Hanger Inc (HNGR) 2006 Q3 法說會逐字稿

Good morning. My name is Luwana, and I will be your conference operator today. At that time, I would like to welcome to the one to the Hanger Orthopedic Group third-quarter results conference call. All lines have been placed on mute prevent any background noise. After the speakers' remarks, there will be a question-and-answer session. (OPERATOR INSTRUCTIONS)

Mr. Sabel, you may begin your conference.

Thank you very much. Good morning, everyone, and again thank you for participating in our third-quarter 2006 earnings conference call. Before we get started, I need to read our Safe Harbor statement. This document contains forward-looking statements relating to the Company's results of operations. 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 in this call reflect the current views of management. However, various risks, uncertainties and contingencies could cause actual results 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, onto the results of our third quarter. We reported EPS on a pro forma basis of $0.15 compared to $0.13 last year. Net sales for the quarter increased by $5.1 million or 3.5% to $151.5 million, from $146.4 million in the prior year's comparable quarter. Our sales growth was the result of $2.1 million or 1.6% increase in same center sales in our patient care business, and a $2.7 million or 22.8% increase in sales of our SPS distribution business.

These results were in line with our expectations, especially when you consider the fact that we had once less workday this quarter than in last year's third quarter. We also ended the quarter with a strong work-in-process backlog that exceeded the same period last year, and we will continue to see an increase -- excuse me -- and we continue to see an increase in patient encounters year-over-year. Tom Kirk will highlight the specifics of that during his presentation.

We had an overall increase in our sales volume related to national contract at Linkia. As we told you last quarter, CIGNA approved our provider network strategy, and as of the end of October all termination notices for the providers not included in the network will have taken effect. We continue to see interest and are having discussions with other providers in considering similar relationships.

At our Innovative Neurotronics division, we will in this fourth quarter conduct approximately 200 patient evaluation clinics across the country to evaluate patients that can benefit from our WalkAide product. Since the launch of that WalkAide product in May, sales of this product by our distribution subsidiary, SPS, are approximately 180 units that have been or are in the process of being delivered by our patient care division. This has been accomplished, of course, without the benefit of any third-party pay, as insurance coverage has not yet been established.

Interest in the product remains very high, in fact, with over 2000 inquiries on our website to date, and a significant percentage of these have requested our detailed information package. Of course, Tom will go into further details on our national and international sales and marketing efforts during his presentation.

Our collections continue to remain strong. DSOs continue to be at historically low levels, and our free cash flows when adjusted for interest payment related to the refinance on our new quarterly variable comp program are higher than last year. We continue to feel that although there are still challenges, our programs and projects that we have invested in are gaining traction, as evidenced by our strong performance in Q3.

The government has announced that the CPI-U for 2007 will be 4.3%. And as of this date, that increase still remains in effect. Obviously, we are working closely with our trade associations and key members of Congress to continue to explain the importance of this increase to the quality patient care and the promotion of a healthy O&P profession.

The projected increase of 4.3% will immediately impact 40% of our book of business as of January 1, 2007, with the balance phasing in over the next several years based on contract renewal dates.

I will now turn it over to George McHenry.

Thank you, Van. For the quarter, sales increased by $5.1 million or 3.5% in total. Our comp sales in the patient care centers increased by $2.1 million or 1.6% for the quarter, in spite having one less sales day than we had in the prior year. For information purposes, if you looked at this on a totally apples-to-apples comparison, we average about $2.1 million per day in patient care. So if you excluded that from the prior-year numbers, we would have reported closer to 3% in comp.

SPS had another stronger quarter, reporting a $2.7 million or 22.8% increase. Cost of goods sold as a percentage of sales decreased by 0.7% of sales due to a 1.1% decrease in the cost of labor as a percentage of sales. Labor costs decreased by $600,000 in the current quarter, due to the fact there was one -- also one less workday in the quarter on the calendar. Material costs increased by $2.2 million or 0.4% of sales compared to 2005, due to a combination of the increase in SPS sales and increased purchase activity at the patient care centers.

SG&A increased by $3 million in Q3, due principally to an additional $1 million invested in our Linkia and Innovative Neurotronics growth strategies, and a $2 million increase in our variable compensation. EBITDA at $20.8 million increased by $600,000 compared to the prior year, due principally to the sales increase.

Our interest was $400,000 higher than the prior year, principally due to increased variable interest rates. The Company paid some duplicate interest during the quarter, about $100,000 on approximately $10 million of the old debt structure that was not liquidated in the original tender offer. The remaining bonds were called and liquidated in July.

Also, total debt increased by approximately $30 million to finance the approximate $15 million of the preferred call and to pay costs and fees related to the refinance.

Income taxes, the refinance caused the effective tax rate for the three months ended September 30 to increase to 48.6% compared to 41.1% in the prior year. The cost of the extinguishment of debt caused a decrease in our estimate of taxable income for the year, which caused certain add-backs in the provision for nondeductible expenses, such as meals and entertainment, to have a greater relationship to total taxable income which, in turn, increases the rate. We will continue to see the higher rate through the remainder of the year, and then we should return to historic norms, approximately a 41% rate in 2007.

EPS, we reported pro forma EPS of $0.15 excluding the cost of the extinguishment of debt and including the impact of the new debt structure as if it was in place on 1-1. And it also took into consideration the impact on the tax provision I just discussed. We provided a reconciliation to GAAP earnings as part of the press release.

For the nine months ended September 30, sales increased by $15.8 million or 3.7%. Comp sales in our patient care centers increased by 1.8% or $7.2 million for the year. A $3.1 million increase in Linkia sales accounted for approximately 0.8% of that 1.8% increase. They increased year-over-year by 9.5%, so we are seeing growth in the Linkia business overall. SPS external sales increased by $9.3 million for the first nine months, which was a 28% increase.

Cost of goods sold as a percentage of sales increased by 0.1% of sales due to a 0.7 decrease in labor costs, offset by a 0.8 increase in material costs. Labor costs were essentially equal on a dollar basis to last year and thus they increased as a percentage of sales due to the sales increase that I just discussed. Material costs increased by $7.9 million versus 2005, due to the combination of the sales increase, both at patient care and at SPS. Of course, we have a higher material cost at SPS since they're a distribution business, and that has impact on the material costs.

SG&A increased by $6.9 million for the year, due to a $5.7 million increase in labor costs, primarily due to merit increases, higher healthcare cost. We also invested $2.7 million in our Linkia and Innovative Neurotronics growth strategies. Rent as a percentage in the patient care centers increased by $800,000, and all of those increases were offset by a $2.9 million decrease in bad debts due to our improved collection experience.

EBITDA at $55.1 million increased by $900,000 compared to $54.2 million in the prior year, due to the fluctuations I just discussed. Interest was $1.6 million higher than last year, principally due to the impact of the refi and higher LIBOR rates on our floating debt.

Income taxes, as I discussed in the quarter, we also had impact on the income tax provision for the year as a result of the refi. We reported a tax benefit of $700,000 for the nine months ended September 30 compared to a $6.7 million provision for the same period last year, based on our GAAP earnings. The benefit reported in 2006 was the result of the loss generated by the $17 million in costs related to the refinance.

Our rate for 2006 would have been approximately 44.9% if you excluded those refinance costs, and that was reflected in the pro forma that we included in the press release. The effective tax rate for the nine months ended September 30, 2006 was a benefit of 34.2% compared to a 41.5% expense in the prior year.

On the balance sheet, our cash balance at 9-30-2006 was just shy of $14 million at 13.9, which was generated principally in the quarter due to our strong collections. We did have $12.7 million in cash on the books at the end of June, but 9.1 million of that balance was paid out to call the remaining bonds that did not tender in the refinance in May.

Our AR decreased by $5.6 million compared to year-end, despite the $15.8 million increase in sales over the last nine months. And DSOs decreased to 59 days compared to 65 days a year ago. Inventory increased by $1.8 million to $78.5 million compared to the year-end balance of $76.7 million. Inventory balance build makes sense compared to our increase in the backlog of sales and work in process, increased sales volume, and our trends and purchases.

Our CapEx for the second quarter was $2.7 million compared to $2.5 million in the prior year. For the year, CapEx was $7.9 million compared to $6.5 million in the prior year. We've had an unusual number of lease renewals in 2006 compared to most years, and frankly, we thought our capital additions in the first nine months would be closer to 10 to $12 million. So we are pleased with our efforts to keep those costs under control.

Cash flow from operations was $15.9 million in Q2, excluding $500,000 in refinance cost, compared to $9.6 million in 2005, an increase of $6.3 million due mainly to a reduction in working capital during that three-month period. Also keep in mind that the current quarter was negatively impacted by $2.4 million in quarterly advances to our practitioners on the incentive comp plan. With this difference in mind, overall cash from operations improved by $8.7 million for the quarter. So we are pleased with that result.

For the nine months, cash flow from operations excluding refinance cost was $12.9 million compared to $13.4 million in the prior year. Again, we had that advance that was actually paid in both second and third quarter; $5 million was advanced to the practitioners, which show a favorable comparison for the nine months as well.

With that, I will turn the call over to Tom.

Thanks, George. Pleasure to be with you this morning. I will review the events impacting our operations for the quarter, and then update you on some of our growth initiatives. First, let's take a look at our patient care division, which we call HPO. We achieved a $2.1 million increase, which translates to a same center sales growth rate of about 1.6% for the quarter. And as George mentioned, we had one less business day this quarter compared to last.

Reimbursement continues to present challenges as payers look for ways to contain their costs of paying for healthcare. Overall, we estimate the impact of these unit price reductions is about 1.5% per year. Looking forward, one bright spot on the unit reimbursement front is that the government has announced that its CPI-U increase for 2007 would be 4.3%. We expect to receive this at the beginning of 2007 on our governmental book of business, which is about 40% of this division's revenue, barring no legislative interventions before year-end, which at this point appears pretty unlikely. This increase or a portion of the increase would then translate to our other contracts over the next few years.

Now let's take a look at the volume side of the equation for the quarter. HPO had about 4.3% more patient billable encounters compared to the comparable quarter last year. For the year to date, we had an increase of about 4.1% more encounters. In addition to our grass-roots business development and contracting efforts, one of our key mechanisms for increasing the volume of business is our national contracting effort, which is managed by Linkia. The majority of Linkia's volume to date goes through Hanger's patient care division, since at this time Linkia's network of outside providers for their newer contracts is just coming into reality.

If we exclude for the moment the recently announced contracts with CIGNA and Great-West, we've seen the revenue from the other national contracts managed by Linkia increase by about 9% to a base of about $32 million over the first three quarters compared to last year. As Van mentioned, the termination letters for the CIGNA contract were sent to the providers that will not be in the network on a go-forward basis, and those term dates are for the majority September 30tg and October 31st.

We are finishing the recruiting for the new network in accordance with the network strategy that was agreed upon with CIGNA, and as a result, we expect the volume of business handled by Linkia to increase as this ramp-up occurs in the coming months.

Another way of improving volume along with improving our patient care is through our patient evaluation clinics. These bring our patients back into the offices on a timely schedule, consistent with their medical condition. These programs generated almost $12 million year-to-date, which is about $3 million higher than 2005 for the nine-month period. This activity produced an incremental $1.6 million of revenue for the quarter compared to last year.

Now this excludes our WalkAide marketing program, which I will address shortly. In addition to reimbursement and volume, we also focus on product mix to improve our sales revenues. We accomplished this by the marketing of higher value added or higher performance products, for example the microprocessor knee system. Looking at this example, deliveries of these units increased by over 55% for this third quarter compared to Q3 of '05. And for the year, we are up slightly more than 30%, which more than offsets the lower unit reimbursements that we are receiving on these devices.

Finally, during our last call we mentioned our [Pathways] program, and it continues to gain acceptance among our practitioners and our patients. For example, we have introduced the concept of providing high-quality shoes which we brand as ANSWER 2, with certain orthotic and prosthetic devices. We've sold 67% more pairs of Answer 2 shoes and 25% more pairs of all noncustom shoe brands in Q3 '06 compared to Q3 '05. So these programs are working.

And as we've also discussed during prior calls, not all of our 13 markets perform the same, due to different demographics, area economic conditions, competitive and contracting issues, and also their mix of business. We are constantly working to improve all of our markets' performance. We're happy to say that two of our markets were double-digit same-store sales growth during this quarter, so we know our programs are working.

And we've seen other improvements in areas targeted for action. As always, during these times of revenue challenge, it is important to maintain a focus on your processes. We are revisiting our basic processes of coding and billing, with the goal of determining ways to reduce paperwork and improve revenues. And a good example of that is our upper extremity clinical review program.

We're also taking a look at the processes of patient intake in processing, which we call workflow. We do two things. The first is to gather additional information on our patients' treatments and their outcomes, and also to improve our overall customer satisfaction and cash collections.

Now let's take a look at SPS's performance. Their outside sales grew by $2.7 million, which translates to a growth rate of almost 23% for the third quarter compared to the comparable quarter last year. Keep in mind again, this past quarter had one less day. SPS is capturing market share by leveraging their superior customer service, a broad product portfolio and timely delivery due to its multisite warehousing.

In their face-to-face visits, they hear the customers' needs and respond with a package to help their customers be successful. Their new catalog has proven successful and as a result, they are putting their catalog of over 60,000 SKUs into electronic form, and it will be available online providing additional benefit for their customers. As we stated in prior calls, their sales growth performance is likely to move a bit lower in the future to more normal levels, in the range of low to mid-teens.

Now let's take a quick overview of some of the projects that we have underway to strengthen our position and/or to generate additional sales. First, we've made several small acquisitions during the quarter as our acquisition program regains traction. We are only considering candidates that have strategic value to us in the form of location, quality practitioners and/or favorable product service mix. And we have ongoing discussions with other candidates that meet these criteria.

In prior quarters, we've discussed Insignia. This technology has now been implicated into our basic processing at all of our patient care centers, and we are not contemplating any additional expansion other than adding new applications to the technology and software libraries. And we are continuing to explore other applications where this technology can add value.

Let me wrap up with an update on our WalkAide product being introduced by our Innovative Neurotronics subsidiary. Key achievements this quarter were the development and initiation of patient evaluation clinics. This is similar to the way that we've performed these in our patient care division, and almost 200 have been scheduled for the fourth quarter. Just to give you an idea of how successful these are, the first 14 that were held, almost 300 patients attended. And of those 300, 100 were qualified and are returning for final consideration and acceptance of one of these units. So we continue to be very optimistic.

We have a website. This website continues to score a high number of hits, as Van has mentioned. We've had almost 2000 requests for information through this website, and if you add in our toll number -- 800 toll-free number, we go up to almost 3100 year-to-date. SPS is also going to be a selling the product to the independent O&P practitioners, and they've initiated seminars to introduce the product to them and to educate their practitioners. To date, four have been held in Florida and California, and more are being scheduled.

The clinical trials are underway and/or planned in seven rehabilitation sites, and these are really necessary to assist us in the filing for our code with CMS. We continue to work with our outside consultants, quantify the benefits that we are seeing in these studies through a health economic study and to prepare our application for code, coverage and price to CMS, which we intend to submit in January of '07.

In order to exploit alternative distribution channels, Innovative has hired six physical therapy salespersons, which we call rehabilitation service specialists. And their mission is to enter, explain and sell product through the domestic channels in the neurorehabilitation centers. As we all know, some of our patients after they have stroke, they go right into neurorehabilitation, and these physical therapists are experts in working with those patients and those rehab centers.

Our monthly sales continue to climb, approximately doubling on a month-to-month basis since the product was available in May . And as Van has mentioned, we've sold approximately 180 of these to date. International representation is being negotiated with the 21 applicants that we have spoken with, and we should have several signed before year end. And we are proud to announce that recently Innovative Neurotronics has received approval for the CE mark and their ISO 13485 standard, which are necessary to sell product in many countries outside the United States.

And finally, we're having discussions with other inventors and researchers who are interested in having Innovative Neurotronics commercialize their product.

In closing, the results of the quarter indicate that the work that we've been doing has helped us manage through this period of reimbursement freeze in patient care. We all recognize there is more work to be done, and we must pursue additional initiatives to sustain us in the quarters that lie ahead, as well as continuing to find ways to achieve revenue and profit increases from SPS, Linkia and Innovative Neurotronics, while always keeping a mindful eye on our expenses.

Thank you. Now I will turn it back to Van to manage the questions.

Thanks, Tom. Luwana, we can now open it up to questions and answers.

(OPERATOR INSTRUCTIONS) Adam Feinstein, Lehman Brothers.

This is actually [Raj Marfleen] for Adam Feinstein. I just have a couple of questions here. The first question is on the number of practitioners. Just the beginning of the year, we are seeing some volatility in this area. The number of practitioners dipped by about 20 in the June quarter, and then it came back up again in the September quarter. Is anything going on here, or it's just a normal practitioners turnover?

No, this is well within the ranges of normal practitioner turnover. And, of course, we are always looking to rationalize our practitioner base, based off of inflow of patients. So in order to continue to provide quality care, we obviously need an adequate supply of practitioners, but that is well within our normal turnover range.

All right. And my next question is on your WalkAide. And I think you guys said you sold 180 year-to-date, correct?

That is correct, at their SPS level.

And what is your sales goal for WalkAide product in '07? Do you have a target?

We are in the process of formulating that as we speak. We obviously have business targets in working with our manufacturing folks. But the final target will be decided in the next couple of days.

We're working on that and, of course, Raj, the real key to this is all the ones we've sold so far have been out-of-pocket purchases at $4500 per unit, because it is not covered currently by third-party pay. When we complete, and we are in the process of completing the clinical trials, we will be able to start to get some third-party reimbursement for this. We will be submitting our application to Medicare in January of '07, and then that takes about 12 months before they would approve it on an L-code basis.

So we do expect in '07 to have some third-party pay, as we can justify the obviously efficacy of this product as the clinicals close out. And then, of course, as we approach '08, we certainly have confidence and hope that Medicare will also see the efficacy of this product and grant us an L-code for it.

Okay, and can you give us the average price per unit? I understand that as the product matures, the pricing is obviously going to change in Medicare and managed care embrace this product. Do you have a number there?

Currently, the unit and the complete form with the cuff sells for $4500. And I think you're right, one of the things that every product that is on the market today when it has received its code, the government insists upon receiving some kind of a discount. We factored that into all of our forecasts, and typically that discount can be 20% to 30%.

So the product still performs very well. Over time, we know there is one competitor out there; there will be others. We continue to believe based upon the comparison of functionality and product features that ours is the superior product. Theirs sells for a couple thousand dollars more than ours. And we still feel that our product is better, and we think in the long-term they probably will be under more price pressure than we will.

And lastly, that has been not nice about the investigation at the West Hampstead facility. So I'm assuming it's really a nonissue can come from that?

Yes, there have been no additional inquiries or any additional movement since the original inquiries that occurred almost 2.5 years ago now.

Okay. Thank you very much.

Arnie Ursaner, CJS Securities.

Good morning. I want to focus on Linkia for one second. Obviously, one of the steps you have to do to move the CIGNA business into Linkia is you've got to notify their practitioners. Can you tell us when that occurred and how that may have impacted the revenue in Q3 and for the balance of the year?

Sure. Let's take it in a couple of steps. As Dan had mentioned, their letters of termination went out to the providers that will no longer be in the network. What we've done is we have been working with CIGNA through our field forces, our business development folks, to go out and make calls on the folks that are in the CIGNA network that are making the referrals to inform them that now Linkia is managing the network. And as a result, from those face-to-face calls and, of course, with the termination of the contracts -- and keep in mind that all of these contract have provisions that provide for the patient care, number one.

So in the case of a new orthotic patient which typically doesn't have a lot of repeat visits, transition occurs very quickly. In the case of a prosthetic patient if they are in the middle of a care program, there is a bit of a transition until that comes over to us. However, by visiting all of the referral sources and telling them the way the new world is working, the new patients coming from those referral sources come right over to us. So that was step one.

Step two was that we have developed a network strategy in conjunction and in accordance with the plan of the insurance provider who in this case is CIGNA. CIGNA sent out the next batch of letters to those providers that will remain in the network, informing them that they now have to come under a Linkia agreement and that their old agreement is going to be terminated. So they have advised them to contact Linkia to find out how this transition is going to occur.

Here again, we are working in that case with the other providers within the Linkia family to get them to speed so that they, too, can go out to the referral sources in their area, which should be in their case continuance of the norm. However, they stand to pick up business coming from the ones that were not in the network.

Net-net, we expect that all the folks that are in the Linkia network are going to see an increase in business, simply because there has been a reduction in the number of providers. So when we take all of those efforts into play and look back at the third quarter, and that was one of the reasons that I specifically left CIGNA out of the comparison, we're going through that period.

As Van mentioned, those termination notices really had term dates of September 30th and October 31st. So we have not really seen the benefit of any of this kind of migration to the Linkia network. We will be seeing it in the fourth quarter. So our work to date has largely been proactive in the sense of needed to be done so that we could migrate that work into Linkia.

Arnie, one other follow-up to that, that is as it relates to CIGNA. We have seen very nice increases in the rest of our national contracts. As Tom has already pointed out, I believe, Tom

9%.

Yes, a little over 9% in the rest of our national contract program, which is availed under Linkia.

And following up on that for one kind of add-on, you obviously are trying to win additional business in the space. Do you know have enough data where you can go to a new potential client and either demonstrate efficiencies or cost savings? Is there an actual benefit you can demonstrate to a potential new customer?

Absolutely. Benefit is demonstrated in two ways. The first is -- and we don't have the hard data and certainly you understand why to this point. The first benefit, now that they've turned over the management of the network to Linkia, they don't have to bear any of the administrative costs of maintaining 2000 contracts, receiving invoices and bills in a myriad of different forms of electronic to paper, sending out one check, one remittance for each one of those invoices. It is now much more efficient. They don't have to worry about continuously qualifying the network to ensure that it is certified, and they are operating in a credited facility. So all of that admin goes away.

They do, however, retain one key element of this whole process, and that is the concept of medical necessity. They make the final decision. We do not adjudicate any of the medical or clinical side of this. So significant benefits in that respect.

On the other side, there is also additional savings because in order to accomplish that volume, they are going to extract a bit more discount than we have today. So they are going to see a lowering of the price of care. We think that it is certainly from our perspective well worth it for us to take that deal. That is why we are pursuing those deals. So they will see benefit in both ways.

To the second way which is the discount, we really can't go in and present absolute savings to them as part of the proposal process. Typically, what we do and why it takes so long is we work with them by analyzing their book of business. There are over 800 L-code procedures out there, and typically each of these has a reimbursement level. And depending upon how many classes they have and how many regions they have in the United States, they all could have different discounts.

So in order to establish their savings on the second front, it really becomes a collaborative process of understanding where they are and reaching an acceptable agreement on how these things are going to be priced on a go-forward basis. So they get benefit in two ways, and I think what we're going to see is it is a highly competitive area from their perspective. As these things get up and word travels very fast and people migrate pretty quickly in this business, we think those benefits from those two sources are going to be well-known and well-understood by all the others.

And we are finding that in our discussions with the others in the space that now when we are walking in the door, we are not starting at ground level zero. They are taking note of what is going on. So I think the proposal addresses all those potential savings, and they get those quantified through our negotiating process with them. Frankly, that is why it has taken so long on some of these deals.

Thank you.

Henry Reukauf, Deutsche Bank.

Just a couple of questions. Just on the -- could you just talk again and remind us the overall unit volume growth, your estimate for the general industry?

The general industry, we estimate -- you know, it's pretty difficult to do volume because we're the only guys that break it out. We would say that the overall growth of the industry has been on a revenue basis maybe 0% to 1%. When we look at the Medicare stats and that represents maybe at best 35%, 33% of the industry, Medicare reports that their payout has gone up, and they are looking at probably 2% to 3% increase in the defined O&P space where we operate.

So the industry does not break down volume and reimbursement, but we are probably pretty typical of what we're seeing out there. We think we're a little stronger and grabbing a little share here.

Okay. Because if I just adjust for it this quarter, the one day loss, it looks like you if you add a 1.5% decline of price you probably were up to about 3% in terms of volume. Is that about what you think you are?

Yes.

So for the general industry, do you think it is -- just in terms of number of patients out there being offset potentially by improvements in care, medication, better diabetic care; do you think the industry is going to slow or maintain itself at current volumes?

No, I think it's going to grow. If we look at what are the drivers, typically it's indeed the most notable one on the prosthetic side is diabetes. On the orthotic side, the two big drivers are patients age because as we've got more seniors out there, backs, knee replacements, hip replacements, etc., all are associated and correlated with the older population. And we've got all the baby boomers moving into this space.

And the other side of orthotics is what we call the wellness, and it's people just through physical exercise, sports and athletics. I mean, that's why we've got sports medicine clinics out there. That is a trend that is here to stay and likely to grow. So we think from a demographic point of view, we are in a very good position. And if you look at what drives diabetes, one of the key causes is overweight and obesity.

And just saw a show on the TV the other day that it is now a very serious problem; has been and getting more so. So certainly from a different demographic point of view, we think going out over the next 10 to 20 years we're going to see increasing numbers.

Okay. I know you have some exclusivity with the CIGNA contract. What percent of their business overall do you expect to capture?

We are the network manager for CIGNA in what I will call the traditional role. These are the traditional providers of O&P care. The other piece in the O&P space is probably in two areas. One are doctors' offices because they have contracts with doctors, and as we know, certain doctors provide these devices; doctors, clinics, etc. Typically, you don't see them doing a lot of custom work. This is not work that they want to get into. That is more of the traditional role.

And in support of the doctors, you've got some manufacturers' reps out there that run what we call stock and bill closets, normally off-the-shelf soft goods, and there are some contracts over there. Those two pieces are in the nontraditional side of the business.

So if we just focus on the traditional side, Linkia is going to manage that, and our estimate is that it is probably about 60%, 65% of their total book of business, with the remainder being in the nontraditional.

Okay. And you should -- I know you don't have centers everywhere that CIGNA probably insured people. So of that 60%, what percent do you think you would capture?

In terms of Hangers' patient care?

Yes.

Probably in the neighborhood of 50%.

50% of that?

So 50% will be supplied by the independents and 50% will be supplied by Hanger, and that is why we make such a deal about this whole thing called network strategy. It is all about providing proper coverage to insure good quality patient care.

And how do you -- either in terms of the percentage if it is 50%, the aggregate -- either the aggregate patient population at CIGNA that would need this care or the overall impact of that 50% on your volume, how do you think that would -- what will that do to your volume if it flowed through the 50%?

Well, given all the percentages, you've not taken me into a zone where I've got to beg off a little bit, Henry. I hate to do that to you because we are under an agreement with CIGNA not to disclose volumes. So we could -- you could back out through all those numbers to get me in trouble here.

All right. Well, I won't push you then on that. I was trying a little, though, just to see, but a net positive is what you are saying.

Oh, absolutely, yes. We've said historically we've been under -- Hanger has been underrepresented in this space typically because with that volume that these big national folks have, they have always been able to extract a little better deal than some of the other payers. And as a result, we sort of have not had our commensurate market share that would be represented with, we always say, about 25%. So it is certainly a big increase to us.

Okay. Then since you do have those wellness plans that continue on, they prevent your traditional business from maybe transferring over immediately. First quarter is where we're going to see the bulk of this move?

I think you're right. First and second quarter, you'll really see that. But we are expecting to see a bit in the fourth quarter here as well, because keep in mind the difference between the orthotic patient and the prosthetic patient. Many of the orthotic patients, we call it treat and street. We will make the device and then they will use it for two or three months, and then who knows, it may just sit in the corner of the closet. So those does do not require the continuing care. It's those prosthetic patients who are under the care of a prosthesis today that will be a little slower coming over.

Which is nice money, I think, to you guys. The 4.3%, it looks like you are probably going to get it. Congrats, it's been a long time coming for years. What do you think about -- what is the schedule now for '08, '09 and '10?

The government reserves the right to make that decision on an annual basis, and typically we don't hear about it until after midyear. It's usually right before the end of the fiscal year, a couple months before that, and they never tell us in advance. Historically, though, when we step back and look at it, it runs about a 3%. Some years it's less, some years it's more. When they've held us down, there have even been catch-ups in the past, and some years that it has been zero.

But I think with the environment that we are currently in, probably if you wanted to go down the middle of the fairway, something around 3% is pretty realistic.

If you look back, Henry, at all the historical, because we've said before this isn't the first time that the government has put a freeze on it. My recollection is this is either the third time -- I think it's the third time that it has been done. And not the history necessarily is going to foretell the future, but typically after a freeze we have a several-year run before there is another action on our reimbursement.

Okay. So we should be thinking about inflationary increases from the government for another two, three years. That's the general thought process.

Exactly, if it follows the way it has historically post freezing.

We'll keep our fingers crossed. Then just the aggregate bonus comp annually, just to remind that again, just aggregate. I know it's split two times.

It's actually split quarterly. Our total amount is about -- on an annual basis, it's about 16 million.

Excuse me?

16 million at the field level.

Okay, yeah. And then you're reserving your '07 thoughts for next quarter; is that right?

That's right. What we're doing right now is we will -- we are reaffirming our '06 guidance at about 605 in revenue and 77 to 78 in EBITDA. But with regards to '07, we're still in the midst of our budgeting process and I need a little more time for that.

Thanks very much.

Rebecca Dernbach, Prides Capital.

It looks like you guys are doing really well on the top line. Congratulations on that. It looks like Linkia is chugging along. Do you guys see the progress in managing your AR continuing to benefit your cost line, or are there any other improvements you expect in cost structure?

I was going to say we're currently running about 3% bad debt, in that neighborhood, and that is down from where it has historically been. I did mention that we do have a program to constantly revisit our processes. We want to take some of the paper out, not only because it satisfies some of our customers; it will also keep our employees a little happier with all of that that we are required to do.

And through that process, we know that the more electronics we get, the better off we are; the faster the pay and the DSOs come down. We are not anticipating any significant change from this level, but that is not to say that we are not going to still improve those processes. But I don't think you're going to see us improve much from where we are.

Okay. On the rest of the cost structure, no big plans there either in the near future?

As we go through the budgeting process, naturally we're keeping a keen eye on that, but I guess when you say big, you're thinking of dedicated initiatives to attack certain areas. We don't have any of those underway. We put a couple of those in in the past years. They were pretty successful.

I will say that the one area where we are looking constantly is in our materials area, and that's simply because the rise in metals cost and the rise in the cost of oil is pretty much reflected in a lot of our materials. So we have an active, ongoing program. Our materials cost has gone up. It would have been a lot higher had we not had these programs to source medically equivalent products, perhaps coming from different countries, perhaps using different designs, whatever it takes to try and hold that cost down. And that is ongoing and active effort in which we have FTEs dedicated to that process.

Well, thanks so much, and congratulations again on working the top line well.

(OPERATOR INSTRUCTIONS) Ray Garson, UBS.

A couple of quick questions. First, you mentioned some small acquisitions year-to-date. Can you just give us the acquisition spend in the quarter and just kind of talk conceptually about acquisitions going forward in terms of magnitude?

In terms of acquisition spend in the quarter, it is very minimal, and I think very minimum is significantly under $0.5 million.

They were small acquisitions so far. We've just started to, as Tom pointed out, identify those strategic acquisition areas that we would like to go into. We have ongoing discussions in a number of those areas with more significant acquisition size than we have recently. As you know, we withdrew basically from any acquisition activity over the last couple years during the freeze, etc., until we redid our balance sheet. And now we are back out looking at strategic acquisitions, and I think you'll see an increase in that activity as we go into '07 and beyond.

Are there bigger -- $10 million plus type deals out there that you're currently circling?

Yes.

Is there any parameters you can give us around size, just for kind of thinking about it?

Sure. Strategically, it can vary probably anything, for instance, from the ones we just recently did which were small acquisitions, but they were strategic in our identification of a particular geography. Going forward, we will continue to look for those, as well as larger acquisitions. And you asked if there are some in the $10 million plus category; there are. There is not an oversupply of those, but there are several like that.

And I would say on average, you're probably looking somewhere in the 2 to $4 million range, would probably be sort of the sweet spot of acquisition candidates to help us densify and/or enter into a new geographic area. As you know, we are not present in several of the continental United States states, and we are currently looking at strategic acquisitions in some of those states that we presently do not reside, as well as obviously the densification program of those that we're already in and being able to add market share within those geographic areas.

And just valuation multiples, any --?

Historically, pretty much where we have been. They're usually somewhere in the 4 to 5 EBITDA range. And typically, our program has been a partial cash and then a payout over a five-year period. Some of them in the past have included earnouts, and they may, depending upon the situation, may be tailored to some earnout in the future for some of the others.

That's great, that's helpful. A couple more. Just with respect to the WalkAide product, you mentioned that to date it has all been self-pay orders, and you walked through kind of the clinical trial timeline and then commercial payer coverage down the road. Are you guys financing any of these purchases, or is that part of the sales strategy here?

Yes, it is. Good point. We have put a deal together with a large financing company, and that deal does provide that a qualifying patient, qualifying clinically as well as financially, can obtain interest-free refinancing for an 18-month period, roughly. Now sometimes it's less, sometimes it's a little bit more, but it certainly gets them through that period where they don't have to write that big check upfront.

Over time and once reimbursement comes in, we think that we won't be using that as frequently. But it has helped us quite a bit in trying to get some of these people past that big financial hurdle upfront.

But that's third-party financing; you guys aren't taking that on your balance sheet?

That is correct.

No, it's third-party.

Great. Then CapEx spend year to date, Tom, you mentioned you're doing better than you thought there. Is that something -- is this level of spending what we should think about going forward, or is it just -- how should we think about CapEx, I guess?

I think that this year we thought we would end up spending approximately $15 million or so in CapEx, and where we are through the first nine months is around $8 million or so. So we are behind in terms of our spend relative to where we thought we would be, and we are fairly pleased with that. But with that said, I think as we look out into '07 and beyond, a $15 million annual number is not a bad number.

Is there anything in the fourth quarter of size of note that would just -- that we should think about versus your trend line here?

No.

Okay, and then the final question I just had on Linkia, two items. First is, I guess you mentioned the sequence of events with respect to the termination letters being sent out. And then you said the people that were going to be included in the network but were not Hanger clinics, they had to contact you guys or something. Could you just give us -- how far along is that? Are you guys now in the midst of various negotiations and that is going to kind of -- I guess how far along is that process, and is there any kind of volatility associated with that as you bring people in the fold that we should think about?

Well, I guess the brief answer is no volatility, but the process stands at this point. CIGNA has sent out the letters to those that will continue to be in the program telling them to contact Linkia, and informing them that they value their services and want to continue to do business with them. When those folks -- and they are doing that right now. Those folks are contacting Linkia, and those letters went out several days ago. With the people that are contacting us, it goes through a process there as well. That process is what is the Linkia deal all about; how does it work; what are the expectations you have of me? And last but not least, what is the new fee schedule? Everyone has an interest in that. How does it work in terms of, am I sending my bills to you; what happens to referral sources?

So there is a lot of information that transpires, and in order to facilitate that, Linkia has been spending all this time putting together a package. So that package is sent to them very quickly. They get up to speed very quickly. We are in the midst of that sell-in, that recruiting program, and obviously we've got to have that thing in place pretty quickly. So we are not expecting to see any turmoil or any sort of a rejection.

Every area is a little bit different because, as we've mentioned, there are different geographic areas in the United States. So in going through that process, it just takes a little bit of time, but there is not going to be any sort of revolution or any of that.

No, it basically -- those who have been asked to remain in the network or to remain with a contract that works through Linkia, if they want to do business with CIGNA, then that's a very simple choice for them to come into the network. Because if for some reason they chose not to come into the network, then obviously there are others that would like to fill that feat, so to speak.

So we have not experienced any problems in recruitment, nor do we anticipate that we will.

Okay. And then I guess in terms of the Linkia contracts established to date, is their annual price adjustments or is it volume driven, or how does the pricing for the contracts and how does the tenor of that structure work?

Well, there is an elaborate fee schedule, as you might well imagine, given that there is over 800 codes and it breaks down into different areas of the country. Under the terms of the contract -- and each one is a little bit different -- there are open periods when the two parties are coming together to either renegotiate or, in some cases, it references off of an index standard. Maybe it is CPI-U like the government uses.

But in the current contract that we are referring to, the CIGNA contract, these things are going to be held firm for a couple of years, and then there will be a reopening period where we will come back and renegotiate. So each one is a little bit different, but the provision is there down the road to open these up and renegotiate. And that is pretty typical of what we've seen historically on any of the national contracts that we've had. So they're going to be locked down for the first couple of years, and then there will be provisions to obtain some price increases.

Great. Thank you.

Dawn Brock, JPMorgan Securities.

Just, you know, you've gotten a lot of questions on Linkia, and I think that it is really clear that you guys are on track. With the numbers that you gave as far as 60% to 65% of the traditional business being captured and probably 50% of that being supplied by Hanger alone; so on a consolidated basis, I am just trying to figure out what kind of numbers we are probably looking for in '07 and '08 as CIGNA comes onboard.

As we've mentioned before, we are still putting together our budgets for '07, and when we come back and confirm guidance or put out guidance for '07, the natural question is what do you expect in the way of overall volume coming out of Linkia. We're not in a position where we can reveal any specifics around the contract or any of the specifics around a payer or region of a payer. So we will be coming out with that information pretty shortly. But right now, we are still in the middle of our budgeting process for all of our business units.

Okay, that's fair. You know, the other thing that I really want to just get some color on is you did talk about the fact that two of your markets right now scored double-digit sales, same-store sales growth. Just a market-by-market kind of 30,000 foot analysis, where are you looking at -- maybe you can give us an idea of which regions did really well, which ones you're focused on, and within that where the acquisition strategy may take off.

Well, the acquisition strategy is a bit independent of the performance results. The acquisition strategy as we've mentioned is primarily to give us more coverage in certain areas where we think there is going to be growth, or in certain areas where we have desired to have a presence. And as Van mentioned, there are three states -- Vermont, Rhode Island and Idaho -- where we do not have a presence. So we are naturally trying to round that out.

We also try to look at this a little bit as well and why I said population, so that we can provide the maximum coverage to some of these insurance companies as well. Having said all that, the areas that we have seen some good performance are up in the New England area and down in the Southeast during this last quarter where they had the double-digit growth.

We have some areas of specific work ongoing and have noticed -- I've also said we achieved some good increases in the Midwest and in some of what is typically called the Rust Belt states. Those areas because of their high reliance on basic industry and the steel industry seem to be having higher than normal unemployment. As a result, there is tremendous transition. There is a number of voter referendums that are out there. I mean, if we look at the State of Ohio where we are really interested in watching what's going on over there. Because as those things change, they change insurance coverage, they change employment conditions.

So we are constantly trimming in order to match that, or we are adding to in order to take advantage of that. But I guess if we were to talk about some specific areas that we are looking at, I think it is fair to say that probably the areas in California because there has been a lot of turnover. And by the way, Governor Schwarzenegger has just signed a bill on medical parity, which is very, very good for patient care.

Some of the caps that were in force out in those states were unrealistic in terms of the cost and quality of care. So with that bill, private payers are now going to have to match the levels that are provided by the federal government, and that is going to help us.

So I would say that it is not one or two areas that we have really put in the cross hairs. This is more of a pruning, trimming, constantly adapting to economic government and insurance issues that just requires constant, constant care.

What will also drive a lot of that acquisition activity potentially is as we become more successful with Linkia and the network strategies that the payers want to put together, we will want to make sure that we have obviously adequate coverage. And if it can be Hanger coverage, that is preferential to us. So that to some degree will drive some of those densification projects or acquisition projects going forward.

Great. I got you. One more question, just kind of, you know, if we were to take that and kind of tail something onto that. If for some reason the letters that went out to certain CIGNA practices, what if those programs -- or practitioners did not want to -- what if they didn't want to join Linkia for whatever reason? What does that do to the exclusivity of your contract with CIGNA?

It doesn't affect us really at all. Obviously, if they do not want to participate, there are several other providers standing in line that would very much like to participate. So it is a fairly straightforward decision that has to be made on the part of the independents.

This program is now in full force, and certainly the recent history shows that people do want to participate. We've tried to choose the most appropriate from a clinical and adequate standpoint as well as a geographic standpoint participant in the independent network, and it is a fairly straightforward decision for them.

Okay. So no pushbacks on providers at this point?

No. No, we haven't seen that, nor do I anticipate that based off of the fact that if they want to be in the -- they want to be able to provide care through CIGNA patient referrals.

In some ways does Linkia provide them some insulation, from having to renegotiate directly with CIGNA on an annual basis?

Is certainly simplifies their life in many respects. They now are part of -- we call this a provider network, but it really ends up being a lot more like a partnership, so that through the negotiation process, they are not facing that alone. They don't have to go through and do that alone. They can be part of a broader network, and it is not all do it or else.

As we've mentioned, it is really a partnership. And when we sit down and discuss with them the advantages, and we know their cost economics because they are no different than us, they've got fixed costs. This leverages those fixed costs. But we talk to them about other benefits of being in the network, and those benefits can be on the material side, those benefits can be on the technology side, those benefits can be on the electronics side through various systems.

So we not only want them in the network, we want them to be a partner with us so that we can better service that insurance company out there and do things with better devices, better care, to actually help those folks perform even better. And that is part of why we've had pretty good success in doing that.

Dawn, I would just follow up what Tom states, network strategy in healthcare delivery, especially in ancillary care, is not a new concept. It may be new to orthotics and prosthetics, and we're the first ones obviously to initiate this, but this is not a new concept. This is a proven concept in all kinds of healthcare delivery, and in particular in ancillary care.

Is it also fair to say -- and I promise this will be the last question -- is it also fair to say that expanding this network, building this network, is also going to give you guys more access to potential acquisition targets if these smaller providers within markets that you may not have penetrated already are willing to say, look, you know what, we would really like to join Hanger and HPO?

Right. It very well may, but as in any transaction, it takes a willing buyer and a willing seller to make that happen. And we obviously have put together, as you well know, the current Hanger mosaic has been primarily an acquisition of both what occurred at Novacare as well as what occurred at Hanger, and then the coming together of the two.

So, obviously, there is an appetite in the field, even though the good news there is that we estimate that probably still 75% plus of the field is still independent, and we think that is great because that leaves us with a lot of room to grow by adding potentially good folks into the Hanger family.

And as we say, it's a marathon; it is not a Sprint. And at some point in time, the independent practitioners, if there is not a family member in line, are going to be looking for an exit strategy in some way to receive value for what they've built. And to the extent that they know and trust Hanger and to the extent that we know them, we would be a natural entity to which they would turn to say, can we put a deal together.

So we're not doing it today in order to muscle these guys in the longer-term. We're going to work together, and so the natural occurrence could be that we would come together in a more financially astute way, maybe.

Exactly. Okay, got you. Thanks so much.

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

Yes, thank you very much for joining us today. We look forward to talking to you early in '07 as we close out the year. Have a good one, guys.

Thank you. This concludes today's Hanger Orthopedic Group third-quarter results conference call. You may now disconnect.