Hanger Inc (HNGR) 2005 Q1 法說會逐字稿

Good morning. My name is Crystal and I will be your conference facilitator today. At this time, I would like to welcome everyone to the Hanger Orthopedic Group First Quarter Operating Results Conference Call. (Caller Instructions.) Thank you. Mr. Ivan Sabel, you may begin your conference.

Thank you, Crystal. Good morning, everyone. As you all know, we released first quarter results last night at the close of the market. Certain statements included in this press release are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Please refer to the Company's SEC filings for factors that could cause actual results to differ materially from the Company's expectations.

We reported last night first quarter net income of $1.3 million, EBITDA of $14.6 million, and our EPS was about a penny ahead of Street consensus. As expected, as sales continued to be similar to last year at about a 1.7 percent decline in our patient care same store sales. This continued decline is in large part due to continued reimbursement pressure at the private pay HMOs, and of course, the freeze on Medicare reimbursement. However, I'd like to point out that our backlog of business or what we refer to as our "work in process" continues to be at very healthy levels, although moving somewhat slower through the system due to increased regulatory and administrative requirements. Had we been able to accelerate the delivery of our growth in work in process, we would not have experienced a decline in same store sales.

We continue to work on programs that will help accelerate this process and enable us to better meet our revenue goals. We have a number of revenue enhancement programs underway that we expect to start seeing results from in Q3 and Q4. Tom will, of course, go into more detail in his discussion on operations.

Linkia continues to be a key part of that growth strategy, and we continue to have confidence that another major national insurance contract will be consummated as we previously reported by the end of Q2. We continue to see serious interest on behalf of all national insurance providers in our Linkia program.

The last topic that I would like to update everyone on is the West Hempstead investigation. We have had no further requests for information since the end of '04 and there is nothing new to report. With that, I would like to turn the conference over to George who will walk you through the numbers.

Thank you, Van. Good morning, everybody. For the quarter, sales increased by $1.4 million, principally due to a $1.1 million or 12.3 percent increase at SPS, our distribution business, along with a $2.1 million increase from acquired practices. These two increases were offset by a 1.7 percent decline in comp sales in our patient care centers. Cost of sales. These were increased in total dollars by $400,000 and as a percentage of sales by 1/10th of 1 percent from 21.9 percent to 22 percent compared to the prior year. And this was really attributable to normal pay increases that took effect on 1/1/04 and averaged about 3 percent, and in combination with the comp sales decline. Our materials were accrued at a rate of 28.2 percent for the quarter, which is our budget for the year compared to last year's accrual rate of 27.3 percent.

SG&A, as mentioned in the press release, increased by $3.5 million. This increase was due principally to $900,000 and expenses that came along with the acquired businesses, $500,000 in salaries and benefit increases, mostly again, the normal increases that were roughly 3 percent on average, $400,000 in rent and occupancy, $800,000 in spending on the Linkia and Innovative Neurotronics efforts, and the remaining $900,000 was in other costs.

The results I just discussed, for the reason I just discussed, the EBITDA was $14.6 million compared to $18.8 million last year. Our interest was approximately $800,000 higher than last year, that's despite a $22 million decrease in debt year-over-year, and that's principally due to higher variable interest rates.

Our deprecation was $200,000 higher than '04, but less than we projected for Q1, in part due to the fact that our additions for the first quarter were lower than expected, and I'll get into that in a second. Our net income and EPS, due to the above changes, was approximately $400,000 higher than we expected in our internal projections, and about 2 cents a share better than we had expected.

On the balance sheet, our cash was essentially at the same level it was at 12/31 at $8.3 million. Our AR decreased by $6.4 million, due to the traditionally weak sales in the quarter, compared to year-end. Our DSOs improved to 65 days compared to 69 at 12/31/04. That was the best DSOs we've had really since the merger with NovaCare in '99. AR over 120 increased to 25 percent from 23.8 percent at year-end. The dollars in this category actually went down by $100,000. The weaker sales in Q1 is what caused the change in the percentage. And in part, that number is staying at that level due to continued issues with appeals in Medicare Region C, which we do not believe will lead to an increase in bad debts, but it does lengthen our collection period.

Our reserve increased slightly from $5.3 million at the end of the year to $5.7 million at 3/31. Our inventory increased by $1.1 million to $68.8 million from 67.7 in 2004, which was similar to the build in the first quarter of 2004 and it's typical for this time of year. Our CapEx for the quarter was $1.6 million, which was below our budget and it was also below last year's spend in first quarter, which was $4.7 million as we work hard to keep a lid on our CapEx.

Cash flow from operating activities decreased by $19.9 million compared to $15.3 million during the same period in 2004. This is a change in the cash flow number pretty much tied right into the change in our net income. This is really normal for the Company during this seasonally weak sales period in the first quarter. And given the payout of our variable compensation plan in order to preserve the tax deduction on those payments, and the first quarter bond payment, that number makes sense and it's kind of typical for us in this quarter. The balance of the year, we'll be generating cash and paying down debt. We have already paid the revolver down by $10 million since the end of the quarter from $35 million down to $25 million, and we are in compliance with all of our debt covenants.

That pretty much finishes the financial review, and I'm going to turn the call over to Tom Kirk.

Thank you, George. Good morning, everyone. Pleasure to be with you. I'm going to address my comments into three primary areas. The first will be some of our operating activities and their impact on our P&L. The second will be an update on our special initiative activities relating to cost control. And third, and last, will be an update on our efforts to expand revenues that Van referenced a minutes ago.

First of all, as George had mentioned, our overall sales are up for the quarter by $1.4 million compared to Q1 of last year. Let's break that into its pieces and examine what's driving that. First, SPS sales are up about $1.1 million compared to first quarter of last year. This represents an increase of a little more than 12 percent compared to the prior year. Now the comparable sales for SPS remained very favorable due to a major product line which was brought on board last year in March. So we're getting the benefit of having that product line for the full quarter this year. SPS continues to emphasize their fundamental competitive advantage of strong customer service and a complete and comprehensive product line.

They are continuing to look for additional products that they can bring into their distribution network in addition to their strong sales efforts. And the major initiative for SPS this year will be expanding their presence and service into the O&P marketplace by developing the next phase of its e-commerce platform throughout this year. They are well positioned, having moved into the new warehouse and distribution center in Dallas, and they look forward to continuing strong year albeit not at the same levels as historically achieved since now, going into the second quarter, we will have the comps comparing back to the new product line that was brought on last year.

The second piece of our sales increase is coming from our patient care division. HPO accounts for the balance of the increase in our consolidated sales, and as George had mentioned, has two primary sources--$2.1 million from acquisitions that were brought into the Company last year, and a -1.7 percent same store sales growth. Let's look a little more closely into what is continuing this downward revenue pressure that we see in patient care.

Four major things that we see. First, and Van touched on this, is the continuous review by our payers on the fees associated with selected codes. All the work that we do is done by L codes and in some cases the Medicare group and the [indiscernible] have examined these codes and have changed the codes trying to reflect an updated economic situation. The migration of these fee reductions that were initiated by Medicare in prior years is actually flowing through to some of our third party payers, and this comes up in two ways. One is just the natural evolution as these contracts upgrade--update over time. And the second is in the negotiating of new contracts with the third parties. And in this case, they're using their volume leverage to try and extract some better deals from Hanger as well as all the other O&P providers.

The second thing that we see is a continued delay of certain patients in receiving comprehensive care and this is being caused by a lack of coverage, which we think goes all the way back to their employment situation. For example, a recent Wall Street Journal article highlighted the difficulty that certain rustbelt states are experiencing and rebounding even in this economy. The article suggested that this difficulty, along with job growth, was due to the absolute decline in the number of manufacturers within these states, the types of new manufacturers that are coming into the states and in often cases acquiring the old businesses, and finally, some of the states' adverse tax systems in terms of encouraging job growth and favorable economic development.

All of these factors translate to the delay problems that we continue to see in our regions. Net effect is that people are just delaying and skimping on the kinds of comprehensive care that they are willing to undergo. The third thing that we are seeing that is impacting our revenue expansion are changes in benefit design which decrease the deductibles and/or the amount of co-pay. And even in some cases, we have seen where employers negotiate deals that impose certain types of caps on selective procedures that we do. We go through these on a one-by-one basis and explain the medical necessity. There is no question that this results in extra time in the process and continued downward pressure on the reimbursement.

And fourth, and final, is some aggressive behavior for this O&P business that we actually participate in. And this is coming from within the broader healthcare provider system. Basically, it's some other people trying to do what classic O&P orthotists [ph] and prosthetists [ph] did. And we'll talk a little bit about what we're doing in each of these areas in just a minute.

Let me continue on the P&L for just a moment. In Q1, our cost of goods sold increased slightly in absolute as well as a percentage of sales basis. And this was due to some slightly higher material cost to handle the increased sales as well as some material cost escalation which was partially mitigated by the work that we initiated in the beginning of this quarter with our special initiative. In this initiative, we are continuing to use our volumes and alternative sourcing options to obtain better pricing on some items as well as some additional education with our practitioners on how to reduce materials and improve utilization in our fabrication techniques. But there is no question that within the--certainly in the copolymer area, due to high oil prices, and in the metals area, we are experiencing some cost escalation though we are seeing our efforts at least bear some fruit in controlling the amount of increase that we had seen had we not undertaken these initiatives.

The second piece of the cost of goods sold is coming from slightly higher labor costs that George comments, which has to do with the cost of living increases that were granted in some portions of our employee base at the beginning of this year. The combination of these two factors, along with the change in our sales, resulted in a gross margin decrease of about $.6 million compared to last year's comparable quarter. This translates right down our P&L such that our EBITDA decreased by the $4.2 million that was previously mentioned due primarily to the changes in the gross margin and some of the G&A accounts that George talked about.

Now, our special initiative to manage costs in selected controllable accounts such as travel, office supplies, communications, and professional expenses, has established fundamental processes and targets for each of these areas. Those processes are quite simply to examine everything that we spend, set reasonable targets relative to the levels that we achieved in 2004, and ask our people through higher levels of visibility to control those costs within the tolerances that we've set. These are being rolled out as we speak and the programs will be fully implemented during Q2 and we expect to see the benefit of those in Q2, Q3, and Q4.

Now, let's return to the key issue of sales development. Van said, "Let's face it. It's all about securing sales in this changing and competitive environment." We are employing a variety of tools to attack this situation. Those tools are in three major areas. First is sales and contracting. Second is technology. And the third is building on our relationships and our O&P experience to take a larger position in the overall orthotic rehab area. We can touch on each of these three areas.

First, for sales and contracting. By sales, we mean our field business development sales force, and we're using them to open new doors to referral sources, and to reinforce existing relationships through continued education, training, and value added initiatives, to help make our clients medically and economically successful in our business. What do we mean by that? Well, for example, on our website, we're putting up some educational materials to help certain of our doctors in the form of mock exams prepare for their board exams. We also mean education at the local level with physical therapists, clinics, workshops. Comprehensive field force effort in conjunction with our practitioners to ensure that the broader clientele that use our services know and understand the value that Hanger brings to this equation.

Also during the quarter, Dr. John Rush joined us as our new Chief Medical Officer. He's on board and he's going to be leading an effort to enhance our medical quality and education efforts while promoting the Hanger brand and our distinctive competences directly to key groups of doctors in the medical communities that we serve. Now, this is a first for Hanger. We think it's going to help us, as I mentioned, in our branding efforts. Now people understand the value that we can bring in effecting higher levels of clinical excellence.

In the contracting area, we've got two efforts underway. The primary one is within our Linkia subsidiary. And we've been talking about that one in terms of our ability to manage a network and bring value to our national payers. We're having discussion with all of these big national payers and some have advanced compared to others. Some are at the stage of contractual negotiations as we speak, while others are still receiving a preliminary proposal in terms of the value and how the relationship works. And we feel very confident that these negotiations are going to pay off and we are looking forward to signing a contract toward the end of the second quarter with one of these large national providers--or payers, excuse me.

The second area is in technology. We're continuing to roll out our Insignia laser scanning system for a variety of patient indications. We use this, not only for prosthetic limb replacement, but also we've advanced into several orthotic applications such as cranial bands, body jackets, ankle [indiscernible]. We've expanded the number of certified practitioners on the system to 450. We've increased the number of scanners to 300. And we have installed 25 regional carvers. This is all about bringing productivity enhancements, a better patient care process, into our patient care centers.

In essence, we believe that this system provides the opportunity for faster, more accurate servicing of our patients while giving our practitioners additional time to spend with their patients and with their referral sources. But we see Insignia not only as a productivity and a marketing tool, but also as a tool to open the door to new applications in providing custom fit devices in clothing. Now, we intend to pursue several of these new applications' commercialization this year. We are working on several of those and we are in the process of rolling some out. And it's our expectation that through the next several quarters we will be advancing this digital imaging technology on new fronts to provide additional revenue while offering higher levels of service to the broader patient population.

Another example of technology, this one in the product area, is in the product that we call WalkAid. Now, we've discussed this in the past, and it's Hanger's first entry into the neuromuscular electrical stimulation market. This provides an additional offering for our Hanger practitioners that will be utilized to improve the ambulation and the quality of life for a large segment of our patient population. We are continuing the development and the testing of this product as we speak, and our goal is to enter the market this year.

Finally, the third area. And this is an area that I mentioned and described as taking a larger presence in the broader ortho rehab arena. Now, we intend to do this and we are doing this by utilizing the two pilot businesses that we acquired at the end of last year and the beginning of this year. We are expanding their geographic presence and expect to employee some other mechanisms to grow in this area this year. Now, these two pilots and this associated business have the ability to provide devices along with ortho rehab equipment and patient training as a natural complement to our fundamental core O&P-based business, which is a service-oriented business.

This is going to permit us to provide a comprehensive total care package to our patients, not only on the custom side, but also being there for them immediately before and after surgery in terms of providing bracing and recovery in rehab equipment as well as training on how to use this equipment in the hospital and in the home setting. It also gives us the opportunity to ensure our doctors that their patients are in good hands by providing a single-source responsibility in a continuum of high quality care. And we expect to be expanding on this model throughout the year. As I mentioned, we've got two primary locations, one in the southwest and one in Northern California and we're looking to augment that into other regions throughout the year by working with other groups of folks that are out in the larger arena of orthopedic service.

So in closing, we see 2005 as continuing to provide reimbursement challenges to Hanger and the broader O&P industry. We've talked about this. We have undertaken a series of projects targeted to the revenue issue while being mindful of two things. One, their investment costs, and secondly, continuing to control our overall expenses so that we can remain cost competitive in this new arena. And with that, I'd like to turn it over to Van as MC for the remainder of the call.

Thank you, Tom. Crystal, we can now open it to Q&A.

(Caller Instructions.) Your first question comes from Todd Corsair.

Hi. Thank you. I'm sorry if I missed this because actually I missed the first half the call probably. But do you guys give timing on or some color on what you expect in terms of the Linkia contracts that you've been looking to conclude?

We have, Todd, previously announced that we expect that the Linkia business will achieve about $40 million for this year, for '05, primarily backend loaded. In terms of the timing, we expect and we hope--we're in the contract negotiations now--to sign a deal with another large payer before the end of the second quarter. So it's the combination of what we have in place and the expansion of that activity plus the ongoing negotiations that would yield that revenue increase occurring in Q3 and Q4.

Okay. In terms of contracts that you've already concluded, would that account for--what part of that $40 million? About half?

That was the--the $40 million is incremental to what we have had at year-end.

Correct. And in terms of new contracts that you need to conclude to actually hit that $40 million number, what portion of that is kind of already contracted or already concluded?

Well, we have--we announced last year that we had three contracts at year-end. We intend to expand those. And then, we intend to add some new ones. And simply because of the relationship that we have with these payers, we can't get into--nor would they like or allow us to get into giving the specifics of the volume amount of these deals or any of the pricing amount on these deals.

Okay. So in turn, you really couldn't specify the revenue contribution of the contracts that--in terms of the incremental $40 million for '05, you couldn't really specify what portion of that is going to be derived from contracts that you haven't concluded?

No, we can't do that.

I understand that. All right. Just in terms of where your leverage is right now as measured by your bank agreement, could you just give us what that calculation is?

Sure, it's 5.8 times.

5.8. And is the covenant currently 6 times?

It is.

Okay. And when's the next step down on that?

The next step down is June 30. It steps down to 5.75. And bear in mind, we paid down the revolver $10 million since quarter end. So we're already below that level.

Okay. So you expect to remain in compliance throughout the year with the--?

--Yes.

Okay, great. Thanks very much.

Your next question comes from Matt Ripperger.

Hi. Yes. Thanks very much. Just a couple questions. Related to the potential new Linkia contract that you've alluded to signing by the end of the second quarter, I wanted to see if you could help go through how that contract could potentially be different from the United contract that you announced before, and maybe go through some of the specifics about what you learned related to that first contract in terms of what you did wrong that you didn't go on back and rectify in this pending contract by the end of the second quarter.

Good morning, Matt. Thanks for being with us. First, there are two different product offerings. So I just wanted to make sure that it's not a case of doing something wrong. I think coming out of the box we sold one product that a specific payer wanted to have. In the ones that we're considering now, we're selling a different product. So it's sort of one day apples to next day oranges. They obviously have different implications, different price points, and different volume points. I would say that the ones that we are contemplating now for the payer that's closest is different in the perspective that we would be much more active in managing the network.

Now, we would still be designing and managing that network in accordance with the payer's overall network strategy. But we would actually take control of the network. We would work to achieve the levels of network reduction that were consistent with the network strategy, which means that we would be much more intimately involved in ensuring that the network performed up to speed, and secondly, that through the network reduction that all the participants in the network of which HPO would be a key factor, would receive ample amounts of volume. Naturally, as you shrink a network, the ones that remain are going to get more volume. So I guess if I were to say what's the key characteristic that's different, it's the way the network is managed and it's the reduction of the network and the ensuing increase in volume across each of the providers that are out there. And also, ensuring that those providers meet certain targets that have been preestablished with the payer. So it's more in network and volume tradeoffs.

Is it fair to characterize it as saying under these new types of contracts you're going to be the first point of contact for the payer's entire O&P spend as opposed to what your previous arrangements were where you were just a participant in a broad network?

That is correct. Yes.

And for O&P work in the future that you don't do in-house and that you outsource to some contracted third party, will you take a management fee on that?

That is the intent. And commensurate with the value that we bring and the services that we provide.

Okay. All right. Is that--?

--Linkia is acting for the payer between the payer and the network. So there are a number of associated services that Linkia would provide, not only to third parties, but also to HPO in acting out and managing that network for the payer.

Is there an opportunity for you to expand beyond just the O&P area in terms of contracting with payers to manage these ancillary types of businesses?

We have had some discussions with certain payers about expanding the product and service line. The feeling was let's get the O&P stuff in-house and underway and then start picking up on some of the ancillaries.

And how quickly from the announcement of the potential contract to starting to book revenues can you ramp it up?

Depends on each of the payers in terms of their ability to--first off, we've got a systems compatibility, not an issue, but a systems compatibility. So we are working through that as part of the negotiations to ensure they can talk to each other. And we would expect then to begin to execute on the network strategy and begin to migrate the business over. So it's going to be a ramp up, but we're probably looking at about a 90-day lag from the time the green flag goes down until we would begin to see some revenues coming in. And then, it would be our intent to ramp those up as quickly as possible because our job is to manage that for the payer.

Okay. And the second question I had is just related to the opening comment about the backlog of business being somewhat higher. And if you didn't have that, you would've had things toward trends pretty flattish in the quarter. Can you just comment again and give some further clarity as to what's contributing to the backlog of business? And is it abnormally high this quarter relative to how it's been?

Matt, it's--actually we've seen some growth in that. But really the process of getting it through the system, as you well know, we cannot recognize any revenue until title in effect transfer to the patient. And in order to meet all of the new SOX 404 regulations, and obviously, a very stringent compliance program that we have here at Hanger, all of the associated administrative paperwork has to be in place before we can recognize that revenue. And that has slowed somewhat. We're working on process improvement to be able to try and accelerate that. And we have seen--we've always had a health work in process program backlog. But we have seen some growth in that because of partially due to the administrative requirements in order to get it through the system.

And it's--I think it's important to understand that a lot of the devices that we provide, in particular, in the prosthetic area, are custom in nature and obviously have some lead time between initial patient contact and ultimate delivery of that device. What we're seeing is in some cases, those devices have been fabricated, they have been fitted and have been delivered, but we're waiting for administrative pieces to still flow into the system before we can actually generate a bill and recognize it as revenue. So we've seen some builds in that, because, as I'm sure many, many other companies, SOX 404 has had an impact on that and in terms of obviously our regular compliance programs.

Now, we don't want to give you the impression--just to chime in a second, we don't want to give you the impression that we didn't have that in place before, but the SOX--and I'm sure you're getting this from your other folks, too. The SOX rules demand that you put in controlled matrices and those matrices for control across all the process are much more rigorous in terms of making sure that somebody has signed off, somebody has initialed. So it's all this sort of administrative stuff so that you're leaving a paper trail to ensure that anybody that wants to investigate afterwards can find signatures, initials, compensating types of control all have to be in place. And obviously, all that went in. We passed our SOX audit last year while some others had problems. All that went in. And we are in the process of fine-tuning and perfecting those processes. But until that--people get into that work habit, making sure that the I's are dotted and T's are crossed, it slows things down.

And just to step back the magnitude of this is we're talking the 1.7 percent. We're talking about a couple million dollars here on our total base of business. It's not--it's a relatively--I'm not happy about it, but a relatively small amount in comparison. And a lot of that is we believe partially attributed to this sort of slow up in the process through the system.

But in this case, there are instances where you've already booked the costs and incurred the materials cost, but you just haven't been able to recognize the revenue yet?

That's right.

And then, the last question I had is your CapEx was much lower than sort of your normalized run rate. If you could maybe revise or update it now on what your estimate is for CapEx for the year, that would be great.

Well, we do expect our CapEx is going to be a little lower than--we have a limit set at the present at $17.5 million. We are aiming to get below that. We don't expect every quarter going forward to be as low as Q1 was, but we're probably going to be somewhere in the $15.5 million range as opposed to going right up to the limit at this pointy.

Okay. Thanks very much.

Your next question comes from Arnold Ersonoff from CJS Securities.

Hi. Good morning. I'd like to understand a couple of things about your cost of your SG&A and cost of goods here. Particularly your SG&A line. You've had a very good control over that line item. But I'm trying to build it out. You had about a 3 percent pay increase. And you've added quite a few sales people. So I'm trying to understand how all of these incremental expenses that you've added are leading to flat--essentially flat SG&A and labor costs as a percent of sales.

Hey, Arnie. The salespeople were added--they were pretty much on the ground by January 1, 2004. So from a year-over-year comparison there was no increase. There was an increase in the baseline salaries, but there were some mitigating factors that lowered the overall G&A so it didn't reflect the full 3 percent increase. For instance, I'll just throw a couple out. Outsourced labor declined because we're done with the bills of the 404 control matrices and a lot of our IT OPS rollout was underway in the first quarter of '04. We no longer need that. We've renegotiated all of our communications contracts. The telephone is down. And these are the things that we announced in the third quarter, the 10.5 million net savings that we expect to realized in 2005 regarding inactive [indiscernible] and they're in process.

How many incremental sales people have you added?

Since January 1, 2004?

Yes.

We've been, Arnie, pretty much flat since that time period. We built up to having 23--from 13 to 23 business development people. We call them business development managers in the field. So we've really not built that force since Jason had mentioned it in the beginning of '04. So comp-wise, same head count.

Okay. And a final question for me, if I could, on Linkia. You mentioned $40 million of '05 incremental revenue very much backend loaded and obviously we're all trying to guess at the potential impact from an unannounced contract. Can you give us a feel for what your Q4 Linkia revenue increment might be? We'll obviously give up a little bit of time to sign the contract, but how much of it would be related to this contract in incremental in Q4?

Well, based on the way the math works, it's going to be upwards in the teens, probably $15 million in Q4.

So to get to your $40 million, that contract has to kick in in Q3?

As Tom said, we expect to have it signed by the end of the second quarter and there's typically a 60 to 90-day build period before we go live.

Okay, thank you.

Your next question comes from Harry Rukoff from Deustche Bank Securities.

Good morning. Hey, guys. Just had a few questions for you. I guess the first is on Linkia. Can you just say year-to-date what the sales were from Linkia? Hello?

We're--we don't report at the present separately from our other sales. So we don't have a number handy to give you there relative to the contracts that are in place. That's something we probably would have to get back to you on.

Yes. I'll have to go down and go do a run based on payer.

At the present, we're just recording--showing as a cost center. We won't know the cost--until we get this next contract signed, we're not going to start attributing revenue to that operation.

Okay. So, it's modest.

Well, right now, it's simply just an extra contract that runs through the HPO business.

How about expenses year-to-date associated with Linkia?

Year-to-date it's about $540,000.

I also just wanted to go through--I know on the last conference call you mentioned probably $12 to $13 million of cost savings that you thought you could get through during the course of the year. I was wondering, on an annualized basis--I was wondering what have you--what steps are you taking to reach that goal and maybe how much cost savings is in there now on an annualized basis?

We've put all of that into the budget figures that we are using to operate, but we still continue to track these individually. They were broken down into four initiatives. What we've done in initiative one is, at the end of last year--it was frankly right at the end of October, we reexamined all of our support staff, and we took some headcount out of the organization. Those folks are out. The severance cost was all handled in '04, so we're seeing the benefit of the reduced headcount this year. In addition to that, we have realigned our field force such that their efforts are now being charged as a support cost into our local patient care centers, which means that labor cost--cost of their salary, is being charged into the local level which is driving a lot greater alignment, but at the same time by having those costs down at that level, it is reporting over into our variable comp plan as the labor cost in the field. So that's one all having to do with headcount.

On the G&A initiative, which was the second initiative, which was designed to achieve about $2.5 million--that first one, by the way, is between the headcounts and the realignment of the field force, is about $2.5 million. The second one--$2.5 million on the G&A area. And what that's about, as Jason had mentioned, it was renegotiating our telecommunications costs. That has saved us about $250,000 across voice and data. It is going after all of our discretionary expenses, the ones obviously that we can control, bringing those down on a par to what we had in 2004. We're using 2004 as our yardstick here. We have been able to track thus far more than $1 million worth of savings toward the $2.5 million goals. What are some of the areas for the remainder of this year? I touched on those briefly. It's to reduce our travel expense, control our meetings. Obviously, travel costs are going up. This is one way. Don't take the trip or use telecommunications via video. Office supplies, overtime, outsourced labor, professional fees. Attacking all of those areas. In the area of professional fees, we expect to see that come down because we have implemented for the most part all the heavy lifting in our SOX 404, and we've reexamined the use of outside help on several other fronts. So we expect that by year-end, we're going to get that $2.5 million.

The third area is in materials. We've been able to document and on our materials approach we have through volume purchasing, changing the sourcing, and improved utilization in our fab operations to date, have reduced our cost by over $1 million. We have as a target $4 million. So our SPS group, which functions as a purchasing group, is working very closely with our operations to make sure that we capture that benefit. We expect that over the full year we'll be able to get that $4 million. Now the thing I mentioned that's clouding the horizon a bit, is the fact that metals and polymers are all going up in cost. It looks like the metals have peaked and perhaps they are even going to come down a bit. But we're expecting to get four out of that.

And last, but not least, is we're going back and going through the fundamental analysis of work flow in many of our patient care centers to ensure that it's operating efficiently. Those patient care centers that are running high levels of over 120, are going to get special attention to understand the particular situations that they face. This is a bit of a battle, because one of the DMRC [ph] regions is using slow pay and forcing things into appeal in their probe audit back into administrative law judges in order to stop some of the fraud. So net/net, it's improve your processes, work with the DMRCs to try and get our payments to the system as efficiently as possible, so that we can collect more efficiently and reduce our bad debt percentage. That we have targeted to be about $4 million. Total those up, it comes up to $13 million. We expect that our practitioners will share in part of that because of the design of our variable comps. So net/net, it should come back to about $10.5 or $11 million as an impact on our EBITDA.

And then just, on an annualized basis to date, what would you say of the $10.5 million that you will realize? How much of that has worked through?

On an annualized basis to date, of the 10.5, we probably have around 30 percent of it.

30 percent. Okay. And then, without Linkia in the budget--just let's exclude that for a second. Where would you think you might be in terms of your EBITDA? I know you're at $14 million--you were at $14 million this quarter. I know it's--this was the weak quarter, so you're going to be up is my belief and assumption. But can you comment on sort of where you might be for the year sort of directionally with your total EBITDA ex-Linkia?

Well, that's sort of a double-edged sword. While we want to be responsive to your question, on the other hand, if I were to give you that answer--and I'm not trying to be cute or smart. If I give you that answer, you do the subtraction and now you've got all the economics of Linkia. And we have told our payers that we're going to try to protect that information until such time as we get sufficient membership in Linkia that we can report it as a segment. So at this time, I'd rather say we're going to wait a couple of quarters until we can build some Linkia volume and I can give you a better picture into '06. But to pull Linkia out and then say this is what the EBITDA would be for the Company would be a dead giveaway on the Linkia economics. And we'd rather not go there.

Okay. Thanks a lot.

Your next question comes from Ali Rudinsky from Citigroup.

Yes. Hi. Good morning. This is Ali Rudinsky. Can you tell us what your variable based comp expense was in this quarter versus the same quarter last year? What you paid out?

Well, we didn't pay anything. You're talking about the payout in the prior year?

And this year. Yes, correct.

We only--every year we make two payouts--one at the end of second quarter and we make one at the end of the year. So there was no payout made relative to the current year. We paid out about $20 million relative to the prior year's variable comp and other bonus plans and we do that by March 15 in order to--.

All right. So you paid out $20 million for 2004 in the quarter.

Right.

And what did you pay out in the first quarter of 2004 for 2003?

In the prior year, we would have paid out slightly more than that. The total payout in '04 for '03 was slightly greater by about $2 million.

So $22 million, then? Okay. And can you talk about are you planning on closing any unprofitable centers? And how is the consolidation going within markets? And are there any markets that you are actually looking to leave?

We continuously review all of our operations from a patient care point of view. IN other words, there is not any real sense in having one on this corner and one on an opposing corner. Obviously, that results from being a company that came from rollups. But if we come across a patient care center that's experiencing difficulty, the job of our regional vice presidents are to go in and work with those practitioners and get them healthy. So at the present time, we don't have any that are underwater. All of them are contributing on a long going basis. Every once and a while we'll have one, perhaps due to a bad debt situation or something such as that, that may report on a non-cash basis to negative EBITDA. But we don't have any in the system. We want them to be better. So we are putting the tools out there to try and work with them and the coaching and counseling, and if need be, we make personnel changes. But we don't allow any patient care groups to sit within our portfolio that aren't performing to levels commensurate with their local market opportunities. So that's number one.

And secondly, we are not looking to withdraw from any areas actually. If you look at our mix, we have a combination of patient care centers and satellite patient care centers. And the satellites are the little dendrites that we send out to begin to expand so that we can keep in line with patient demographics so that we get into a high growth area. Southwest, for example, if you look around the Greater Phoenix area, look around the Las Vegas area, you see those kinds of expansion activities. And we are not withdrawing from any regions of the country.

But we do go in and examine and when we see there's an opportunity, we'll build out a satellite in services on a part-time and grow it into a new business.

Okay. Just the comment was really more based for the Midwest where you've had some difficulty in Ohio, and certainly the other states. I do realize that you're doing quite well in the Southwest. Has there been any material changes in the Midwest and the operations of those centers?

We have realigned the management out there. In addition to that, we are looking for what we will call "best practice mentors." And so, what we're doing is bringing over some people that are specialists in labor, specialists in fabrication, putting additional sales help into those locations. And we are--when I talk about the specialists, there are unique situations out there. We find opportunities all the time. Patient needs care. Can't get it because they don't have the employment situation that was supported. It's amazing. Local communities, church groups will rally around that patient and find ways to get the job done. And so, we're exploring alternative mechanisms of financing some of these things and working hand in hand with our patients to get it done. But we are not looking at what I will call a collapse in the variance. We think it's going to come back, obviously, in some of those Midwestern rustbelt states. The governor of the state is highly energized around these situations, particularly after that news article that I referenced. So we are trimming, modifying, and managing each of those patient care centers commensurate with the kinds of opportunity that's in the area.

Okay. Can you remind us again about the variable rate comp, what that is primarily based on? Is that based primarily on collections or is that billable--the amount billed per center? How is that really factored in?

The major driver on it is collections. It's cash in the cash drawer, if you will, offset by labor costs, and then, performance of materials versus a materials allocation that we give them. We give them an allowance, if you will, based on their product mix. And so, if they bring it in under that target on the materials side, they get to share in that. But you're right, it is the major driver is the percentage of the collections with the offsets we just spoke about.

Okay. Lastly, with that. With the budget that you current have today, is your expectation that the variable rate comp will be the same, higher, or lower for next year?

With the budget we have today we would expect it to be higher. It will not be--it will--not dramatically higher, but certainly if the sales goals we have are met in the second half that will drive a higher level of variable comp.

So the expectation is that salaries in general should be at least stable, if not higher, in 2005 versus 2004?

Yes. We do look at base salaries. Base salaries [indiscernible] placement factor and then the variable comp will be impacted by sales increases that we expect.

Great. Thank you very much.

Your next question comes from Andreas Dirnagl from JP Morgan.

Yes, good morning. I just wanted to clarify a couple of comments you made to make sure I'm understanding them correctly. Tom, I think you made the comment that there is sort of a 60 or 90 day ramp up period after signing the Linkia contract. Does that mean that since you are highlighting that you will sign hopefully another contract by the end of the second quarter, that sort of by definition, your backend loaded revenue from that for the year is literally going to be back ended into the backend as well, i.e., the majority of it will be in the fourth quarter as opposed to the third?

Well, we are doing two things. One is, we are continuing to work with the payers that are currently in the Linkia family, if you will. And we want to increase the volume and the revenue that will be flowing through that we've been successful on the modest scales, but obviously, we want to expand that. The second thing that we are doing is that while we are in the negotiations with this one key player we are trying to do some of that work that would be normal ramp up work in terms of deciding network strategy now, so that we can hit the ground running in a much more efficient fashion. So it's really going to rolling throughout. But you're right. There is no question the largest impact would occur in Q4, but we still expect to see impacts in Q3 as well, resulting from some of the existing contracts we have.

Okay. And sort of within the Linkia family as you just referred to it, there appear to be sort of two types or even two sizes of contracts. Sort of the national contract and the regional contract. I mean, I know it depends on region, but can you give us an idea as to sort of what order of magnitude difference you see potentially in those in terms of revenue that they can eventually clear?

Ultimately, we think that the big bang and the majority of the revenue will come of the national payers. Just their scale and size alone and their book of business is enormous compared to, for example, the two regionals we have or some of the other regionals that we're talking about. Linkia was, when we think about, really designed to take advantage of Hanger's coast-to-coast scale and size. And so the sweet spot is going after those big nationals and saying we can take this burden off your hands and clean up your administrative front-end and improve the clinical side of the patient care we give you. So it is targeted toward the big nationals and they've got the big books of business. So it is--when it's all up and all in, when we're looking back a year or two from now, we will see a huge disproportionate amount into the nationals compared to the regional.

Okay. And you sort of highlighted the differences between sort of the first contact with United in terms of potentially the new contract you want to sign. You sort of characterized them as different products. It's been a year since United has been signed. I think we haven't seen any revenue or only a very small amount of revenue to flow through that. Do you expect that first contract to be a significant contributor to your incremental revenue for Linkia for the year, or is it really sort of focused on the newer contracts with a slightly different product where you have control of the network?

I'm not sure if I understood. Is the question do we expect that the majority of the revenues will come from the new contract or do we--first, let me just see if that was your question.

Yes. I mean, basically, I'm just trying to get an idea as to sort of if there is a significant portion of the incremental revenues that are going to come from United versus the new contracts given the difference in the sort of products that you're selling under them?

Oh. Well, we think it's going to be a continued ramp up on the existing one. But there is no question that the new product that we are working with another large national payer is going to bring in volumes faster on the ramp up scale than the older contracts. Maybe that's a good way to answer your question. And by doing work up front, and by selling the product that we are now selling to the new guy, we expect that that volume is going to be bigger and come faster.

Okay, great. Yes, that was great. Just one final question, and I think Jason made a comment that sort of Q4 revenue associated with Linkia and then the number $15 million came out. I'm just trying to clarify what that $15 million was.

The question was asked earlier what revenue incremental do we expect Linkia to generate in Q4. And we're estimating $35 to $40 million for the year from Linkia, the majority of it coming in the back half. The math works to be about $15 million of incremental revenue from Linkia in Q4.

Okay. But given the fact that it's going to be very backend loaded, I mean that sort of less than half. Does that mean you're--I mean, the math has to work out then that you are going to do $15 to $25 million worth of Linkia in Q3.

In Q1 through 3.

Okay. And then, I know you don't have the number. Can we get sort of a best estimate at this point as to what it's been sort of for the first quarter? Was it more than a million?

As we said earlier, we're gong to have to do a dump based on payer because we don't have revenues flowing through our accounting segment for Linkia yet. So I'm going to have to get you that offline.

Okay, great. Thank you very much.

Your next question comes from Howard Bunson from DNY Capital Market.

Yes. Thank you for the question. Can you quantify the impact of these code changes you were talking about earlier in the call?

Well, we've seen a number of them just to make sure that we're level set. For example, when the DMRCs came in and they looked at replacement liners, gel liners that go instead a prosthetic patient's socket, and they changed the reimbursement on that one. That we've been able to tabulate up by going back and looking at the number of times that code was hit. And what we saw was about a $4 million impact for Medicare. Medicare is about a third of our business. So over time, that is going to migrate because those fee schedules get picked up to the renegotiating process and it migrates to the balance of the business. So net/net, that liner after several years is going to be worth about $12 million of lost revenue. That's one of them. Now that occurs--that tail will occur over a period of probably five years as it migrates through all of the insurance company fee schedules.

We've also seen some changes on some of the body jackets, TLSOs and LSOs. We've seen some changes on certain kinds of knee braces and other selective procedures. For example, one that was focused upon recently was in the microprocessor knees. If we were to add all of these up, and we are active on all of these, as are our trade associations in terms of going back and making sure that everybody understands what's going on, they would exceed $50 million. So it is not an insignificant amount. And it is something that we attempt to mitigate to increase productivity as well as increasing the technology in our products by bringing to market, in combination with our manufacturers new products that have higher reimbursement. So it's not unlike any other business where you've got the product life cycle. What happens is it's an eventual drive toward commoditization and when volumes get high enough people can go in and check the manufacturing processes and see that what used to be a very manual operation has now become automated and they want to share in some of that volume-based manufacturing operation. Not unlike the way Detroit does it.

So net/net for us over the past few years and projecting into the future, we're going to probably see a $50 to $60 million hit in these things.

Now, would you say that you're 25 percent of the way through this code change or 50 percent?

Well, in the case of the liners, I think we're all the way finished. We're going into our fourth year on that. Body jackets, third year on that. So I would say that we're probably more like three-quarters of the way through. But it's anybody's guess as to which one they may pick next. Now, this is not something new. This has been ongoing for years and years and years. And the benefit was that they would select one, do a study. In some cases, we've actually seen some increases on these things. In other cases they've been decreases. But the mitigating factor in prior years was that we always got, while small, we got some sort of a cost of living increase across the whole fee schedule. Now that we've been frozen, these selective fee reductions are becoming a lot more visible.

I see. So this is basically a permanent issue that will be constantly reviewing other products and changing the code on those products?

They review them constantly. That's their charge by government. Congress says mandate it and that's what the DMRCs do. So whether or not it results in a fee reduction depends upon the economics within that specific device. So that occurs throughout all of medicine where, I mean--big article yesterday just on imaging and what's going on there. One would expect it's going to happen across the board. And it's just part of the ebb and flow of the process.

Okay. And one other question. I missed part of the call. Did you provide any 2005 revenue or EBITDA guidance?

No, we haven't changed guidance at all. The guidance we gave on the last call is still the guidance that we're comfortable with. In the neighborhood of $600 million of revenue and $82 to $83 million of EBITDA for the year.

82 to 83?

Yes.

Okay, great. Thank you very much.

Your next question comes from Case Widlock with Smith Fund Management.

Thank you. Just a couple of questions, if I could. Following up on an earlier question about the bank debt covenant, because you are relatively close to the step down on June 30, do you anticipate having to go back to the banks prior to that just to give yourself a little bit more cushion?

No, we don't.

Okay. So I guess you don't anticipate really the need to draw on the revolver between now and year-end?

Well, as we mentioned, we already started paying down the revolver where we generally use cash flow in Q1 and pay down debt in Q2, 3, and 4.

Okay. And then, can you update us on what the current cash level and bank debt availability is as of today?

At quarter end--I'll just carry the calculation through from quarter end. At quarter end, we had $8.2 million in cash and roughly $8 million in availability. Since that time, we've paid down the revolver by $10 million. So you can add $10 million to the availability.

And did you use cash to do so?

Cash from operations. I believe our bank balances are roughly the same.

Okay. And then, my last question is--you just reiterated that you have no change in guidance. Relative to your budgets for the first quarter, were you ahead or below budget?

We were a little bit ahead.

Okay. Thank you.

Your next question comes from O. J. Statis of RBC Dane Lawson.

Hi there. Just one last question on my end. What's the update on the West Hampstead investigation and what's the cost associated with that you a year-to-date basis?

The update I gave in my introduction. We have had no additional requests for information since the end of '04 and there is absolutely nothing new to report. We've had no movement, no contact, since the end of '04. The cost is about $100,000.

Okay. Thank you.

There are no further questions.

Okay. Thank you all for joining us this morning. Look forward to talking to you at the end of Q2. Have a good day.

This concludes the Hanger Orthopedic Group First Quarter Operating Results Conference Call. You may now disconnect.