Hanger Inc (HNGR) 2005 Q2 法說會逐字稿

At this time, I would like to welcome everyone to the Hanger Orthopedic Group second-quarter earnings call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks there will be a question-and-answer period. (OPERATOR INSTRUCTIONS). Mr. Ivan Sabel, Chairman and Chief Executive Officer, you may begin your conference.

Good morning, everyone, and thank you for participating in our second-quarter 2005 earnings conference call. Before we get started I'd like to read our Safe Harbor statement. Our presentation today contains forward-looking statements relating to the Company's results of operations, time tracks and credit arrangements. The United States Private Securities Litigation Reform Act of 1995 provides a Safe Harbor for certain forward-looking statements. Statements relating to future results of operations, contracts and credit arrangements in this document reflect the current views of management.

However, various risks, uncertainties and contingencies could cause actual result or performance to differ materially from those expressed in or implied by these statements including the Company's ability to enter into and derive benefits from managed care contracts, the demand for the Company's orthotic and prosthetic services and products, and the other factors identified in the Company's periodic reports on Form 10-K and Form 10-Q filed with the Securities and Exchange Commission under the Securities Exchange Act of 1934. The Company disclaims any intent or obligation to update publicly these forward-looking statements whether as a result of new information, future events or otherwise.

Now with respect to the Company's second-quarter performance, I am very pleased to announce that Hanger has achieved 3.1% sales growth in this quarter. The sales growth was primarily the result of a 3.4 million or 2.5% increase in same center sales from our patient care centers and 0.8 million or a 7.9% increase in sales from the Company's distribution segment. This represents the second consecutive quarter of improvement in same center sales from our patient care centers and it is our best result since the fourth quarter of 2003.

With this increase we have achieved sales of 149.6 million and earnings per share of $0.11 for the second quarter. Even with this increase in sales we ended the quarter with a healthy backlog of work in process at our patient care centers. The Company also continued to demonstrate excellent management of our working capital. The main driver was a reduction of 4.6 million in our accounts receivable compared to the December 31, 2004 balance which lowered our DSO's to 66.4 days. We also generated 23.7 million in cash flow from operations which we have used to pay down 23.1 million of our debt which brings our debt from 412.5 million to a current 389.4 million.

I know there are questions concerning the status of our Linkia initiative so I want to spend a few minutes bringing you up to date. Obviously we have not announced a signed contract, but we do believe we are still on track to meet or exceed our original goals to make national contracts one of our core competencies. The negotiations of contracts with two national payers are substantially complete and we are simply waiting for the payers to process the agreements through their respective compliance and review procedures. As soon as this process is completed we will be in a position to formally announce these contracts.

We are currently working toward an expected program initiation some time in mid fourth quarter. The revenue and volume we are expecting from these contracts unfortunately will not benefit the third quarter of 2005, but we do expect some additional revenue and profit in the fourth quarter of this year and George, as part of our call today, will offer some insights into guidance for the remainder of this year.

Once we have executed these contracts and begin implementation we will be in a better position to quantify the impact for 2006. I know the structure of the deals and the quantification of the impact of these deals are as important to you as they are to us, but during the question-and-answer period today I do not believe it is in our best interest or the companies we are negotiating with to expand beyond what I have just said for the guidance that George will be furnishing.

As a result of the revised expected start date to these contracts we have met with General Electric Healthcare Financial Services, the administrative agent of our bank facility, and yesterday we announced commencement of a process to both amend our financial covenants and extended the majority of the revolving credit facility. These meetings have been very positive and George will, again, address these in detail later in the call.

I also want to bring everyone up-to-date on the West Hempstead billing investigation. Based on the preliminary results of the independent investigation, management continues to believe that the evidence gathered to date indicates that any billing discrepancies are likely to be primarily at the West Hempstead patient care center. To date the U.S. Attorney General's office has only requested information from that one facility. Based on the initial results of the investigation, management does not believe the resolution of the matters raised by the allegations will have a materially adverse effect on the Company's financial statements.

So in summary, our base business stabilized and has begun to show signs of improvement. We generated 19.4 million in EBITDA in the quarter, a 1.8 million or 10.1% increase over the prior year. We continue to manage our expenses, working capital and have lowered our capital expenditures. These results generated free cash flow that was very significant and we used that to reduce our debt by 31.2 million over the past 12 months.

Linkia continues to make significant progress toward the execution of two contracts with national payers. We believe in the product that Linkia offers, we expect Linkia will create meaningful value for the Company and its shareholders. The only disappointment has been timing. Instead of having significant revenue and profit recorded in the latter half of '05, we're going to see that move primarily into '06. Every payer from the nationals to the regionals to the local health plans have all given us extremely good feedback regarding the concept and want to move forward with a contract and implementation.

As we have stated previously, we elected to start with the nationals and work our way down based upon membership size. However, this has resulted in taking more time than we had expected due to the legal and regulatory issues inherent at the large national players. These delays are unanticipated but we fully expect the promise of the Linkia concept will be realized. With that I'd like to turn the call over to George to discuss the quarter and the revised forecast.

Good morning, everyone. Thank you for joining us today. First I would like to discuss the results for the quarter. Sales -- as Van mentioned a minute ago, comp sales in our patient care centers increased by 2.5% for the quarter and SPS continued to perform well with a 7.9% increase. Our cost of sales margins improved by 1.7% as a percentage of sales compared to 2004 principally due to improvement in material cost. Our material cost improved due to a combination of a change in the mix of sales favoring prosthetic sales which have a better margin and the impact of our efforts to reduce costs which have begun to have a favorable impact on our purchases.

In terms of SG&A, there was an increase there of about $3 million compared to 2004. The principal reasons were a $2.4 million increase in labor that was related to inflation and increased healthcare costs and an $800,000 increase that was budgeted to support our growth initiatives, principally Linkia and Innovative Neurotronics.

Our EBITDA, as a result of the above, increased by $1.8 million to 19.4 million compared to 17.6 million in the prior year. Going further down the income statement, interest was approximately $900,000 higher than last year despite an overall reduction in debt due to the increase in variable interest rates that affect our revolver and our term B obligation.

Depreciation increased only slightly by $77,000 compared to the prior year and that was to due to being significantly below budget in terms of our additions for the first six months. We had roughly $4 million in additions for the first six months with 2.4 million in second quarter and that was compared to a budget of $17 million. And if you compare it to prior years we were spending in the $20 million range in terms of additions as we rolled out Insignia and our OPS system. So we're significantly off our past trend there and that favorably impacted our depreciation.

For the year for the first six months our comp sales in the patient care centers increased by 0.5% as a result of the good second-quarter performance and SPS for the first six months was at a 9.9% increase. Our cost of sales year-over-year, the gross margin increased by 4/10 of a point from 50.4% in 2004 to 50.8% this year and, again, the principal reason was the favorable results relative to material cost.

Our SG&A increased by $6.5 million compared to last year, 2.5 million of that was associated with the inflationary impact on labor and the healthcare costs that I mentioned a minute ago. 1.6 million was tied into our growth initiatives and the balance, 2.3 million, related to inflationary pressure in our fixed operating cost such as rent and travel.

EBITDA as a result of the good second-quarter performance improved to a point where it's now only $500,000 behind 2004 at 36 million compared to $36.5 million last year. Again, the same results were shown in depreciation for the six months; that increased only $300,000 year-over-year due to the lower additions and the interest was again impacted by variable interest rate increases and it increased by $1.6 million.

On the balance sheet our accounts receivable, as Dan mentioned, decreased by $4.6 million and that's despite a 3.1% increase in sales during the period. Our DSO's improved to 66 days and the overall aging of the receivables really improved pretty dramatically. Our (indiscernible) 120 day old receivables were reduced to $23.3 million which is 20.7% of total AR, and that's compared to $28.2 million at the end of last year or 23.8%. And you have to keep in mind, this is in the face of having -- we do have some continued issues in Regency (ph) with Medicare where they are automatically putting claims into appeal which has not impacted our overall flexibility but it has impacted the aging in that part of the country for the Company. And we're pretty happy with that reduction in the over 120's.

The inventory increased by $4.2 million to $71.9 million from 67.7 at year-end and that increase both supported the increased sales in our practices and our distribution segment and to some degree helped us meet some purchase commitments at SPS.

CapEx -- I already mentioned for the quarter was $2.4 million, $4 million for the year. We don't expect to be able to keep the second half as low as we did the first half. Keep in mind, our budget for the year is 17 million. The second half will probably be more in line with what a normal budget would be, about half of that $17 million number.

Cash flow from operations at $23.7 million was $3.7 million better than last year. That was due to a combination of the increase in net income and a reduction in our working capital compared to the same period last year.

Now moving on to our expectations, based on the current expectations for the Linkia contract implementation, Hanger is adjusting its guidance for the third and fourth quarter. Revenue is now expected to be 149 million to 151 million in the third quarter and 154 million to 156 million in the fourth quarter. The revenues for the third quarter assume no incremental Linkia revenue and the fourth quarter assumes only a minor increase. EBITDA is now expected to be in the range of $19 to $20 million in the third quarter and $22 to $24 million in the fourth. Based on those results we see the year coming in at a range of $585 million to $590 million in sales and $75 million to $78 million from the standpoint of EBITDA performance.

At this point we're not going to change our 2006 expectations. Once the Linkia contracts have been executed and we've had some time to work on implementation and can firm up the start date for operations we expect to be in a better position to evaluate the performance of the contracts and modify our 2006 guidance if necessary.

Based on the revised earnings expectations, as Van mentioned a minute ago, Hanger approached GE Healthcare Financial Service, our administrative agent, for the revolving credit facility and the term date. GE has proposed to modify our financial covenants and other items within the credit facility. In addition, the maturity of the revolving credit facility will be extended to match the maturity of the term loan date. It had originally been scheduled to expire in February of '07. GE has agreed to underwrite most of the revolving credit facility changes and we believe the modifications to the term loan B are within current market conditions. We expect to begin the amendment process next week with the intent to close the amendment the week after Labor Day.

That's all for now from a finance standpoint. I'm going to turn the call over to Tom.

Good morning, to all. A pleasure to be with you this morning. I'm going to take the next few minutes to provide some color on the events that impacted our operations for this past quarter and then I'll turn my attention to discussing some of our improvements in growth initiatives.

For the quarter overall our sales were up by $4.5 million compared to the same quarter last year. This equates to about a 3.1% overall increase and in order to understand that let's go down to the divisional level and take a closer look at SPS and HPO. SPS's sales are up eight-tenths of $1 million compared to last year, this is an increase of 7.9%. This growth is slightly less than the growth we've become accustomed to at SPS, particularly over the past few quarters, but it is in line with our expectations and it confirms what we forecast on the last call.

You will recall that SPS assumed a major new product line in March of '04, so in this quarter they're comping against essentially similar product portfolios. Notwithstanding this transition, SPS has generated these sound results by continuing to reinforce their competitive advantages of strong customer service and a complete product line. The manifestation of these advantages in the past quarter was the addition of some smaller suppliers into the product portfolio and an outreach program to some of SPS's smaller customers.

In this case our sales team worked with these smaller customers on a regional basis to band them together in order to establish some informal buying groups. These buying groups in turn then came back and awarded SPS a significant purchase order and we anticipate that this is going to continue and the sales team is going to take this example of creativity and roll it out across the country.

So on this score it was really an element of an above and beyond effort of the sales team. SPS is also benefiting from their recent publishing of their new catalog. We know once we publish a new catalog bringing out all the products that we do see some benefit on the sales line. Further on this score SPS anticipates having an electronic version of that catalogue which will feature initially the 20,000 to 25,000 key items in their portfolio available by the end of the fourth quarter and this is part of the overall e-commerce plan that I mentioned to you last time.

Now let's turn our attention to HPO. HPO accounted for the balance of the sales increase or $3.7 million. This equates out to a 2.7% overall growth for the division. Let's look at the drivers of this increase. The first one is that we've had an improvement that was spread across all of our business arising from the existing Linkia payers. The second stimulus to our growth in sales is that we've now begun to see some traction on our marketing and growth initiatives that we've been implementing over the last several months and quarters. (indiscernible) I'll be talking about some of those a little bit later. And finally, we've had the benefit from some small acquisitions that were made after June 30, 2004.

Looking at our HPO business, we know that this base business continues to be challenging in terms of revenue pressure. Continues to be the result of a series of factors, some of which we've talked about, but I do want to spend a little bit of time discussing them today to bring you up to date on what's going on out there.

The first issue is this continuous review by payers, particularly the federal payers, on the fees that are associated with our selected codes, and these take many different forms. For example, in some cases it's to help economics evaluation where the local demarks (ph) will come in and study a code procedure and it may or may not result in fee reductions and we have seen some of these over the past few quarters and years, think we are mainly through that process.

In other cases they may come in and look at reclassing codes and that may result in subsequent fee changes. Or in another example they may create new codes and sub codes which then may combine base codes and add codes together. The net result of all of this is the government has a continuous program underway of not only evaluating new codes for new procedures, but also evaluating the existing codes to ensure that the economics of the delivery of those are in line with the health benefit.

And unfortunately, as we mentioned the last time, after the federal government gets finished with these, these changes are captured by outside third party payers and ultimately find their way down through the negotiating process into the contracts that we negotiate and all of the O&P suppliers negotiate in the community.

It is an ongoing process, we think we have seen the biggest hit certainly on the federal side. We think there still is a little bit more of this migration into the third party payer fee schedules yet to come, but certainly not as significant as what we've seen over the past couple of years.

The second major area that's giving revenue pressure is that the size of some of these third party payers has been increasing; consolidation is continuing to occur in the healthcare industry and I don't have to tell you about that. There's no question that these firms then come back and use that leverage when they negotiate with us to try and aggressively reduce prices charged for their procedure. Fortunately we have a fixed cost labor model and we're in a position to take advantage of that increased volume in leveraging our fixed cost model and we'll talk a bit more about that later.

The third area are the continuing changes in our health insurance benefit design programs which serve to either inhibit or delay patients in receiving timely and quality care. Some examples of these kinds of benefit design changes are deductibles or caps on the amount of reimbursement that the third parties will pay for certain procedures. This is becoming troublesome -- so much so that we've been working with national and state association and other participants in the O&P space to make sure that we're providing education to all of the policy makers on this issue.

In some states we have already managed to have legislative changes made so that we can ensure that quality care can be provided on an equivalent basis with federal levels. And I'm happy to report that we're working with the Amputee Coalition of America in supporting their efforts for a grass-roots statewide effort so that the amputees of this country can get good quality care and are not capped off.

And the last major area that's causing revenue pressure is with all these changes in the marketplace we are seeing some aggressive pricing by individual O&P providers that are desperate for receiving business as well as we've seen some impact on pricing by certain individuals out there who are not qualified to provide care. And obviously you remember seeing how some of this fraud and abuse was written up recently in the paper which just conspires of a lot of extra work in the system and George has referred to some of that when he mentioned the probe and its impact on our receivables.

I'm going to be talking a bit more about some of the projects we have underway to counteract some of these trends on the revenue side, but let me just for the moment continue with a brief discussion of the other factors that impact our P&L. As George has mentioned, our cost of goods decreased slightly for the quarter on an absolute and percentage basis in spite of our higher sales -- primarily attributable to our material costs. They were down partially to our special initiative which really focuses on better purchasing and better utilization of materials through our fabrication process. This benefit we were able to capture in spite of an increase in pricing that we're seeing on all of our polymer and metals based materials.

Last time I reported to you that we held a special seminar during our education fair back in February to help our people better understand how to use materials and we think we're seeing some dividends on that. Labor costs have increased slightly, as George had mentioned, reflecting the cost of living increases that were giving at the beginning of the year. But the combination of our higher sales and our lower cost of goods resulted in a gross margin improvement of $7.4 million compared to last year.

Coming down the P&L EBITDA increased by 1.8 million on an absolute basis and on a percentage basis it went from 12.2% of sales last year's quarter to 13% this year due primarily to our higher gross margin and our efforts to manage our SG&A expenses. George has already reviewed SG&A but, just as a footnote, let me mention that if we were to exclude the salary inflation, health costs, the cost of our growth project and adjusting out for the small acquisition, our SG&A expenses were actually less than those in the comparable quarter of last year. We believe this is a result of our special initiative to manage costs and selected controllable accounts such as travel, office supplies, communications, professional expenses.

We think that initiative is taking hold. We put our targets out there in the second quarter. A substantial benefit in the communications area. We negotiated a new national purchase agreement with a large office supplier company. And so we think we're going to continue to see benefit from that in the third and fourth quarter.

So let's now go back to the key issue for us which is sales development. And as I mentioned, with our fixed cost labor model we get substantial benefit at the bottom line with each dollar of incremental sales. We know the marketplace is tough in the core business, but we've implemented some programs to capture market share. In addition, we've launched some efforts to bring online some new types of revenue generating opportunity. We group all of these efforts into three major areas. The first one -- capture market share using sales development and contracts. The second one is using our product knowledge and our process technology to exploit some market imperfections that are out there in order to launch some new sales opportunities. And the third is using our knowledge of orthopedics and healthcare relationship to assume a broader role in the overall orthotic rehab area.

Let me amplify each of those for you and give you some examples. Let's take the first area of capturing share. We're continuing to deploy our field business development sales force. We're out there working with our practitioners in opening doors to find new referral sources and in reinforcing some existing relationships that we have through education, training, value added initiatives that all help to make our clients medically and economically successful in their business. Our business is providing solutions to our referral source and high-quality care to our patients. This field force currently covers about 20% to 25% of our sales territory and they are making a difference.

And the other area that we use to capture share is contracting. This is primarily our Linkia subsidiary that is our provider network management company. You are aware of the status of these negotiations based on the comments of Dan and George has quantified the impact on our forecast for the third and fourth quarter of this year. But I'd just like to add that we do continue to see additional business coming in from our present clients for our Linkia products as well as interest from other prospective clients when we go out and introduce this concept into the marketplace.

Now let's turn to the second area which we've call exploiting market imperfections through our technology. We're continuing the rollout of our Insignia laser scanning system for a variety of patient indications. We use this for not only prosthetic limb replacement, but also several orthotic applications such as cranial bands, body jackets and Ankle Foot Orthosis. For example, the supply of cranial bands this quarter versus the same quarter last year is up over 100%. We now have 547 certified Insignia users out there compared with 450 at the end of just this past first quarter of this year.

These folks are using 343 scanners compared with 300 that we reported to you at the end of the first quarter of this year. All those scans are being sent to three national and 26 regional fab centers for carving. This is up by one additional regional carver since March 31st. Our ultimate goal here on these regional carvers is about 29 or 30 at full buildout. So we're making progress along those lines.

But as I've mentioned to you even on prior calls, the Insignia system not only is a productivity and marketing enhancement, but it's also a linear and volumetric measuring tool which when combined with the proper software can be extended to other applications. For example, we have launched a business commercialization effort to provide better patient care to burn victims using Insignia to measure them for custom garments and masks. These garments and masks have demonstrated their efficacy in clinical trials in improving the skin grafting and recovery process. We've completed the software for the mask portion of the project and have held our first clinical and marketing seminar this past June to train our marketing and our clinical personnel.

Our practitioners and marketing personnel have been assigned to major vendors, burn centers and they're out there now demonstrating the efficiency of this tool. A second seminar is planned for early September. We're also developing software that will enable compression garment manufactured and expect to have it complete in the next several weeks. In both of these applications Insignia is displacing a laborious process of measurement. It can expose the patients to pain and infection. We think that this is a significant advantage and will provide a benefit to the burn centers as well as to the burn patients.

We're also contemplating extending Insignia into the custom shoe and shoe insole business. This is going to be an augmentation to our expanding sales effort of diabetic and our orthopedic shoes. We call the line (ph) Answer To (ph). We launched the Answer To pilot about a year ago and, based on its success, we're now commercializing a full product line through a combination of internal and external distribution channels and relationships.

Another good example of filling a market void is our WalkAid product for improved ambulation on stroke and other patients impacted by drop foot. Drop foot is a condition where the foot does not flex normally as it swings through the swing phase cycle of walking. We've discussed the WalkAid and its benefit on some prior calls, but let me just bring you up to date. As we've mentioned, it is our first entry into the neuromuscular electrical stimulation market. Currently there is no product in this market that adequately satisfies patients' needs.

We've advanced the product in its technical and clinical evaluation since the last quarter and we expect to file an FDA application by the end of August and we'll be filing that on an expedited status spaces. We have done all of the groundwork in order to launch some clinical tests and those tests will be starting shortly and we still maintain a goal of entering the marketplace this year.

Now the last -- or the third area of how we're going to address the sales issue is one that I describe as assuming a broader role in the overall orthotic in the rehab area. Through our two pilots, which we purchased at the end of '04 and the beginning of '05, we've seen the appetite and the benefit for a bundled orthopedic rehab solution package. Included in this bundle are devices, ortho rehab equipment and patient training, all of which are delivered in a high-quality mobile and responsive manner. These pilots have been growing sales nicely and we're going to be rolling this concept into other markets and applications in the U.S.

We are currently engaged in discussions with outside service providers and service consumers in order to secure our position in the marketplace for these services and to strengthen the appeal of our value proposition. A synergistic benefit that we've seen to this entire area is that it is a natural complement to our base O&P service and having both permits us to provide a comprehensive total care package to our patients while giving assurance to their doctors that they're in good hands with a single source responsibility provider and a continuum of high-quality care.

In closing, we continue to see the competitive and the reimbursement issues in our marketplace. As a result, we know that we have to constantly find ways to be more productive and efficient in delivering our services and products and convincing our referral sources that we should be the provider of choice. We also recognize the need to find and develop new sources of revenue that have good margins and returns. To meet these challenges we've undertaken a series of initiatives to control our costs and we think they're getting traction and are working well, as well as a set of projects targeted to the revenue issue and we think that those are underway.

And we've not lost sight of the fact that in all of these efforts we've got to manage the investment costs of our new areas, control the costs of our overall projects so that we can provide the shareholder value that we know that our shareholders demand and expect. Thank you very much. With that I'm going to turn it back over to Van Sable who will monitor our Q&A session.

Thank you, Tom. We can open it up for our Q&A session.

(OPERATOR INSTRUCTIONS). Arnold Ursaner, CJS Securities.

I want to focus a little bit more on Linkia and the opportunity there with the new contracts. While I know you can't be unduly specific about them, can you give us a little bit of a feel for the opportunity there and whether the structure of the contract is different than the previous ones you've had?

Thanks very much for that question. The structure -- we'll take them in reverse order. The structure is different from the previous ones. I think we had mentioned in the past that the previous contracts have really set us up, particularly the one big one that we've announced, have really set us up more in line as a preferred provider where we are a participant in the network of the third party insurance company. We believe that the interest of the insurance company as well as the patients can be better served when we use Linkia at its full capacity which is to be the manager of the provider's network.

In that case we actually, in conjunction with the insurance company, take over the whole network. We relieve the insurance company of the administrative burden thereby adding benefit to them in the form of simplification and cost reduction. And we can also assure them that through the management of that network that we can provide quality care through protocols in all of the typical total quality management tools. So it not only simplifies it administratively, it also provides good quality backend to the care that's given to their membership.

And also by managing that network it really allows us to control who gets in and who gets out because we really do understand this industry from the bottom on up. We naturally designed that network in conjunction with the insurance company and in accordance with their network strategy, so they are full participants in the strategy of the network. It gives us much more control. It also helps us -- in addition to controlling the quality also helps us monitor how the volume is divvied up among all the participants because we're only going to put volume into the hands of those that can demonstrate that they can handle it and we're not going to have extraneous suppliers, i.e. the overall benefit of a volume increase.

So the benefit of the new contracts would be total management of the network, which means that we will be allocating volume in accordance with their network structure and coming back to them will be the benefits that we've discussed. So it is similar but a much higher level of participation by Linkia. Also we'll be able to ensure that all the people will be electronically capable so that all bills will be sent electronically, all remittances will be received electronically and then dispersed electronically, much greater simplification of the overall. And of course by providing all those services Linkia will get a benefit in terms of reimbursed for their cost and we get the volume benefit.

In terms of the overall opportunity these -- don't want to go into much depth on this one, Arnie, but these are very large national payers that have a significant book of business approaching over tens of million and approaching $100 million in their total, total rehab space. So as we look at this and decide how well this factor down, each one gets modified by that network strategy in terms of the piece that falls down to us. In other words, a practical example, if someone had $100 million worth of business and the network strategy called for a reduction of say 50%, and depending on Hanger's participation in that 50%, we could see a significant volume increase.

But suffice it to say that both of these players have significant books of business on a national level and we can see the amount of business that Linkia will manage being in the high tens of millions. And then our respective piece coming out of that will depend upon this network strategy that both have decided to carry on.

Thank you very much.

Kevin Fischbeck, Lehman Brothers.

Good morning. I was wondering if you could provide us a little bit more color on Linkia and what exactly has been causing the rollout to occur a little bit more slowly than expected. And then now that you do have some experience with deals, will new announcements come more quickly or do all these contracts have the same type of leadtime? And then finally, if you can comment a little bit about the acquisition of PacifiCare by United, does that automatically roll in or is there going to be further negotiations around that new business?

Let's try to tick them off as you've asked them, Kevin. The first one is what's causing the delay. I think it's been a learning experience on both sides. Certainly one of the things that we've seen is, as we've mentioned before, we're a very small piece of their overall action in terms of all the healthcare demands of their membership. We know that those numbers rise to levels of $150 to $175 per member per month and O&P is a small piece of that, in the neighborhood of $0.60 to $0.70.

And so we have seen through this process that we are just not getting front burner action. As other issues come along, positive or negative in their shop, and that includes acquisitions that they may make, other investigations or other things or analyses that they're conducting in other areas of their business, our project seems to get put off and gets lower status. Some of them have gone through organizational changes which has resulted in one case in our educating three people on the sell in process of what it's all about.

So the first delay is just the overall priority within their system. The second delay is that we're forging some new ground on the O&P side here and, as a result, in working with these people to get to all of their states and all of their legal folks, that has been a much more arduous process than we anticipated. And so it's not to say that there's anything in there that's going to kick us out, it's just that in one case we actually had to work our way through all the regional VP's to ensure that the program that we were putting in was going to be consistent with all the employees or all the employers that were within their membership and that we were providing quality care. We almost had to go out and get a regional buy in before doing this.

So it has just been a much more difficult process than we first imagined. We still have that goal in sight, as Van has said, and it's still going to happen. Now having learned from that, the answer to your second question is that we think we can be a little smarter on a go forward basis. We're really going to do some things within the process so that we can walk in the door on some of these other folks that, as I called them before, the prospective clients with more information in hand, we can use what we've learned, and so that we'll be better prepared.

We also know that as we're working our way down -- if you remember Van said we started with the biggest ones and now we're working our way down, we don't think they're going to be as complicated when we get into some of the smaller nationals or into some of the regionals where they'll have so much of a gauntlet in place. And so on a go forward basis we're going to do some things on a proactive basis and we don't expect to encounter as many obstacles. So we're anticipating less leadtime on a go forward basis.

And then just PacifiCare?

Yes, it will roll in. United's history that we've seen typically is that they acquire and then they sort of slowly integrate. They let the Company stand out there. So we will integrate right into that program. Any subsequent changes to that we are certainly not aware of at this time. I think as United digests the acquisition and integrates it they'll provide additional color to us on this.

And Kevin, just as a follow up to that, we have an excellent working relationship with both organizations, both PacifiCare as well as United.

And then one last question. If you could provide a little bit more color on the same-store growth during the quarter. How much is Linkia, how much was (indiscernible)? It sounds like pricing was flat or maybe still under a little bit of pressure? And then how much of a benefit if any was there from these other initiatives that you announced such as the innovative Neurotronics?

Innovative Neurotronics is still in the development stage yet. It's not out there. The growth in the quarter is primarily coming from some of the marketing efforts that are out there. As I've mentioned, we've got those two pilots out there. Linkia, the existing people, the existing clients of Linkia are moving up. We certainly did not see the kind of growth over the last year that we anticipated, but we have been seeing growth. We have been picking off additional business and so it is rising. So the primary drivers when we come to same-store is the Linkia which, of course, spreads across all of our businesses. Some benefit from our field business development effort and then getting some traction on some of these new programs particularly our two pilots that are out there.

So would you say that this growth is more kind of a sustainable growth that we should be expecting or is there anything going on particularly in this quarter that may have skewed that number one way or the other?

I think it was a good quarter. We don't see any speed bumps in the road at this time. On a go forward basis we think that the augmentation of some of the new -- the other things that we've seen and the roll out of some of those programs should enable us to continue at about this trend.

Okay, great. Thanks.

Mosem Javey (ph), Dain Rauscher. Richard Fullerton, Fullerton Capital.

A couple more questions on Linkia. So you were kind enough to walk through the example where large providers got a 100 million book of business. So let's say that you're currently 20 million of that book, could you give us a sense as to what portion of the volume share might go to you over a couple year period of time, where might it settle out?

We certainly can take that example and use it in a generic case. As I mentioned, I don't want to be specific to any of the carriers, but the numbers work. If a provider out there say has $100 million worth of business and he's now servicing that need by a series of 2600 contracts across the United States -- let's say his network strategy would permit a 50% reduction in that strategy which would now mean the network provider basis would shrink to half of that or say 1300. We would look at who qualifies and who doesn't on the outside. Hanger has 620 patient care centers throughout the United States which would indicate that in this example that we would capture 50% of that insurance company's business.

So if his book of business was 100 million and we were currently doing 20 we would see ourselves rise to 50 million. Over time we want to fine-tune the network, we want to make sure that it's quality people. And obviously over time Hanger is not wanting to be in a static position, so we want to continue to grow our presence through satellites and all the other things we've talked about. So over time we would like to march up on that 50 million so that we could go to some higher levels. But that's pretty typical of what we're seeing and pretty much in line with those people. The ratios hold for the most part regardless of the overall size of the book of business of the carrier. But that's a practical example to consider.

So it sounds like it could be an initial -- whether the initial 12 months or whatever you'd call it, but an initial big uptick and then maybe a more gradual steady market share gain to a somewhat higher number than 50 overall?

It really depends on the negotiations with each of the providers as to how big that initial step function is. We forecast -- and of course we now have been working on building out Linkia in a controlled fashion -- but we forecast it, it's probably going to take two to three months of get ready. Now that is to find the network, to get the network established, qualified, get them into all the protocols, get them e-commerce ready. At the same time working with the provider to make sure that they can accept -- we blackbox into all of their -- equivalent of the A37, A35's which was a build-in, the remittance is back. That all of that gets ready. So you've got that lead-in time. Obviously that will get shorter as we build out more and more clients within Linkia.

Then as we begin to take over the network we're again reliant upon how the existing insurance provider wants to -- do they want to terminate all and restart the remainder -- how they want to make that transition. So we can imagine a ramping up over a couple of quarters. Or on the other case, if people want to go to what they call a hot start it would be much more of a step function. But ultimately if we were to look out there on any given contract and say well, what happens over six months, that's where you'd see the big step up initially. It may come gradually or it may come more abruptly and then marching on out for increasing levels of their book of business.

And by the way, we also hope and anticipate that once all this gets going we can, through the Linkia contract that's in place, we can define additional services that can go in there beyond the core O&P. And we've been talking to folks about that. So it's a bit of some add-on so that we can expand not only in terms of Hanger's share of the business but the overall size of the pie.

Okay, great. Thanks for her that elaboration. Regarding the Q3 and Q4 updated guidance where it looks like you took some revenues out of the estimates, is that solely related to the push out and timing of Linkia?

Yes, it is.

Great, thanks a lot.

Mike Petusky, Thompson Davis & Co.

Wondering if you could talk about the possibility of going back to United Health and restructuring their contract more like these new contracts that you hope to sign here shortly? And also if you could talk about just how the next six weeks lays out. Obviously you've got to be assuming for revenues to start ticking in on the new contracts in Q4, you've got to be assuming these new contracts are actually signed and done in the next few weeks. And also if you could talk about the timing on the amending of the covenants and meetings and increasing the maturity on the revolver, etc. Thanks.

Let me tackle your first two and then George can comment on the third one. I think the first question is what is the possibility was the word you used and that's an appropriate word -- what's the possibility of going back to United to negotiate a different deal. I'd say the possibility is excellent. Certainly right now they're pretty much consumed with the integration of their newest acquisition and, based upon their trend, it doesn't sound like they're going to stop there. We know that they have an active and pretty robust ongoing effort in the acquisition area that, as I said before, doesn't always give us top priority.

I think the possibility becomes even enhanced after we would get some other clients into Linkia because they may be able to better understand the benefits. It is a small community out there, folks move around, they sort of keep a watchful eye on what the other ones are doing. And nothing will inspire some envy or perhaps curiosity as well as bringing out one or two of these others and letting them here or see of the advantages. So the door is always open. We naturally would be very interested in going after that.

At the present time, however, we've been devoting our full effort in going after these two that Van mentioned earlier. We think let's get these, let's get these full-blown Linkia plays, let's demonstrate some success and then we're going to come back and talk to United and see where they want to go on that. And others certainly, but certainly United. We've got discussions with others underway and, to your point, bringing United into a full Linkia contract is something that we'd like to do, but we're going to do that after we get some other things signed. That was number one. You had a second question on Linkia, too? Sorry I forgot.

No, more I was asking just (multiple speakers) the next six weeks or so layout -- timing of meetings, mending the covenants, revolver, reducing the churn on the revolver, timing of the contracts?

The process starts next week and we expect to close the week after Labor Day. (multiple speakers). That's the amendment process. I can't get any more specific to that because we haven't talked to the banks.

And then your fourth-quarter guidance has to assume then due to just the time it takes to get these things going that the two contracts you're talking about start or are signed during the next few weeks, correct?

Certainly as we announced going back a couple quarters, we anticipate the signing and then the subsequent announcement of those by June 30th. For all the reasons that we talked about before it hasn't quite happened that soon. All indications are it is right around the corner. Based upon our view of what's going on in this process I would certainly answer your question affirmative and that's the basis that we're going on. We've been doing everything to turn paper and get it back as promptly as possible. It is on the other side of the fence, but we have to make some assumptions and they're the best ones we have at this point to go with.

And Mike, the discussions are more focused in honesty around implementation as opposed to a specific date of actually signing a contract.

Actually, let me ask one more question if I could. I'm getting more questions from investors on some of the new product development stuff -- WalkAid, burn garments, etc. Could you just talk about potential market sizes in some of those bigger products?

They're very large markets. I can give you a little bit of color on some of that. Obviously the trick is you don't really know how much you get of that potential market until you get finished with your clinical trials and then actually get into commercialization. But if we want to take something like the WalkAid, and we know that there are 700,000 stroke patients a year. We know that 500,000 of those survive. We believe being conservative that 25% of the survivors would be candidates which would give us a pool of ongoing annual 125,000 patients that could benefit from the WalkAid or a combination of the WalkAid with one of our classic orthoses orthotic devices Like an AFO.

Depending upon how our health economic studies come out, we'll reach a price point -- it's not going to be $10,000 and it's not going to be 500. So it's going to probably be somewhere below the average of those two and that gives you some sort of a feel. But discussing what they are at this time -- we haven't even developed yet our pricing strategy nor our healthcare economics on that. Pricing strategy is do you want to go for saturation or do want to hold it up as a high-end product and then have it only on severe cases.

All of that is part of, obviously, the commercialization effort, but that's a pretty good sized market. In addition to the fact that there's over 4.5 million people that are out there today sort of as a base business. Certainly we're going to go after some of that existing business as well as that annual flow. So it is a sizable market. That's just the U.S. We would intend to go international as well. So that's a big market.

On the burn garments, our research has been -- here again research is always focusing on what is today, and I'll give you some color on that. There's 300 major burn centers in the United States, there are about 300 minors. Every hospital to some extent or other does burn patient treatment, but these are the major ones and they're pretty big. Size of the bigger ones can be 500 patients a year, the size of the smaller ones could be a couple hundred patients a year.

One of the limitations today, even though the efficacy of burn masks and burn garments have been used is that in the case of burn masks for example, they're used on the face, it's an awful process. You can imagine after skin graft procedure the way that the mask image is created is that they actually will put a plaster of Paris type material on the patient's fact. It subjects that patient after that grafting process to infection; furthermore it's very painful. One of the docs told me they sometimes have to sedate the patients when they do this.

The ability to go in and scan and capture an image where it didn't have to have hands-on, where it didn't have any pain could grossly enhance the market here. So as we look at this overall marketplace, all of these patients and we examine that garments, masks that typically on a per unit basis could be anywhere from the $1000 to the $5000 level per patient. It's a sizable market and we might be able to expand the penetration, the use of these devices because Insignia is a tool that eliminates infection, eliminates the anesthesia risk, eliminates the pain. So it could be a sizable market.

So I think as we look across all of these -- these markets are huge. The real challenge to us is to price appropriately so that we can establish what is the relevant share that we think we can capture out of this and then do our homework on estimating how much our tools and our marketing efforts could expand the overall market. But they are meaningful. And certainly as we go down this process we are measuring all the metrics and as we really get into the commercialization phase on a more detailed basis we will be giving more color around what it means to us.

And Mike, what this does is it starts to evolve Hanger out of a --obviously our core business of prosthetics and orthotics is still the cornerstone of our business, but these new initiatives, utilizing the technology that we've developed, really takes out of and starts to spread the continuum of services that we're able to provide patients.

I think you said earlier that you thought WalkAid you would actually start commercialization towards the very end of this year. What about burn garments? What's the timing on burn garments?

We are currently out there on a limited basis. As I mentioned, we had our first seminar. We have targeted 20 of the 300 major burn centers as what I will call a pilot test. We have assigned an orthotist to go work with those on -- with a marketing person to demonstrate how Insignia works on the mask. We want to make sure that we really understand this. So that one is out there today.

We have concluded and we'll be approaching contract signing with the manufacturer of the material that these masks are made from. There's a lot of intricacy -- intricate kinds of things going on here on the material side. So that is there. Materials are in place, software has been written, people are deployed, 20 in the target. So that's ongoing now.

On the garments, as I mentioned, completion of the software in the next couple of weeks we'll be working with the garment manufacturers to lock them down so that they will be in a position to receive those digital scans and go directly to their laser cutters and then manufacture the garments. Then of course once that gets done we'll be training our personnel on how to go do that. So it's sort of the phased role in that's going to go out over the next six to 12 months.

Terrific, thank you.

Matthew Ripperger, Smith Barney.

Just a couple questions. Do you have the breakdown in terms of the revenue for prosthetics versus orthotics in the quarter?

Yes, I believe we do. Hold on one second.

We can give you the split from a percentage standpoint. It's roughly -- the quarter was roughly 46% prosthetics, 44% orthotics and we had some other sales. The year is closer to even.

You mean year to date it's closer to even?

Yes, so you can see there was a swing in the quarter.

With prosthetics growing faster than orthotics?

Right, and that has better margins for us.

It has better gross profit margins?

Yes.

So was that mix shift one of the contributors to the better gross profit margins in the quarter?

Yes. And it's a higher price point and it's a lower material cost, but there's more labor component and of course the labor is a fixed cost.

So when you look at sort of -- the revenue growth sequentially was up 12% and cost of goods was up 6%, which is the main reason for why gross profit margins improved so much. How much of that gross profit margin improvement would you attribute to mix versus some of the contracting initiatives that you've put in place?

It's probably equally split between the two. It's hard to analyze that because you've got a lot of transactions flowing through. But it's probably pretty equal between the two.

And then in terms of going forward through the remainder of this year, how would you recommend we look at cost of goods as a percent of revenue given that it's been somewhat volatile going back historically? Do you think you can maintain it at this level?

Matt, when you look at gross profit and cost of goods there's two numbers that are summed together in our public reports. There's the materials number and there's the labor number. We're running at about 30.4 million of labor per quarter in the cost of goods and we're running right now at about 27.8% of revenue for cost of materials. We don't really imagine that fluctuating too much between like 27.6% and 28%.

The only thing that's going to change that going forward, and it will be to a lesser degree with the news on Linkia, is the cost of materials. The margin is going to be less from a gross profit standpoint in those transactions. That's going to have some impact in the fourth quarter on our margins. It won't be dramatic because we don't have a lot of sales projected. It'll be more of a factor next year.

And the margins on Linkia will be less because of the mix of the business or because the price point is lower?

Price point.

And can you give a sense at this point of what the relative margin would be on Linkia versus your current margins?

No, we can't because until we sign the deals and start implementing we don't really have a good view of that.

Okay. And then I had a question for Tom actually. Going back to the point you were raising about demerks (ph) and doing these sort of intra-year reviews, I just wanted to make sure I understood. Basically there's a specifically laid out fee schedule that you abide by when you bill Medicare and yet the demerks have the ability to go back and do these intra-year reviews and adjust the fee schedule which is having a negative affect on your pricing?

Let me get a little more specific on that, Matt. First, it's not triggered by any point in the year. They are really chartered to do this almost on a continuous basis. And so it is not specific to any month. And the way the procedure works is they will look down their overall billings, they will determine where they're spending money, what are the high frequency codes, take a specific code. If they see that it's being used a lot they'll conduct sort of a preliminary investigation. What's going on, they try to correlate that back to why are we seeing so many people with this indication that's causing this thing.

So they'll first try to establish a link between consumption and then the cost that they're seeing. As they satisfy themselves that everything is in order there and in some cases we know from the fraud that went on they saw an awful lot of scooters and other things that were out there that resulted in certain actions to control the cost on that side. For example, they froze down and wouldn't issue new supplier numbers for a while because they saw that many of these people that were providing mobility assist devices were all coming off of new supplier numbers. So they'll take some action there.

They convince themselves that that's all valid and justified, then the next thing they'll start to look at is gee, if we're paying $1200 for a certain procedure, is that warranted, how long has that price been in effect? Do the economics of providing whatever it takes under that code still make sense? Well, if that price was established and then grew over time with their CPI increases maybe 15 years ago, they go back and they look at the underlying work that causes the price to be what it was.

In one case we saw that years ago that price was established because there was a high manual component of the work. Each one was custom-made, that's what led to that price. What they determined was that in today's world many of these are not custom made because the suppliers and the materials have changed such that you can almost go with either a small, medium and large. Or they have said well, it's custom for the first one but then subsequent ones you've already got the size and measurements and unless there's been a change in the patient we shouldn't be paying you the way we used to do it where everyone was one off and everyone was custom.

Or they may come in and say well, the whole price of manufacture of this device -- well, it used to cost 500, now it costs 200 so we know you're purchasing the device at a lower level. The device is more sophisticated, there's less time involved with putting it on. So they'll write up a complete dossier on this and they will propose a fee change for that specific code. They put it out there for public comment. You do get a chance to respond. But in some cases it's difficult unless they have really misunderstood what was happening and that happened a couple of times and we were able to correct that and bring that back in line.

But we do have indications where they went out -- in the case of a liner for a prosthetic socket, that was the example I had in mind. It was historically always custom-made; now the first one is custom, subsequent ones are more or less coming right off the same dimension. So they cut the reimbursement from $1200 to $600 because of that. Now in the case of Medicare, we do about 7,000 of those a year. That had a meaningful impact. Well, now that is now listed out at 600 on the fee schedule, so as we then go through our contracting process no insurance company wants to design their own fee schedule so they all grab onto the Medicare fee schedule.

So a year, two years down the road somebody is going to reference back to that Medicare fee schedule which will include the 600 for that code, so it ultimately migrates through your whole book of business because Medicare is about a third of our business. So it is an ongoing process. The same is also true -- I don't want to make this sound like it's totally onerous. If we introduce a product enhancement or a manufacturer does, they are equally willing to look at the issuance of a new code and then the pricing structure behind that code in order to allow you to capture the true value that is inherent in the provision of that device. So it goes both ways.

So it is a dynamic process that goes on from time to time. And actually what we would like to do is focus more on the new and have all the existing stay the same. But we know that's not realistic. Certainly Medicare is not in the position to allow that to happen. So that's what I was getting at and they have several mechanisms that they go through in that whole code review process.

But would you include the positives and the negatives of this whole code review process? I assume it's a net negative?

For the last couple years it has, it has taken a big bite out of us. We can look at other specific time periods where it's been a positive, but in the near recent past it has been a net negative and that's why we've listed it out as one of the key changes and one of the negative pressures on our revenue.

So even though by law that Medicare has to keep the fee schedule flat for O&P for the next couple years as they have the last few, because of this intra-year process that flat is actually negative?

What they've said is we're not going to give you a CPI increase. Historically over the last almost 15 years they would come in and -- just sort of the peanut butter approach, everything on that schedule went up by 2%, 1.1%, whatever they deemed appropriate. What they've said is we're freezing that. In other words, you get no CPI increases, but they still maintain the review from a health economics to see if the costs are in line and also the review for the admittance of new codes and pricing changes if we've enhanced the product. So that is ongoing continuously.

One last question is I understand there's a correlation between Medicare -- the fee schedule for Medicare and commercial. Is that a 1 for 1 correlation or are your commercial rates at a discount to current Medicare rates?

We run the gamut. There are certain portions of our business where we actually get above Medicare fee schedules. There are others -- and frankly, this is what the negotiations are all about and each one is a bit different. There are others that are a discount to the Medicare fee schedule. I guess the key variable that determines that is how much volume is at stake. Obviously with a fixed cost model we can afford to be more generous in exchange for volume. If it's small and one off then we're going to be more near the Medicare fee schedule. So they're all different and, as I say, they go from above the fee schedule to below it.

Thanks very much.

Scott Willen (ph), TCW (ph).

Just had a really quick question on your liquidity, if you just go through your revolver balance and your cash?

Sure. Revolver balance at the end of the quarter was $13 million, and our cash balance was 8.9.

Thanks.

Casey Klagger (ph), Locius (ph) Capital Fund Management.

A couple of questions. One is with regard to the term loan and the revolver. Do you anticipate those negotiations will result in an impact on pricing, and if so, sort of the magnitude?

Can you repeat that?

Sure, this is a (indiscernible). On the negotiations with the bank group in terms of extending out the revolver and adjusting covenants, do you anticipate you're going to get anything in exchange for that that will pump up the rate, and if so, how much?

As we discussed earlier, we're going to launch into those negotiations next Tuesday with the bank group, and we believe there will be some market gives and some market asks, but I don't want to dissect that at this time. But we don't anticipate material moves.

Two other questions. One is, can you give any guidance or what is predicated in your guidance for the third quarter in terms of where you think comps will come out? I know you're comping like this quarter against a negative, I think, 1.2% of last third quarter.

When you look at the total volume revenue that we are expecting for third quarter, it is going to be right in line with what we have delivered in the second quarter. Second and third quarter last year were pretty similar, as far as total revenue and year-over-year comp comparisons. We do have, like Tom pointed out earlier, we do have a little bit of Linkia benefit in the second quarter. We expect that same benefit in the third quarter. We expect the same volume benefits into the third quarter. And like we said earlier, 149 to 151 million for the third quarter.

But what assumption, I guess, is that for same-store sales?

Roughly the same as second quarter.

Since we gave you a $2 million window there, obviously a $2 million window would have about a -- a little bit over a point impact on your comp either way.

In the fourth quarter EBITDA, the ramp-up there on your estimates, can you give us just a little bit more color as to what is driving that?

Well, we have identified that we expect mid fourth-quarter implementation of these contracts. Other than that, I'm not willing to dissect it any further.

My last question is, if you compare these results back to fiscal year '03, because last fiscal -- in the second quarter of '04 was a pretty disappointing quarter. So my question is how can we get back to the margins we saw in 2003? I think a lot of it seems to be driven off of the SG&A in line and cost information that you are seeing. Can you try and address that?

I guess at the simplest level -- and that is why we have announced that we have got some special cost containment initiatives. We have got to control our costs. We are, however, as George mentioned, using some of those costs to build these new businesses, and we are trying to do that as economically efficiently as possible to do that. It is a balance between how much of today's profit do we want to invest in that. We also recognize that the dynamics of our business are changing. That's what we have been talking about up on that revenue line and what we're seeing out there in the way of reimbursement and competition. And the way around that is to get a little out of that cycle by using our core strategic advantages; it's 620 patient care centers, 1000 practitioners, and very good relationships to drive some new kinds of business in there, further leverage our model or come up with some new products and services that we can cross-sell against our existing business. This is the essence of our overall strategic direction where we're going.

So we hope to better leverage the model with products and services. That means that we can create some margin opportunities and then hold the line on those costs, so that we don't consume that. And at least we can counter the compression that we are seeing, because with the government freezing our top line and then the migration of that into our fee schedule, we are obviously in a compression mode. We have got to continue to award our good people with salary increases. Our landlords don't care about that, so they want to go up. So we've got to try to hold the line on that while we build additional margin in at the sales line and grow. The game plan is leverage that fixed cost model.

Then just to look at that a little bit further. In terms of the costs that you can control, you addressed labor and landlords. I guess those are increasing with inflation. Do you see that trend continuing? In other words, that doesn't seem to be -- you can only control those so far as the market dictates.

Well, you're going to have inflation in rent, you're going to have inflation in labor. You have to keep your good people, and in order to satisfy the new volume that these revenue initiatives are trying to obtain, you have to have the capacity to handle that. So, obviously, we are going to continue to see some inflation in cost.

Do you see that accelerating or decelerating?

We see it staying about the same. Healthcare cost is going up for us just like everybody else. Rent goes up. We don't see that being -- taking any abnormal trends, but it is fair to say if you go back and start looking at 2003 where we had a couple quarters where we approached 20% EBITDA margins, while we will be able to drive our margins higher by bringing in incremental sales, we are not going to be able to approach those kind of margins.

Okay, thank you.

(OPERATOR INSTRUCTIONS). Todd Corsair, Bear Stearns.

Just on the subject of taking out costs, I think you guys had identified previously that you guys put some brackets around a certain amount of costs that could be taken out of the structure. I think it was over a year's time, or maybe it was actually -- I guess it was sort of characterized as about 13 million in terms of producing materials, costs, and reducing bad debt expense and G&A, as well as I think some headcount reductions and sales staff realignment and things like that. I'm just trying to get a sense of for the first half of '05 here, have you guys -- have we seen the benefit of that, or is that still to come? Could you give us an update on that?

Sure. All four of those initiatives are very alive and well and certainly in force. Take them off sort of quickly for you. The first one was on the headcount and the reductions, and actually those people were taken out of the organization at the end of last year. We made some other alignment changes, moving our sales force down into the field and having it work more closely with our practitioners, which is to say that some of that cost is going to be absorbed at the local level and, therefore, will be an offset on the variable comp plan that we have for our practitioners. That is implemented, that is in place. That was 2.5 million; that is there.

Second one was our G&A initiative, which was to save $2.5 million on a real and annualized basis, because it had started early in the year. We are tracking right along that almost on a pro rata basis. Part of the SG&A cost containment that I mentioned, the negotiation of the national deal with a large office supplies provider, renegotiation on some of our data lines, restructuring; I mean nickels make dollars. In the case -- we have got a lot of PDAs that are out there. We are moving from one PDA supplier that costs us $600 a month per device down to another one that gives better service at $60 a month. So significant differences there.

Those things are in place and are working. We're carefully utilizing our meetings. We're doing our teleconferencing as opposed to flying people back and forth. As a dispersed company, we have to come together sometimes, but all of those things are in place on the SG&A. Targets are all out there, and we think that is why we have not seen inflation when you take out and adjust for some of those things as I mentioned before. So we think the SG&A one is going to do the job. That was 2.5 million. Materials is targeted to four. We think that that is one of the key reasons, that and the mix that George mentioned, that is allowing us to -- we are seeing some pretty strong attempts to push prices up on our polymer materials. All of our sockets are pulled and formed. We use hydrocarbon-based foams when we cut and carve cores to make our sockets, to make our orthotic devices. So we are seeing some pretty big pressures there.

So we are changing the way we buy. We are buying offshore on the commodity items and we're trying to work more closely with our vendors so that we can load them with specific volume and buy smart. So we think our materials -- and as well as materials cost is how you use it as well, the seminars that we've put on to try and take people that really understand how to make specific devices and diffuse that technology and that knowledge into the company, that is all in place. We think we are tracking pretty nicely across that. We have got about half of that already in the bag, and we think through the second half we should be able to get the remainder of that, and that is $4 million.

Last but not least is our accounts receivable project. That is well underway. We have targeted those folks that are having some struggles with collections where we can track that through watching our accounts receivable. We have got a team that is dedicated to that. Part of what they are doing here is why we have seen some improvement in accounts receivable and why the collections are down. That is one that we are going to have to make the case back to the auditors when we come to year-end, that all of the actions that we have taken demonstrate sufficient merit so that we don't have to maintain the same bad debt percentage.

So that one, while I know we're making good progress and I can see it on the accounts receivable, we are not going to have a final decision on that one until we get out to year-end. And so the work we are doing now is to prepare us for those discussions with our auditors. So I'll put a question mark around that one. And the only color I can provide is you can see it in our accounts receivable number.

So I think we are tracking on all of those initiatives. I wish that we weren't in sort of the inflationary environment on materials because we would be seeing a lot more benefit here, but it is really the net that appears on our P&L. So we are optimistic and we recognize there is a lot of work to do out there, but we still think we can bring all or at least the majority of those benefits in-house on a net basis.

That is pretty much in your guidance for the balance of the year then.

Yes.

Just a few housekeeping items. As far as the scheduled principal amortization on the term loan, could you just describe what that is in 2005 and 2006? I just want to make sure I have that correctly.

Quarterly it is 375,000. So every year, you see 1.5 million on short-term liabilities in terms of long-term debt.

And that is the same in '06?

Until the end, and then it is a bullet maturity or the balance of the bullet maturity on the last payment.

Okay. What was cash taxes for the quarter?

$1.4 million.

Okay. As far as -- do you guys have any -- you don't really have any NOLs or anything like that; is that right?

They're pretty much used up.

So you pretty much should be a full cash taxpayer at this point so far?

We won't be a full cash taxpayer. We've got (indiscernible) like anybody else, timing differences.

Did you say -- what did you say for CapEx for the quarter?

The quarter was 2.4 million.

2.4. And also recollecting that there were possibly some earnouts that you guys had to pay out in the second half of the year; is that right, and if so, how much is that?

During this quarter, we paid out just over $1 million.

There is nothing in the back-half --?

They will be somewhat similar going forward but diminishing over time, because we haven't used the earnout vehicle for quite a while. We are just paying off past acquisitions.

Okay. As far as the -- I know you are not getting into what you think the rate is or anything like that on the revolver, but would you anticipate that the size remains the same at 100 million?

No, we're actually going to decrease that to 75 million.

All right, probably comes down to 75, okay.

We don't have access to the last 25 anyway.

Right. That was actually my next question was at the end of June 30, what was the availability?

I think it was 22, wasn't it?

Yes, we could have borrowed an additional 22 million and still be in compliance.

Okay. Letters of credit?

Right now, there is 2.2 million outstanding. That is primarily to support our workers' compensation insurance program.

That was the June 30 number. And the term loan, that was 147.4 at the end of the quarter?

Yes, 147.375.

The other thing was just wanted to get an updated in terms of how we should be thinking about Medicare pricing. Beyond the coding and all of that, there is a price freeze which if I am correct -- correct me if I am wrong -- is in effect until the end of '06?

That's right.

And then at that point we go to competitive bidding, right?

What has been mandated under the Medicare modernization Act is that CMS has to examine competitive bidding across the whole demi-post (ph), which is DME and prosthetic and orthotics. It is up to them to determine how that process will work. It will be applied initially to 10 of the largest statistical metropolitan areas, and then it will be rolled to the next 10. It is also up to them to determine who gets to provide it, and it is also -- as part of the quality standard, and it is also up to them to determine what is in and what is out of competitive bidding. As we understand it, we participate in the panels, but CMS has been very clear to point out to the panel that they are the final decision maker here, and while they are willing to take input, they are not willing to debate or discuss.

So all indications would appear that the amount of orthotics and prosthetics would be very small in terms of what would be qualified. It would also appear that none of the prosthetics will be included; that is all custom. The only way that they feel they can maintain an adequate competitive bidding program is where they can get the supplies from manufacturer A equal the supplies from manufacturer B. So they have an apples-to-apples comparison, which would indicate they are really down on the commodity end. If they have excluded prosthetics, they're on the commodity end of orthotics.

They are also -- and the reason for mentioning they get to decide what the quality is and who gets to provide it is they have come to the conclusion, and rightfully so, that some of the things that they originally felt were commodity products when used on one patient versus another patient have dramatically different outcomes. So they are recognizing that even the application of a commodity product needs to have a trained or certified professional installing it, which now means they can't bid it. Their consultant during two pilots that they had, one in San Antonio, Texas and one in Polk County, Florida recommended that no orthotics be included. They felt that the juice just wasn't worth the squeeze. So we don't know exactly where CMS is going to come down.

There is a list that the industry associations have gotten together and have sent to Medicare saying if you're going to include any commodity items on here, these are the only ones that we could possibly agree with. And even these, we should have some discussion and debate about who gets to provide them. That list represents less than 5% of the whole orthotics schedule. It is a very, very small piece of our business, because we are much more on the higher end or the custom side.

So as Medicare evaluates where they are and how all of this competitive bidding works, I think there is two things to take into consideration. If they do go to competitive bidding on orthotics, it is likely to be very small in terms of what Hanger's portion of the provision of (indiscernible). The second thing to consider is that Hanger is the only one of the O&P providers with a large national footprint, which means that depending on how they go and implement this, we should have a natural benefit in terms of our ability to bring our leverage on suppliers, to be out there already with all of the points of care. So if it does go to competitive bidding, we should be in the catbird seat, so to speak, in terms of how we could enter a bid relative to anybody else.

If we don't go to competitive bidding, that means we should qualify for a CEI increased earning in '07.

That was going to be my follow-up question. So it would be just kind of something low single-digit probably, increases you'd get; that you would probably get a little relief on pricing there?

Yes, and over the past couple of years we have just lost about 2.5 for '06. It looked like '05 came in slightly north of 3. They have in the past sometimes granted a little bit of catch-ups so that you could make up for lost ground. I guess that is not open for debate, discussion or visibility. We have no idea, but it is our expectation occasion that all those things are going to be up on the table. We would expect to see something in the way of a CPI in there, and we know they're mandated to do something on competitive bidding, but we don't know what that is yet.

Great. Last couple of things, could you say about how much leadtime is there from when you sign one of these national Linkia contracts to when the benefit -- when we start seeing the benefit in the numbers? Is it weeks, months?

I think we have touched on that a bit earlier. We estimate 60 to 90 days, and it depends upon the complexity of the buildout. It depends upon the readiness of the insurance company, depends upon the network strategy, and that is when you can start to see some benefit and then a migration forward for that. Again, depending upon whether they want to, as I mentioned before, a hot start, whether they want to ramp it up. A lot of factors involved.

This will vary from one contract to the other.

Okay. The last thing is just on United, the deal with United. I guess just trying to understand, this is -- at this point it is kind of a regional deal, right? It is not with United nationally; is that correct?

No, our deal is with United national. We are the preferred provider.

For the whole --?

For all of the entire country.

Okay. Have you guys put any numbers around about how much EBITDA you guys are getting from that now, in terms of contribution?

No, because currently that all flows right through the general patient care revenue stream.

Okay, very good. Thanks very much.

Henry Rokoff (ph) of Deutsche Bank Securities.

Just a quick question, really a reminder. Do you guys still do a material accruals estimate at the beginning of the year and then hold it throughout the year, or did you put in a new system that then allows you to sort of match the inventory exactly?

Henry, we do an annual physical at the end of September, and in between the annual physical we use the growth profit method. We're constantly looking at our purchases, history, and adjusting that accrual based on that, based on sales mix, based on a lot of different factors that we tracked. But the methodology has not changed year-over-year.

Thanks a lot.

SPS is a perpetual inventory.

Okay.

Richard Fullerton of Fullerton Capitol.

Yes. Let's see, given that it is obviously fixed cost model and so forth and with Linkia and going back to suppliers, etc., etc., you are in a position to gain some share. Could you just talk about briefly how fragmented the market is, whether there is some regional players that have some decent regional share? And as an adjunct to that question, could you talk about possible smallish acquisitions down the road?

Sure. Market is overall very fragmented. We estimate that the total market as we define it for O&P services is roughly 2 to $2.2 billion. We estimate that we have about 25% of that. As we would come down from that -- now we have 620 patient care centers. It is our estimate that there is about 2800 patient care centers that are out there. It gives you some idea geographically dispersed throughout the nation. In terms of who follows after us, probably the next two players in line would be in the upper teens to low $20 million range. One of them is located in the Northern Midwest. The other one is located in the southern part of the West Coast.

Coming down from that, there are some players in the 5 to $10 million range that are scattered throughout, and the next grouping would be in the 6 to $7 million range. And below that, it's largely a cottage industry. So it is very fragmented and, of course, healthcare is a regional business. And part of what I referred to when I talked about the competitive dynamics of this is that those folks tend to get entrenched in their local communities and know their doctors, and it is difficult to change patterns of care. One of the ways is through contracting. The other way is through technology and, of course, they are the two avenues that we are pursuing.

In terms of acquisitions, we have for the most part not been pursuing acquisitions over the last six months, preferring to look at them from two perspectives. One is to understand if we are going to spend acquisition dollars, do we want it to be in core businesses or do we want to maybe acquire into some of the newer areas that I have spoken about. We bought two pilots in one of the newer areas, and we are evaluating those and we are very pleased with the results that we have seen. So we are judiciously looking at that area, trying to decide where do we maximize the value for the shareholder, how do we get that leverage. And I mentioned before, some of these new areas give us cross-selling capability, which are very desirable. I think that's an overall key.

Some of the difficult conditions that are out there in this fragmented -- and I will use the word abused -- kind of competitive world is that because George mentioned before that some of the Medicare probes that are ongoing have really strained some of these moms and pops in terms of their receivables. Some of them are out trying to get equity loans on their property, on their assets, and so we have been able to bring some of those folks into our organization primarily by buying their working capital and then giving them a job.

So as we build out contracts, we are not sure that it is in the shareholder's best interest here for us to be going out and buying other guys, because we are seeing some people migrating over to us. So we do not have an aggressive programs on acquisition in mind. As a matter-of-fact, it has been so minimal recently that we are just taking our time to evaluate technology, evaluate contracts, and evaluate some of these changing dynamics. And we are only going to spend it when we think it makes sense. So there are no bogeys out there for numbers we have to achieve, and we think that there are going to be opportunities out there and we are going to make sure that we spend our money in the right place.

Do you have a sense as to how many active practitioners there are at the 2800 centers?

3300.

Okay. Let's see, would you expect any sort of targets as to how you might be able to grow your own practitioner account from slightly over 1000? Do you have a five-year plan on that?

No, we don't because in the industry, supply and demand balance for practitioner is in balance. We are graduating out of the schools about the same number of folks as we see come out of the profession due to retirement and career change. So things are pretty much in balance. What we have really seen, and yet we know we are seeing growing population, we're seeing increasing number of patients; what we've really seen is the productivity impact, which strikes at the core of how and why we decided to pursue Insignia.

As I've mentioned before, a practitioner can do some jobs, for example, in 40 minutes that used to take three hours. So while we are always interested in getting geographic representation in growth areas, we do that through satellites, which doesn't necessarily mean we have to have another practitioner out of the box. And we are trying to enhance our productivity and also really raise the standard of the practitioner up on the professional scale so he has more time to deal with patients in his referral sources. So we are not so much interested in building out practitioners just to have more of them. We are interested in geographic representation. We are interested in making them better professionals through the use of technology. And out of that comes a productivity ticker.

So it is not just a numbers game, but it is really how can we utilize the assets that we have better. And with Linkia coming on board, that is a natural instrument to capture share and to provide more patients at the threshold of our existing patient care centers.

Okay, great. I guess the last question switching gears but on a related topic, in terms of receivable collections, you are in the 60, 70 days right now. Is that going to come down a bit with Linkia?

Linkia should help us, because it is going to be all electronic, but quite frankly, the major payers that we are doing these deals with, we're already electronic with them. I don't expect it to be a dramatic decrease. When we put OBS out there, our new billing system, doing electronic billing was part of the equation, and that is part of the reason that our receivables are getting healthier.

Okay. So more of the same, you think?

We always thought that high 60s was probably the best we were going to be able to do, and we are getting a little better than that. I think at this point mid-60s to low 60s is probably the best target we could expect.

Okay. And the competition, the mom and pops and the 5 to $10 million companies, do they also do you think run 70 days?

They are all private companies. They don't send us any information. Most of them are using QuickBooks.

Yes, so maybe it's more like 90 or 100.

I have no idea.

It would only be speculation.

Okay, thank you.

There are no further questions. Do you have any closing remarks?

Yes, thank you very much, Sonny. I'd like to just thank everyone for their participation today, and we look forward to talking to you at the close of Q3. Have a good one. Bye-bye.

This concludes today's conference. You may now disconnect.