend about a half million dollars in the quarter on the OPS and Insignia roll out. Both of those things we think over time will help us. We, we also had other expenditures, you know, probably in the 3 to $400,000 range tied into expenditures we're making on Linkia and on the new products that we're working on that are hitting a number of areas on the P&L. So all told, about a -- probably 1.5 to 2 million in the quarter that's tied directly to our efforts to drive sales.

And then the rest is natural growth.

The rest, some of it is 404 related, there's as I mentioned before, in the quarter there's about almost 2 million that's just simply tied into the acquired practices. That's tied into the sales increase that we have there. And there's some normal inflationary salary sale increases, rent increases. We had about a half -- we spent 600,000 more in liability insurance. Those kind of things.

But ongoing stuff.

Those are ongoing. The only thing I see in the mix right now that should decrease is in '05 the Sarbanes-Oxley 404 stuff should level off at a lower item and actually in the third quarter, the OPS/Insignia costs should -- that was 500,000 in the quarter, that should be significantly less, maybe a couple hundred thousand to finish the rollout.

All right. Thanks, very much.

Your next question comes from Kevin Fischbeck of Lehman Brothers.

Thank you, good morning. You highlighted about a $2.1 million increase in variable compensation, which I guess is just a bonus accrual for the practitioners which I guess is a little bit surprising to me given the negative same-store results and the fact that cash flow appeared to be strong more from stretching the payables than from cash collection. Can you provide a little more color on what was driving that increase?

The year-over-year increase there is really -- if you remember, that plan is a plan that is driven off of cash collections, and the cash collections were strong in the quarter. We had good cash flow so that can have, that can bounce around a little simply because of the fact that a major component of the calculation is cash.

So it's more cash flow than really like AR collection?

It's AR collections, yeah.

Kevin, as new companies come in via the acquisition route, they move on to that plan as well. So if you're just looking at that account on a year-over-year basis, the impact of acquisition also increases the accrual for that account.

If you look at year-to-date, Kevin, the accrual for the first 6 months this year versus last year is about the same. So what happened is there was just some movement between the quarters in terms of the accrual because of the fact it's a cash-based calculation.

Okay. That makes sense. And then let's see. You know, you talked a little bit about negative volume in, I guess, the prosthetics business. Can you give some more color on what trends you're seeing there, and why it's not showing up on the other side of your business and if you could also give a little bit better break out of kind of how much of the negative same-store growth is kind of pricing versus volume?

Sure, Kevin. First let me clarify that the slowing in the growth of the prosthetics on a year-over-year basis where we're actually increasing, but not nearly as dramatically as orthotics and, as a result, that's what's changing the mix. Orthotics has been a target that we went after. On the prosthetics side, what we're seeing, one, is this geographical influence, typically that has been a region that was very strong on prosthetics. Secondly, we also know that there's a little bit of cycling that long goes on in this business in terms of 1 year or for 2 or 3 years you may see very strong prosthetics growth and then it may slow down. The third thing that you see is that due to the -- some of the benefits plan changes, people are not coming in and getting whole new devices. They're coming in for either refurbishing, maintenance, or a tune-up, if you will, but they're making due to with some of the older devices and making them last a bit longer. And then the fourth thing that's impacting this as we know, some of the new technology when it comes out follows the normal kinds of technology curves and particularly let's take a look at the microprocessor. Some of the reimbursements on a units basis in that area, and we are the largest provider of those devices in the U.S. -- have declined. I mean we're getting clipped with some unit reimbursement pressure. Insurance companies are suggesting that now that the volumes are up, they should see a bit of a price break, so they're squeezing down on those, and it's all those factors that are acting on taking the total revenues and slowing it down on a growth basis year-over-year.

Okay. And then you talked about increased competition. Are you seeing it more from I guess, one, between mom-and-pops or one that the referral sources, and then two, is it just showing up more in capturing volume or this kind of contributing to the pricing pressure?

I think you have a little bit of both. Mom-and-pop is always a difficult competitor simply because they run a cash-based business and they're going to go out and attract some revenue and as we're successful in getting some contracts they try to come in some of the back doors on the referral sources. And certainly the other 2 factors that you mentioned in terms of the quest of some of the referral sources that have begun to do some of their own work or some of the direct sales by manufacturers, as they become more proficient in delivering these devices to doctors, it concerns primarily some of the low end, easier-fitted stuff, but nevertheless we are seeing that trend, and I should add that we are evaluating that. And we've got couple of ideas for some pilots in mind, see if there's not an efficient mechanism for us to capture some of that. It's a little too soon to talk about that, but it's under evaluation at the present time.

Okay. And then the last question from me, the Linkia initiative -- you guys had originally outlined a goal of $50 million of incremental revenue in '05. Does that still seem like a realistic target or are some of these issues that we've been talking about kind of delayed the rollout for the impact in '05?

As we look at '05, that target still seems to be a valid target.

Okay. Thanks.

Thank you.

Next question comes from Michael Maguire of Leerink Swann.

Thanks, good morning. Just a follow-up on the SG&A question. Could you just provide some color as to where -- or I guess what expenses came in substantially different than your expectations? I know you've given a good amount of color as to what composed the increase year-over-year, but could you please just let me know what the -- where this came out relative to expectations and what was a little bit higher than you had expected?

Okay. Mike, you know, we went through and did a lot of analysis on that very question and while our expenses are up over the prior year, there are a couple areas where they were higher than we expected. The professional cost associated with 404 is higher than expected. We didn't expected to get hit on renewal with a big liability insurance increase. That's something that we think over time, we actually believe we're getting better service from this new provider and over time we're going to reduce our claims and reduce our cost, but there's been a lot of pressure on liability insurance in general along with, you know, kind of pressure you get on -- recently on D&O coverage. That was not expected. The -- as you know, 1.8 million was acquired practices, we -- you know, that's not part of the issue. The rest of the costs, quite frankly, as we analyzed them were a cost that we budgeted that we believe will be -- are going to be recurring and they're tied into for the most part either our sales generating programs and -- that we -- even though our sales were weak, we believe it would be the wrong thing to abandon or cut back on those, because that's how we're going to start moving the needle, and -- or they are tied into the compliance issues tied into Sarbanes-Oxley and/or improving our systems, improving our -- from an accounting standpoint and billing and collecting standpoint, and our systems from a standpoint of things like Insignia that'll improve our capacity out in the practices. So those are things that were budgeted, unfortunately when they hit, when you have a sales decline they go -- in a pretty much fixed cost model, they go right to bottom line.

And I think it's fair to say, Mike, that, you know, it wasn't necessarily an increase in G&A that led to the profitability shortfall. As Tom pointed out, it's more of a sales issue, compounded by a sales mix change that has increased our cost of materials. Had those 2 items not happened, the budgeted expenses that George went through would have been covered and our profitability would have come in in line with expectations.

Okay. And then on the mix shift, is there anything you can speak to thus far in Q3 that, is this a trend that you're seeing that may continue with regards to pressure on your prosthetics side?

It's too soon to see anything on the Q3 side. Suffice to say that we are pleased with the orthotics side coming up, as you recall, it was a bit weak last year. We are evaluating the role that the microprocessor and some of the new products can play, because they're going right into the sweet spot of prosthetics. We're increasing the number of patient evaluation clinics that we have. So we have observed it, and we're going to go after it.

Okay. And then on the reimbursement pressure, could you -- could you just provide some clarity and remind us, I guess, with regards to how long are those contracts? It seems like there may be some fluctuations quarter-to-quarter whether it be from the government side or the managed care payer side. Could you just provide some color as to how those negotiations typically occur, how long a price may or may not be locked in, and then the implications with regards to your operations quarter-to-quarter?

Most of the of the contracts are annual and they come up for annual review, negotiations on the larger ones typically occur toward the third and fourth quarter with a commencement of early in the year. The federal government just works straight off of its Medicare fee schedule, and we know that beginning in July -- or excuse me, January 1 of this year, the fee schedules were in place. Some of the reimbursement pressure that I mentioned in terms of evaluation of specific devices, that goes on on a continuous basis, and so we have seen, for example, some evaluations on a device and it was to be effective on July 1, and then also throughout the year, we're -- through our contracting team and actually through even our practitioners and our market leaders always looking for opportunities to pick up new contracts. And when they become available, and less say it's with a local hospital, that is on the date when we can get the signing, so we may pick up a several hundred thousand dollar contract with a local hospital May 1, something like that and it typically would run on an annual basis. So there's quite a mix in terms of how they come on and how they go off. And in terms of how they impact our operation, we usually see the most profound effect as we go into the beginning of the year, because they are the larger contracts. And that -- as I mentioned, that season of negotiation typically is at the third around early fourth quarter in the year.

Would it be fair to characterize that the majority of your revenue as, you know, locked in terms of pricing as of 1-1-04, as of the beginning of the year?

Yeah, that's pretty fair, because they are -- they're referencing to fee schedules that are established, but they're subject to modifications through the year.

Right, I'd say the one exception, guys, as Tom mentioned, the constant re-evaluation of the L codes, which in past years has -- used to be neutral, and we're seeing that being slightly negative from a standpoint of reimbursement.

Okay. Fair enough. And I'll just have -- I'll throw one more out there and jump back into the queue. Could you just define what resolution would mean as you sit down with the credit holders on the debt covenant? What exactly would resolution mean to you guys, and what are the implications on your cash, and potentially on your P&L going forward, if there are any?

The number one thing we have to fix is we have to cure the covenant default. Whether that means waiver or amendment, we'll work through that in the coming weeks. You know, it's probably premature and it's probably not the right forum to discuss potential ebbs and flows in the agreement. I think it's more appropriate to come forth after the document has been signed up and report what has changed.

Okay. Thank you.

Your next question comes from Jeff Moore [ph] of Aris.

All my questions have been answered operator. Thank you very much.

Thanks, Jeff.

Thank you, guys.

Your next question comes from Robin Russell of Anaram [ph].

Sorry if I miss this had already, but could you walk us through the difference between the earnings before taxes that you report the in the NT 10-Q versus what you reported this morning?

Sure. I mentioned the process that happened. It really -- the entire difference is due to the restatement where we wrote off accounts receivable that in the 12(b)25 filing that was required to show an estimate of earnings, they were -- that write-off was entirely made in the current quarter. And as we evaluated that accounting issue, and it was tagged as a prior period adjustment, most of that adjustment ended up being restated in the prior years. So that accounts for the entire difference.

So why not actually outline that in the release instead of opening yourself up to the liability of putting that NT 10-Q out there, and having the big, you know, downturn in the stock and a big downturn in the bonds?

Well, we were following the advice of accountants and lawyers. We were advised that the disclosure made should be the most conservative disclosure which was to account for it entirely in the current period since under both scenarios either a change in estimate or a prior period adjustment, it was possible in both cases -- well, it was definite it was a change in estimate being a current period. Under the scenario of a prior period adjustment, there's still the possibility that it would be recorded as a current period adjustment depending on the test we had to do that wasn't -- that had not yet been completed. And that was the advice we received, you know, with 20/20 hindsight, it could have been done better or a little different. I -- you know, certainly it could be done better. Quite frankly, the Company had never been -- encountered an issue like that before.

Okay. And I guess just given everything that's happened, I'm surprised that your CEO couldn't change his arrangement to actually be on this call. It would be nice to be able to hear from him.

Well, in his defense, this date had been moving and until the final resolution of the accounting change that George spoke about was finalized and we nailed all that down. As you know, we moved this date and by the time this date was actually locked down, his business meeting couldn't be moved and so, that's why I tried to explain up front. He certainly is aware of all that's going on, and as you know he runs very open door policy and certainly will be available for any subsequent follow up discussions if you'd like to do that.

Alright. And just lastly, it sounds like you're encountering certain weakness across different regions, and I guess realizing that, you know, people have to pay some out-of-pocket copays when they're buying prosthetics or orthotics, I realize that, but at the same time I'm just curious, I mean these are things that people actually have to buy. Is it that people just aren't getting upgrades, or they're doing the least amount of possible because they just can't afford it. I guess I just don't understand how the economy can really be negative on this.

You know prosthetic care as device that most Americans probably will never have to pay for. And when you think about the cost of a new device, the historical replacement cycle has typically been 3 to 5 years, and a typical below knee prosthesis costs you anywhere from 8 to $12,000. If your copays and your deductibles increase, and require an out-of-pocket expenditure of 1, 2, or $3,000 to replace the device, especially with the current state of the economy, a lot of patients might opt to stretch that replacement cycle from 3 to 5 years to 4 to 6 years or 5 to 7 years, coming in for maybe a repair or an adjustment and pushing off the replacement. So what you're doing is you're capturing revenue from an adjustment or repair in lieu of a replacement.

Okay. Thanks.

Your next question comes from Randy Gulk [ph] of Munazinage [ph].

Yes, hi. Couple questions, one is you mentioned that the fixed cost nature of the business model, but just, you know if you fail to jump-start the revenues with some of the initiatives that you've put in place, obviously when you've got increase in expenses, you know, the result is a pretty disastrous outcome. What could you do, or how could you reconfigure the business model to become, to increase profitability? I know you don't want to do that right now, but let's say you get to early '05, what are the options?

Certainly as interesting question and it's one that we are evaluating. We do feel first I want to be very positive in saying that we do feel that some of the activities and the programs that we have in place do provide the leverage on the fixed cost model. Should that not be the case, it's too early to discuss possible changes in the business model that you've alluded to here. We certainly recognize that as something that needs to be evaluated. It's too soon at this time for us to start to second guess and talk about elaborate changes in the business model.

And I think it's also, you know, fair to point out that we have good visibility into the results of these efforts, and with Linkia and with some of the other others, we are pleased with the progression of the results. Two, three, four months from now, we will have good data in front of us to make the appropriate decisions, but as Tom pointed out, at this point we feel very comfortable with the investments made and the returns that have been generated to this point.

And can you just refresh my memory? I missed the number on Linkia. Was that 50 million in the year or was that 15? I wasn't sure on that. Also on the other sales initiatives, what are your expectations for 2005?

What we've announced for Linkia in prior publications was that we felt that it would provide a minimum of 40 to $50 million in the year 2005. So it's not 15.

Okay.

It was 40 to 50.

Okay.

And on the other efforts, each has individual goals which we are measuring and we would be more comfortable talking about those a little bit later in the year because they are in the ramp-up stage and, for example, even with our business development managers that are out there, this was a team that we put in place in the fourth and first quarter of this year. We've had to even go back in and make some changes not only to the program but to the personnel. So these are efforts that are launching off our Insignia scanning system, while it is primarily a capacity and patient treatment device, we have noted that it has certainly benefit in terms of media days, inspiring interests, opening doors, and we believe it has the capability. Last year at this time we were just getting this program launched. At year end we had about 96 to 100 of these devices out, so we're tracking them but we are not in a position now where we'd be comfortable making any prognosis about those programs into 2005.

Okay. Anything, I guess you wouldn't be able to give one on a total combined basis then, either, for that, for the regional sales, executives, et cetera, as opposed to giving independent individual prognosis?

Obviously we will evaluate the cost associated with that investment versus the return and we just deployed these guys at the beginning of the year. We got to give it some time to get some traction, and we'll be looking at that at the end of the year.

Can you just walk us through the cash flow, how you got from the $1 million at the end of the quarter to the $18 million before the interest payment?

Sure. We normally had strong cash flow during July and into August. As I mentioned before, we generated about $20 million in cash flow from operations in second quarter. Third quarter, we'll be close. There was about $5 million borrowed that was part of the cash balance that you mentioned, the $18 million. But most of it was generated from operations.

So in the third quarter you're saying cash from operations will be close to what it was in the second quarter?

It's going to be a little less.

Okay.

We've got a -- we pay a bond payment in the third quarter, and we have a advance on the variable compensation to our practitioners in the third quarter, so it will be a little less.

Okay. And so you borrowed 5 million, so currently you have, is it 45 million under the revolver?

45.5.

45.5. Okay I'll get back in line and let someone else ask.

Okay.

Thank you.

Your next question comes from Steve Abrams [ph] of Grey Wolf [ph].

Hey, guys.

Hey, Steve.

Hi, Steve.

We're having a hard time hearing you, Steve.

Can you hear me better now?

No.

Barely.

How about now?

Great.

Sorry about that. Can you talk a little bit more about these contracts that are coming up for renewal in Q3 and Q4? Do you have any sense of visibility on whether or not pricing's going to be up, flat, or down?

I think the discussion was about what was the typical contracting season and then I had made some reference to it last year where some of the national folks were trying to exert some volume pressures on the negotiation. Part of the Linkia strategy is to get out in front of this, Steve. It is specifically to offer them a better package. Left to the typical kinds of negotiation, it comes down to at what price will you take care of my membership's prosthetics and orthotics needs, and so what we're intending to do with the Linkia program is to -- and we have had discussions with all of the 6, 7 major healthcare companies regarding moving them on to Linkia which has a tremendous amount of value in terms of reduction of their administrative costs and also in the form of partnership of working with them to better understand their actual clinical costs and help them manage that. So at the present time, we believe that the best road for them and the best road for us is to pursue the Linkia approach through what I would call the managed network of care. It's too soon to look and say if they choose not to come into this program and work with us, where might all of this go? We believe that we can best service their needs through the Linkia, so it's too soon to really be looking at that and typically what happens, we don't see a universal approach to negotiations. I mean, it's not a case that's so much like liability insurance where the overall market is up or down. These are ebbs and flows based on the financials of each of the specific carriers. It is largely driven by how big their reserves are, what a lot of the state insurance commissions tell them they have to do with their premiums, and so we don't find the blanket statement that goes across and says well, this will be tough negotiating or easy negotiating here, and we really have to wait until we sit down across from the table with the individual parties, determine what their needs are and where we go. But as I mentioned before, we are trying to get out ahead of this, particularly with the large nationals by actually offering them a better package.

And as you pursue Linkia, are you -- is that part of what's causing more competition from the mom-and-pops, in other words, as they kind of look across the landscape and see you guys potentially sign up some of the large players, is that sort of changing the dynamic a little bit in the market?

There's no question that when you push in on this it's like pushing in on a balloon and you push in on one place, and it's going to pop out somewhere else and we'd be naive to sit here and think that we could be successful in Linkia and it wouldn't pop-out somewhere else. And I believe the answer to question is yes, which is, frankly, one of the reasons that we have our business development managers out there, because they are local on the ground, they are intimate with those referral sources. It's another reason why in preparing the overall strategy here, we put the team of contract administrators out there so that they could stay current with that. We don't want to wind up just doing a major rotation among all the payers. But yes, you are correct, and the other thing that is driving some of this competitive behavior across all the fronts is the fact that whether you're a doctor, whether you are a device provider, in one way or another the reimbursement squeeze has impacted on all these folks and there is a relentless search for finding additional revenue out there. And so what you see is across the healthcare professions people invading each other's space, and that's why I've said we've got some pilots that we're contemplating to try and sort of preemptively stop some of that migration into our space.

And that's where competing with a unsophisticated competitor is a difficult situation. The mom-and-pops make decisions on contracts at times that just make you shake your head, and even if they're open panel contracts, we have to walk from some of those things because the margins are just nonexistent.

Right. And then can you talk a little bit more about the impact you're seeing from suppliers, and just as a thought, I would think that you would see more of a impact on the orthotics side than the prosthetics side. If you could speak to that as well, that'd be helpful.

Are you talking about increased prices from suppliers?

No. You made a reference, I believe you made a reference to some of your suppliers basically going directly to the referral sources.

On the orthotic side, uh-huh.

It is on the orthotic side.

Can you describe what exactly it is that they're doing?

Well, sure. A manufacturer employs several different channels of sales teams. They have in-house employees. They run their product line through representatives, their manufacturers' representatives, and they've been beefing up those channels in terms of the number of personnel and the sophistication of their delivery. One of the ways that they beef it up is instead of just using a sales-type representative, they may go out and actually hire a certified fitter, or they may even go to a higher level and hire physical therapists, or an orthotist, employ those folks to go out and start working with doctors and hospitals to move the product line directly. So it is a competitive dynamics of the field. It's a relentless search to try and figure out how they can get more volume, and in some cases they've even obtain some contracts, so that they can do the billing as well. So that was the reference to the direct sales. It's that changing dynamic in their channel of delivery.

Can you name some of the folks who are doing that?

Well, I don't think it would be -- as we are customers of theirs, and we're partners with theirs. We're competitors and partners.

Fair enough.

And so it's all the usual suspects.

Okay. Okay. Thank you very much.

Thank you.

Your next question comes from Beckett Wolf [ph] of Laurel Ridge Asset Management.

Hi, guys. I just wanted to confirm. You said your operating cash flow for this quarter is going to be just slightly less than the last quarter. Is that correct?

For the third quarter, yeah, it's going to be -- it'll probably be in the order of 5 to 7 million less than last quarter because of the payments I outlined.

Okay, so 5 to 7 million less. And then with respect to the bank group, I mean, what -- obviously you've got the meeting tomorrow. Where are they, obviously the revenue's going to be -- is a big issue for them, but where have they been focusing their efforts at this point in terms of trying to understand what's happening with the business?

You know I think their analysis is very similar to your analysis, and I think the discussion is going to be centered around what is your current baseline run rate, what are the opportunities for improvement, both in sales and in profitability, and we'll walk them through that tomorrow.

Okay. And then heading into the fourth quarter, how should we be thinking about the cash flow? Obviously understanding you're going to have the different levers, you know, revenues and costs, but should we be assuming that third quarter run rate continues, or how should we think about that?

When you think about the payments payment cycle of our Company, we have a bond payment that's due in first quarter and in third quarter. We have a bonus pay out that 2 years ago was in the first week of the fourth quarter, and last year was in the last couple weeks of the third quarter, so if the bond payment -- or the bonus payment is in the third quarter of this year, we don't have any large payouts in the fourth quarter. You have good collections off of second and third quarter revenues. So you have a quarter that's fairly similar to second quarter.

Perfect, okay. Thank you.

Your next question comes from Ellie Randiski [ph] of CitiGroup.

Yeah, hi. Just a quick question for you regarding costs. Obviously, we had a significant increase in SG&A and material cost in the quarter. And you know, just the question is is, do you think that costs are now going to be contained at this level or do you expect to see costs continue rise off of these levels?

Some of the programs that we've outlined so far will be continuing through this year. There are others such as our OPS roll out, for example, which was the billing platform that we expect to have complete by the end of the third quarter. We also know that these regulatory requirements aren't going away, and we are faced with the challenge that every other public company is of getting process controls, etc., maps, templates, you name it -- all in place for a fourth quarter walk through and subsequent audit by our auditors on the SOx 404. So while at the present time, while we don't expect to see any major decreases, we don't expect to see any major increases off of what we've currently been running.

You know, there's one exception to that. We should see some increased Linkia costs in third quarter. I think the other things Tom was talking about, the OPS cost should go down a little bit, the compliance costs are going to go up a little bit. We think our run rate's going to be about the same as the second quarter. We're going to have costs of this investigation in the third quarter and we can't sit here and quantify that. That's all hourly rates for attorneys and it depends on how active the investigation is. The -- so Linkia costs and the investigation costs will be the only 2 new things in our mind in the third quarter, the base that are at at second should be about the same at third, other than those 2 things.

So, in other words, we should be expect EBITDA to be further pressured by those 2 items, and since you already said that you think the same-store sale trends are going to be relatively where they were in the second quarter, we should probably see EBITDA fall slightly from these levels?

We're seeing it, we think it's going to be either in a range of, you know, probably a million either way of, you know, where we were in second quarter depending on how those costs play out. We think our sales will be a little bit stronger.

Okay.

You know, we don't think it's going to be much below second quarter, you know, that's our gut feeling at this point.

Okay. Now since pricing power is relatively limited here, what is your expected return on the investment of Insignia? Is that -- are you going to get more business because of the additional quality that's going to bring to you, or do you actually believe that people are going to pay more because you actually have a better fit?

I don't think since the rates are all specified in the L codes, it's not realistic to expect that the better fit is going to result in the higher unit payment. We think Insignia is going to pay dividends for in us 2 ways. One is that we believe it opens some doors and it allows us to get in front of people and actually have them understand the Hanger story, and the device in and of itself can provide better patient care, thereby satisfying a doctor or a patient with the assurance that they're getting the best that technology can bring. We all want to go get the best when we're paying the dollar. And the second advantage of Linkia is that we have been able to demonstrate by actual tests with our practitioners where they have reported that they can process patients more effectively in a cleaner environment so it's a little bit more user-friendly. So it increases our through put, and as we've talked about, the ability to go out and get some of these volume contracts on a national basis is key. We've also understood, and we're working with the appropriate insurance company in this case and future companies to understand where their membership is. We wish that that membership would report uniformly across all of our patient care centers, but, you know, that's not going to be the way. It will be concentrated in certain areas, and we think that by using Insignia we'll be prepared, ready, willing, and able to handle their loadings needs so it becomes what he I would call a capacity enhancer.

You also mentioned, I believe in the queue, that were in the midst of negotiating and potentially announcing another large national contract. If you do win that contract, are you planning on releasing a press release?

Certainly anything that is of a material nature to the Company we want to share with the investment community. And we are in the process of negotiating with several of these companies now. So when we're favored with a contract, we certainly would be very proud of that to announce our new partnership with these fellows, and would make a press release.

All right, thank you very much.

Thanks, Ellie.

Your next question comes from Casey Klegar [ph] of Luxia Swan [ph].

Hi, thank you. The first question is on the 3 central billing offices that haven't been put on to the OPS system, do those constitute a large amount of the collection cycle, or is that a small amount in terms of percent of billing?

Percent of billing it's a relatively small amount.

Okay, so that's not --

When we say central billing office it's more of a --

It's more collections.

-- collection, it's a group of 4 or 5 offices in a geographic territory.

Okay. And when are -- what are sort of the plans and the tim table to bring in those 3 central billing offices?

Third quarter. They require a multi-user version of the system that's not yet out of test. So it's going to be towards the end of this quarter, but we expect to get everybody pretty much -- everybody on the system by the end of the quarter.

Okay. And then in terms of the West Hempstead facility, how many other patient care centers are in the scope of the independent investigation as it is now? I think you referenced there are some, and I just wanted to know if you were able to provide more specificity there?

I believe the prior press release discussed that 13 centers had been included in the original subpoena. Beyond that we can't give any more color at this time.

Okay. That's helpful. And my last question is just in the back of the queue, I guess it highlighted some deficiencies on internal controls, but didn't go into great detail. Can you just tell me what steps you guys are taking on that front? Are you comfortable with those steps to date, et cetera?

Well, the -- what that's referring to is that -- and we believe we have dealt with the issue, the OPS system is what gave us the additional visibility of our AR and identified this adjustment that we reported in the second quarter. So getting our practices on one platform, they used to be on more than 15 platforms, has in our judgment resolved an issue but in hindsight we, you know, we felt the amount of that adjustment identified that there was an inherent weakness in the previous 15 plus platforms that we had.

Okay. Appreciate it. Thank you.

Your next question comes from Ray Garson of UBS.

Thanks, just a couple of quick ones. First, with respect to the special investigation, you talked about charged in the third quarter. Did you all accrue any expense in the current quarter, and then is the intention in the third quarter to break that out as a separate line item on the P&L, or just embed it in the SG&A.

We didn't mention anything about a third quarter charge. You have us as a disadvantage there. I -- you might be misreading something.

I thought you said you expect to incur charges associated with the special investigation investigation in the third quarter in an answer to a question that Ellie asked about margins.

Okay, I'm talking about the professional fees. You know, we -- the audit committee employed a special investigator to do an independent investigation of this matter. They hired forensic accountants to assist them. We're going to pay their professional fees.

No, I understand that, but my question is did you guys accrue any expense associated with that special investigation in the second quarter, and then in terms of just the accounting for that, incremental costs related to that investigation, is that -- will that be a line item on the P&L, or will that be embedded in your SG&A?

The -- we don't -- it depends on the materiality of the number in the third-quarter results, and we do not know what -- how material the fees will be because they are billed on an hourly basis.

Okay. And there was nothing in the second quarter as it relates to an accrued expense?

There was no accruals made in the second quarter other than fees that had been billed for work that was performed in the month of June.

Okay. And then just in terms of CapEx going forward, could you just give us -- I assume that that should tailor off here through the back end of the year, given the completion of the billing and collection. Is that accurate?

It you should. We're probably going to be in the neighborhood of 6.5 to $7 million for the balance of the year.

In total for the balance of the year?

Uh-huh.

Okay. And then I think you also said earlier that cash flow from operations in the third quarter of kind of 13 to 15 million and in the fourth quarter, 20-ish, kind of consistent with the second quarter and then with the lower CapEx that throws off some good free cash flow. Can you give us perspective for what you might use that for? Is it debt reduction here, given kind of the change in near term profitability outlook, or are you still looking at M&A type stuff?

Our objective is primarily debt reduction. The cash flow from operations for the third quarter I think you overstated a little bit. George said I think 5 to 7 million --

Right, versus -- I'm sorry, go ahead.

Right, right. But, yes, your analysis is correct. It will be used for debt reduction.

But, so just -- I want to be clear here now. You said 5 to 7 million down from the second quarter. Am I interpreting that right, or no?

We have an interest payment that we just made of 10 million.

Right.

And we have a -- we'll have a payment in advance on our -- to our practitioners on their bonus that will about 7, 8 million, so we're probably going to be in the 5 to 7 million.

Not reduction, 5 to 7 total dollar cash flow from operations.

Okay, okay. Thanks for that --

Because you're relieving a couple of accruals.

No, I understand, but I misinterpreted -- I'm glad we clarified that. And then the final thing was with respect to DSOs, you talk about a target to getting down to 70 in '05 -- is that something -- do you hope to get some traction and maybe a little sooner than that now that the system's largely in place, or the working capital kind of outlook just more generally, can you give us some color there?

Well, we need to do some work to get down below 70 days. Now that we have the system, we -- and we concentrated on getting it up and having it not impact the operations of our practices, we're going through a process of writing reports to make it easier to manage our receivables and working with the practices to improve their work flow around the new capabilities of this platform, and that's going to take some time. We expect to have some impact in '05. We don't expect to dramatically reduce our DSOs this year, plus there's a few things that are going on that we can't control. The Medicare -- one of the demarks is rejecting an unusual amount of claims and while that hasn't affected collectibility, it has stretched out those claims. That activity is going to continue through most of the rest of the year before that plays out. So we think we'll have some impact next year to answer your question. And we think this year we're going to be positioning ourselves to get to that point.

Ray, I just want to add that that that region C demark that George was talking about is not just for Hanger, that is across the whole industry, and other companies are reporting the same degree of frustration with the delay in getting paid.

Okay. Thank you.

Your next question comes from Joe Gaggan [ph] of Atlantic Equity Research.

Yes, hi. I just have 2 quick questions. You referred to, a couple of times, the state of the economy. I just wanted to try to understand what you think of that, and then I just want to understand, it says in the press release about an error that led to an overstatement of receivables and an equal understatement of bad debt. What exactly was that error? Those are the 2 questions.

Let me take the first one, Joe, and then George will take the second one. When I refer to the state of the economy, I'm really looking at the quality of jobs that people have and there has been some rotation. We read about it in the paper, and we certainly see it on the local level where people have had higher paying jobs, for whatever reason they've been phased out over the last few years. We noted along with other healthcare industries that they lost benefits at this time. Cobras ran out, et cetera, they have replaced those jobs with some others. Typically they're lower paying jobs and the benefit programs are not as good. They have lower levels of benefit and higher levels of contribution. So when I'm looking at the state of the economy, it's through the eyes of our patients in terms of what is kind of coverage that they really have on their benefit plans that's coming from employers or the kind of programs that they can buy themselves. If their seniors, in conjunction with the Medicare or Medicaid state program. So it's all with that particular bias of who's paying the medical bill.

Okay.

Because that he is the part that we have to look to for reimbursement.

Okay.

As far as the adjustment was concerned, the -- when we got all our practices except these 3 central billing offices on the one platform from over 15 platforms, we identified receivables -- some receivables that were not collectible. That the -- that they were receivables that we could not properly identify when we had all these different platforms that had different methods of tracking AR, and once we evaluated that, using -- you have to use 20/20 hindsight when you evaluate a situation like that, and either have an item that was a estimate that was off or an item that you -- if you had all these systems in prior years, or had the new system in prior years, you would have been able to specifically identify that this receivable should have been written off at that point. And if that's the case, if the adjustment's material to any of the periods involved, you have to go back and you have to restate.

Okay. Alright. Thank you.

Your next question comes from Mohsin Gadit of RBC Capital Markets.

Hi, there. Just 2 quick questions. I think the covenant that was violated was a 4.7 times maximum leverage covenant. If you were to modify that with the banks, what would you like that to be raised to? That was number one, and number two, if you do get the modification or the waiver on the covenants what will be new availability on the revolver?

Again, I think it's premature to talk about that outside of the bank group, and as soon as that amendment is signed I would be happy to talk about the agreed upon results. And I can't really answer the second, until I know what that level's going to be. But in our discussions with the bank, we will put out a business plan and discuss the needs of the Company and we will operate within that band. So I will come back to you and answer that question in a couple of weeks.

Okay. Great.

Your next question comes from Darlene Hawk of [Inaudible -- background noise].

My question was answered, thank you.

Thank you.

Your next question comes from Harry Rokhoff of Deutsche Bank Securities.

Yeah, guys. Just a quick follow-up. You mentioned -- sort of gave the guidance on the operating cash flow for the year with third quarter being down a little bit because of the coupon payment and the bonus payment, and operating cash flow being back to about second quarter and the -- in the fourth quarter. Does that mean EBITDA, which is going to be sort of flat second to third, is probably still along that same line in the fourth quarter?

You probably see benefit in the fourth quarter from the beginnings of the revenue through input of Linkia, so you could expect, you know, 5% higher EBITDA levels.

Very good. And then just on Linkia, at least I don't know, I know you did a $50 million as sort of a goal in terms of the revenue. The profit margin on that business as it rolls in, what do you anticipate there?

The throughput of Linkia is probably going to have an incremental margin excluding the sort of fixed cost of setting up Linkia. The business that hits our patient care center will probably have a 30 to 35% fall-through margin.

35.

For the first 40, 50 million. At that point, you probably have to reevaluate your fixed cost structure and add resources to process additional work, so you might have a diminished return and kind of a plateau step effect. As far as the Linkia cost you have, you know, you know, a 6 to $8 million investment in the Linkia fixed cost structure in order to process this work on an on going basis. The good news there is the incremental work, or FTEs that you need to process additional work is very minimal, because most of it is electronic and automated.

So the 6 to 8 million is a recurring annual expense.

That is now part of our fixed cost structure.

Now part of your fixed cost structure. The 30 to 35 million in sort of margin on that business is --

-- 30 to 35% of 50.

Sorry, sorry.

It's alright.

The 30 to 35% margin on that business is before those fixed expenses.

Correct.

And you believe there's some leveraging that you can do after that, --

Correct.

-- And if you go beyond that, then you might have to ramp-up a little bit on your underlying fixed costs.

Correct.

Not dramatically but . . .

There's some variables that we'll have to evaluate as the revenue comes in and that is the benefits out of the Insignia system that Tom mentioned, how much the efficiency that gives us, and the efficiency of just the leveraging of the fixed cost structure and our personnel. We'll evaluate that over time and add the appropriate amount of labor to satisfy that demand.

And the geographic region of the existing versus any subsequent contracts that we may receive would obviously, one in the southeast and one on the west coast would be an entirely different matter than two in the southeast, so that's where this geomapping becomes very critical.

Thanks very much.

Thank you.

Your next question comes from Randy Gulk from Muzinich.

Yes, hi. Randy Galope [ph] from Muzinich. I have a question on the credit facility again. I guess the thing that boggles my mind a little bit is the timing, I know you had a lot going on in the recent past but I guess with Tom -- Tom, even with your experience in the past with Jay Alex, why was it so close and why weren't you working with the banks on this on an earlier basis? And then my next question is you said that you would announce the changes of the credit facility when they are made but when will you actually file the credit agreement?

The credit agreement will be filed with the third quarter Q as an attachment I would imagine.

You mean when the changes were made?

Right.

And, you know, we couldn't work in advance with the banks until we knew what our results were. That was pretty critical. And we've been wrestling with the accounting issue that I described before sort this past weekend, so we had to go to them with numbers and we felt, you know, given that we have a public/private syndicate in the banks, we wanted to be extra careful in terms of what information we disclosed before we had information to disclose to our equity holders. We didn't want to risk anybody getting information or, you know, possibly passing information on to the public before it was ready for disclose.

But of the covenant facility, the covenant was getting close already, you know, depending on where numbers, I guess where your expectations were but it was already fairly close even at the end of the last quarter.

We were 4.39 times at the end of March. Our covenant limit was 4.75 times. Debt reduced during the quarter. It went from 434 million down to 420 million. The earnings as we've discussed them today drove the covenant violation, and as George mentioned and I've mentioned in the past, we did not have a number to take to the banks as it related to West Hempstead, as it related to this AR adjustment, as it related to our bottom-line profitability until we went to the agent bank a few weeks ago and discussed our prognosis. We got on the phone with the banks last week and discussed our liquidity position and discussed our timeline and expected timeline going forward. And now we're going to meet with them tomorrow and go through the items that we need to address.

And the -- you indicated that you expect to have this result before Labor Day, which obviously is early September. You know, given the situation and the lack of ability to borrow that just seems, I know we're dealing with the summer and people traveling and I know it takes time for the credit facilities -- for banks to -- or for the banks to go through the process but, isn't that quite a lengthy time, or are you just being conservative on that length of time. And, you know, are you absolutely certain you've got no problem until then?

Well, we're going to ask the banks for a forbearance agreement, and we're going to ask that to be signed up before we get the amendment. We want to give everybody time to be able to be comfortable with the numbers and projections that we give them before they are asked to make any changes to the agreement, so from a fiduciary responsibility standpoint, we're going to ask for a forbearance agreement so we have access to our line prior to the -- amending the agreement, and we would expected to get that sooner than the date of the amendment. In the interim, as we disclosed in the pressure press release, prior to making our interest payment yesterday we had $18 million in cash available in banks so we think we have adequate cash flow. We don't make the practitioner variable comp advance until the end of the quarter. That's well after we feel we'll have a amendment signed or have something done with the banks and so if, quite frankly, if we didn't feel comfortable we would have made different disclosures in the press release and in the 10-Q.

Thank you.

Your next question comes from Steve Abrams of Grey Wolf.

Hey guys, just a follow-up. I think I heard you say that Q4 you would expect EBITDA to be up 5% from Q3, and if you could just talk about that, I guess I've always under the impression that Q4 tends to be a little seasonably soft, with the obviously the March quarter being softer, so if you could talk to that, that would be helpful.

It's mainly throughput of our initiative Linkia. We expect to start to see some traction in the fourth quarter, ramping up to a $50 million run rate for '05.

Do you have a sense of how much Linkia will hit Q4?

Our estimates are in the single digits. But we'll report that as it comes in.

And if Linkia -- and that's 30 to 30 -- I'm sorry?

I was going to say, it's a function of how quickly we can move through the transition with our partner.

Right, and that 30 to 35% incremental margin, that's EBITDA margin or --

Yes.

Okay.

That's not to the consolidated entity, that is HPO business generated from Linkia. The costs -- the fixed costs of Linkia are underneath that.

And if you do, let's say, 10 million or a little less than 10 million in revenues and, you know, I guess basically generate around 3 million of EBITDA and you have 2 million of cost, that's basically the 1 million you're talking about?

That's one way to derive it, yes.

Okay. But you don't expect to see seasonal softness?

Actually the past 2 years' fourth quarter has been strong and it's kind of refuted historical norms.

The sales are usually a little stronger than prior quarters. So we don't expect it to be behind second or third quarter.

Okay. Thank you.

Thank you.

At this time there are no further questions. Mr. Kirk, are there any closing remarks?

Well, I wanted to thank you all for your continued support and understanding through this period. We certainly are very sensitive to the releases that we made and their impact. We, like you -- you are our investors -- are as determined as we possibly can be to cooperate with all the people on the outside and get through these investigations and other matters as quickly as possible. So thank you for your continued support. And we will be talking to you at the end of the next quarter, and if there are any material announcements we certainly will be making press releases in the interim. Thank you.

This concludes today's Hanger Orthopedic Group conference call. You may now disconnect.