Hanger Inc (HNGR) 2006 Q4 法說會逐字稿

At this time, I would like to welcome everyone to the Hanger Orthopedic Group's fourth-quarter year-end results conference call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer session. (OPERATOR INSTRUCTIONS) Thank you. Mr. Sabel, you may begin your conference.

Good morning and thank you all for joining us for our fourth-quarter and year-end results conference call. I'm very pleased to report net income of $4.9 million, or $0.17 per diluted share, and 3.2% revenue grow for the quarter ended December 31, 2006. Of note, the sales growth in the fourth quarter was principally the result of $3.9 million or a 2.9% increase in same center sales at our patient care business.

For the year ended December 31, 2006, our net sales increased by $20.6 million or 3.6% to $598.8 million from $578.2 million in the prior year. Our pro forma EPS for the year was $0.49. The sales growth for the year was principally the result of $11.8 million or a 2.2% increase in same center sales in our patient care business, and a $10 million or 22% increase in sales of our Company's distribution segment, SPS.

In the fourth quarter, cash flow from operations was $15.9 million compared to the prior year's $12.3 million, excluding the impact of the refinancing. Cash flow for the year was $29.3 million compared to the prior year's $25.7 million.

We're very pleased with how the performance of our business continued to strengthen as 2006 progressed. Our patient care centers were able to increase same center sales growth by over 2% in a very challenging reimbursement environment. Our distribution business generated over 22% sales growth for the year.

In addition, our growth initiatives achieved important milestones, with Linkia rolling out its full network management service solution for two significant national insurance providers, and with Innovative Neurotronics successfully launching the FDA-approved WalkAide product. As reported in our press release, our pro forma EPS grew by 32%.

Finally, we enter 2007 with a solid foundation for growth, having completed a successful refinancing and having been granted our first Medicare price increase in three years. Now I would like to turn the call over to our Chief Financial Officer, George McHenry.

Thank you, Van. Good morning. Results for the quarter, first, Van already discussed the sales increase and the fact that most of it came from our patient care centers terminating their strongest quarter of the year.

I will move on to cost of sales, which as a percentage of sales was 50.9%, which is a 6/10 of a percent increase over the reported results for third quarter and a 1.1% increase compared to the full year. That is due to an increase in material costs.

To understand the [COM], you should focus on the year, during which we ended with a full-year COM rate of 30.1% due to a number of factors, including the mix change caused by the $10 million increase in SPS sales, which have a higher material cost than the patient care centers; the impact of the freeze; and normal inflationary pressure.

Now going into 2007, with the Medicare price increase and the widening of margins from increased sales of WalkAide, we expect COM to decrease by 40 to 50 basis points to 29.6% to 29.7% of sales. We expect the overall cost of sales to decrease by between 60 and 70 basis points.

SG&A decreased by $4.8 million compared to 2005, primarily due to a $3.8 million decrease in labor cost that was related principally to a combination of favorable healthcare cost adjustment, less contract labor, and lower variable compensation. Also playing a factor was a $2 million decrease in professional fees; an $800,000 decrease in bad debt expense despite the sales increase; and all those decreases were offset partially by a $900,000 increase as we continue to invest in the WalkAide and the national contract effort.

EBITDA increased by $1 million to $22 million from $21 million in the prior year due to the factors I just discussed. Interest and depreciation was essentially the same as last year.

Our provision for income taxes at 46% was disproportionate to our earnings due to the impact of the cost of the refinance, which has an impact on lowering our reported income compared to our permanent timing differences in the provision. That rate should improve next year.

EPS as Van mentioned improved by 21% to $0.17 compared to pro forma EPS of $0.14 last year, excluding the impact of the $3.7 million booking of loss carryforwards last year. For the year, our sales increased by $20.6 million or 3.6%. As Van mentioned, our comp at patient care increased by 2.2% and SPS reported a strong 22% increase in sales, growing their outside sales by $10 million.

Cost of sales increased year-over-year by 1.1%. I believe I have already went through the factors that tie into that.

Our SG&A increased by $2.1 million due to our cost control efforts throughout the year. The principal reasons for the change were $2.7 million in higher labor cost. There was very little headcount change in our core business, so this modest increase was due principally to the impact of merit increases and increased healthcare cost year-over-year. We also had a $3.6 million increase in SG&A that was tied into, again, our continuing investment in our growth initiatives. All this was offset by a $3.7 million decrease in bad debt expense, which we decreased from 3.4% as reported in 2005 to 2.7% in 2006.

EBITDA as a result was $77.1 million in 2006 compared to $75.2 million in 2005. That is a $1.9 million increase, and it is in the range of guidance that we have been providing all year. Depreciation increased by $700,000 due to the relatively low level of additions this year. We spent $12.8 million on CapEx compared to a budget of $15.5 million for the year.

Our interest increased by $1.5 million for the year due principally to the debt structure that was in place prior to the refinance. Subsequent to the refinance, interest was slightly less than prior year, as it was in Q4, despite the additional debt incurred to pay fees related to the transaction and to redeem a portion of the old 7% preferred stock in our refinance. EPS for the year increased $0.12 or 32% to $0.49 compared to pro forma $0.37 in 2005.

On the balance sheet, AR decreased by $3.8 million, despite the $20.5 million increase in sales. Our DSOs improved to 61 days compared to 64 days at the end of last year. 61 is slightly higher than the 59 reported at the end of Q3. That is principally due to the sales increase quarter-over-quarter.

I would like to highlight that the receivables over 120 days was $17.7 million at the end of the year, and that is a rate of 16.3% of total AR, which compares to $22.6 million or 20.4% of total AR in 2005. So we reduced our oldest receivables by $4.9 million, and that is the lowest balance in our history. Over the last two years, we have had really very good success in this area.

We have reduced our over-120s by $11 million in the past two years. This is really the reason why you can see we have had improvement in our bad debt expense, because our receivables are getting lower and they're also getting cleaner.

Inventory decreased by $900,000 to $75.8 million compared to $76.7 million last year, despite the sales increase. So we [get] that number down. CapEx for the quarter was $4.8 million; and as I mentioned before, $12.6 million for the year.

Van really already covered in his comments the cash flow was strong for the year. Excluding the refinance, we grew our cash flow by about $3.5 million, so we think we did a very good job there. AR, of course, played a part in that improvement.

Finally, we want to establish guidance at this point for 2007. Our guidance for 2007 is a range of sales of 620 to $630 million. That is sales growth of 3.5% to 5.2%, in that range. Our EPS guidance is $0.59 to $0.61, which is a range of growth in EPS of between 20% and 24%. Now I would like to turn the call over to our Chief Operating Officer, Tom Kirk.

Thanks, George. Good morning to all of you. We appreciate your being on the call, knowing that some of you probably have less than desirable weather conditions this morning. I will review the events impacting our operations for the fourth quarter, offer some comments on the total year, and provide an update on some of our growth initiatives.

First, for our patient care division, HPO, in the fourth quarter we achieved a $3.9 million increase in sales. This translates to a same center sales growth rate of about 2.9% for the quarter. Overall for the year, they added $11.8 million in sales or 2.2% same store sales growth.

Now let's take a look at the three components of price, volume, and mix that have combined together to achieve these increases. Reimbursement on the price side continues to present challenges as payers look for ways to contain their cost of paying for healthcare. Overall, we estimate the impact of these unit price reductions at about 1.5% for last year.

Now the government has announced a CPI-U increase of 4.3%, which we began receiving on January 1 of this year. It is going to impact about 40% of HPO's revenues during the year. This increased rate will begin translating to our other contracts, but will take several years to migrate through our total book of business.

On the volume side of the equation, for the quarter HPO had about 6.3% more patient billable transactions compared to the comparable quarter last year. For the total year, we had an increase of about 4.7% more transactions.

In addition to our grass-roots business development efforts in contracting work, one of the 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. At year-end, Linkia's base book of business stood at about $52 million.

If we exclude for the moment the provider network management contracts which are still filling out, Linkia has experienced a growth rate of 9.2% year-over-year. Over the past two quarters, Linkia has made significant progress in building out their provider network in accordance with the network strategy of each of the payers. To date, over 150 independent members have joined to participate in Linkia's network provider contracts. As a result, we expect the volume of business handled by Linkia to both the Hanger patient care centers and the other independent members of the provider network to increase as the ramp-up occurs in 2007.

Another way of improving volume and quality patient care is through our patient evaluation clinics. These clinics bring our patients back into the office on a timely schedule consistent with their medical condition. These programs generated more than $16.5 million in revenue for the year, which represents an increase of more than 45% above the revenue for this activity in 2005.

In addition to reimbursement and volume, we also focus on product mix to improve our sales revenues. This is accomplished by the marketing of higher value-added or higher-performing products. These products include the microprocessor legs, knee, and feet systems, POWER KNEE, and WalkAide units.

For example, if we look at the microprocessor knees, which have the highest volume of the value-added products, unit deliveries increased by over 3% for the quarter compared to Q4 of '05. For the year, unit deliveries were up slightly more than 20%, which helped to offset some of the lower reimbursements due to a fee change that we received from Medicare during the year.

Finally, during our last call, we mentioned our [Pathways] program, and it continues to gain acceptance among our practitioners and patients. We continue to see sales growth of our higher quality shoes branded as ANSWER 2, along with certain orthotic and prosthetic devices.

We still see differences across our 13 markets due to regional demographics, area economic conditions, competitive and contracting issues, and the mix of business. For the fourth quarter, we had one market that achieved double-digit same store sales growth, and one market that was almost double-digit. For the year, we had two markets that were in the high single digit growth on this measure. Now, we have improvement plans for all areas that are below our target. Our operating management is proceeding to execute on these plans.

As we discussed during the last call, we initiated a process improvement effort on our basic processes of coding and billing with the goal of improving revenues and monitoring good clinical care. For example, our upper extremity clinical review program developed by this team was implemented, and it produced a significant positive benefit for revenues and profits.

Also during this year, we initiated a patient clinical study program to compare our patients' functional improvement over successive periods of time. This formalized program is the first of its kind in O&P and will form the basis for an outcomes research program to demonstrate the efficacy of what we do to the payers. In addition, we have expanded our satisfaction survey program with the goal of improving our performance in the eyes of our patients and referral sources.

Now let's turn our attention to SPS, our distribution company. Their outside sales grew by about $0.75 million, which translates to a growth rate of about 6% for the fourth quarter '06 compared to the comparable quarter of last year, in spite of comping against a very tough fourth quarter last year. For the year, SPS is up by about $10 million or 22%. In order to achieve this, they added new suppliers; improved their product mix; worked with their customers to provide better value sales propositions; and as always, delivered high-quality customer service in order to capture new customers and sustain high levels of revenue growth to existing customers.

By year-end, they completed their new e-commerce systems, which lists over 60,000 SKUs in electric catalog form and is very user-friendly. The practitioners that are on this system have made very positive comments on its ease-of-use and time-saving benefits.

Now, let's turn our attention to the WalkAide product being introduced by our Innovative Neurotronics subsidiary. The key achievements for this division in the year are -- over 200 patient evaluation clinics were held in our Hanger patient care division in the last half of '06. This translates to over 600 practitioners being trained in the use and the fitting of WalkAide.

Over 26 patient evaluation clinics and seminars have been scheduled by SPS for the first half of this year and the end of last year to support the independents. Counting the seminars from '06 in the first month of this year, about 140 outside independent practitioners have been trained.

We have five clinical studies under way, and two more institutions have asked to initiate a study. These studies are expected to be completed in May of '07.

Our application for a CMS code was filed in December of '06, and this is a month earlier than originally planned. This application will be expanded for coverage and reimbursement as soon as the clinicals are completed. We hope to receive notification on reimbursement by year-end; and if received, it's going to provide a significant positive impact to sales.

Six rehabilitation sales representatives who are physical therapists were hired at the end of last year, in order to penetrate the Rehabilitation Institute and that entire market segment. These PTs are already making a difference by stimulating demand, establishing rehabilitation protocols around the WalkAide, and making direct sales.

Now, on the marketing side, the website continues to score a high number of hits. There were almost 2,800 requests for information through the website or our toll-free number in the fourth quarter, and almost 6,000 for the total year. Our business development managers, practitioners, and rehabilitation sales representatives are pursuing each of these leads.

Monthly sales continued to climb, continuing the trend established last year. On the international scene, over 40 applicants have applied to become distributors for the WalkAide. The first two have been signed and trained.

As reported to you earlier IN, Inc., has received the CE Mark approval and the ISO 13485, both of which are necessary to sell product in many countries outside the U.S. This will be a significant effort for the Innovative Neurotronics team in terms of signing up new distributors throughout 2007.

In the area of other products, the IN, Inc., team is having discussions with other inventors and researchers who are interested in having their products commercialized by this team.

Finally, a few words on acquisitions. We have made some small acquisitions during the quarter as our acquisition program continues to gain traction. As we have mentioned, we are only considering candidates that have strategic value to us in the form of location, quality practitioners, and/or favorable product-service mix. We have ongoing discussions at the present time with several candidates that meet these criteria; and we would expect to see some of these reach fruition during the year.

In closing, the results of this fourth quarter and the year demonstrate that the work that we have been doing has helped us manage through the reimbursement freeze period in patient care. We all recognize that there is more work to be done and that we must pursue additional initiatives in order to add value and revenues in the future months, in addition to the CPI 4.3% increase that we have been granted.

Thank you. I will now turn it back over to Van to manage our questions.

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

(OPERATOR INSTRUCTIONS) [Raj Kumar] of Lehman Brothers.

I'm filling in for Adam Feinstein, and I have a couple of questions here. First, I want to touch upon the Linkia revenue. I think I missed a number. You said $52 million for the year, right?

That's correct.

So after your first nine months, you made $32 million. So you made about $20 million the fourth quarter, correct?

I would have to look back to make sure that that was the nine-month number; but that sounds about right.

Okay, and what are the contributions from the CIGNA and the Great Health contracts in the fourth quarter?

As a policy, we can't disclose the benefit from individual contracts, because those contracts are under a confidentiality agreement, and they expect us to honor those.

Okay. As we think about 2007, how should we think about the run rate for the Linkia? Is the fourth-quarter number a good proxy for '07?

We expect to see some growth on those contracts, as we have mentioned. Some of those were signed, and we are building up in the network programs, so you should see some increase on those.

We think you ought to think in terms of our guidance, in terms of overall guidance in terms of revenue, the 620 to $630 million. Within that incrementally the Linkia should be 6 to $8 million between the high and the low.

Okay, okay. Also, I think, your tax was high this quarter. Can you provide more color on that?

The tax rate?

Yes.

Well, the tax rate as I mentioned was impacted by the almost $17 million in transaction cost that was expensed back in the second quarter related to our refinance. It creates a disproportionate provision because it lowers your taxable income.

Our taxable income was about $6.5 million; and ordinarily, with that transaction pulled out, it would have been up around $25 million. So that is really a onetime impact on the provision. It should return to a more normal rate in the 41% range next year.

Okay, and I have one last question. I just want to get about the uses for your free cash flow; and also want to specifically get your sense for your goals going forward in terms of your target leverage number.

Well, first of all, we have accumulated a fair amount of cash on the balance sheet, and we do expect you have good cash flow continuing into 2007. We are continuing looking at that and analyzing whether it makes sense to make a paydown on the term loan. At present, we are earning over 5%, close to 5.25%, on the funds, so the delta is not huge on the paydown.

So we are weighing right now the benefit of doing a paydown versus looking at using that cash for an attractive acquisition. We will over the next 30 to 45 days make a determination of what the best use of our existing cash balance is.

Going forward, our goal will be to pay down debt, reduce our leverage. We have steadily reduced our leverage down to under 5.2 times EBITDA at the end of the year from a high of 5.6 after we finished the transaction. We should be able to operate down into the 4s during '07.

Long term, our goals would be to reduce that leverage further. We would be more comfortable in the 4s and the low 4s, 3.5, 4 times for leverage. We will be looking at a deleveraging event once we feel our stock price is in a range where it will be an accretive transaction.

All right, thank you.

Adam Feinstein of Lehman Brothers.

you. I guess we are double teaming you guys here today. Just a couple of quick questions here. Just with respect to the guidance, George, you gave sales and you gave earnings. Do you have an EBITDA number?

We want to focus on sales and EPS as the metrics this year, because we think it will help all the Street focus better on what our targets are. We had a lot of -- we ran into a lot of lumpiness in the different estimates that were out there when we are focusing on the EBITDA. So we think these are better metrics to look at, and we are not going to be giving guidance relative to EBITDA.

Okay, maybe if I could just ask it a little differently then, should we look for margins to be higher in 2007 relative to 2006?

Yes, we do expect our margins to improve by about 50 basis points.

Okay, great. Okay. Then, if you could just talk a little bit more about the SG&A costs, I know you highlighted bad debt expense being a big driver to some of the improvement there. But just I guess it was down in absolute dollars. So just trying to think about that, and trying to think about that trend for next year.

I guess on the bad debt side, should we look for further improvement in 2007?

On the SG&A side, we do expect our SG&A to go up next year, a big driver of the reduction in SG&A was for the year we had a $3.7 million decrease in bad debts. Now we don't expect to be able to -- with our bad debts now running at 2.7%, which is a pretty good rate for a healthcare company, we think we might have had some more juice in reducing our DSOs; but our bad debt we are hoping to hold at present levels in '07.

We do expect to have some increase in our SG&A just from inflation -- we are a fixed cost business; and from merit increases for our people. And we are going to continue to invest mostly in IN, Inc., to be ready when the codes are granted for the WalkAide in January of 2008.

All right. Then just do you have a number, George, for the bad debt for the allowance on the balance sheet?

Sure, the allowance was at $3.4 million.

Okay, all right. Then just shifting gears, with the price increase, it definitely gives you guys a benefit going forward. I remember when you had the payment freeze some of your commercial contracts were tied to that fee schedule, and it had some negative impact.

So I guess as we think about the next couple years, what are you guys thinking of in terms of your commercial contracts and the opportunity there? How should we model that? What would be your expectations?

We think that we will get the benefit immediately on about 40% of our book of business. Now that includes the Medicare which is around 32, 33. Remember, it only pertains to the L-codes. Then we have a little bit coming from the VA.

Then, we will pick up an immediate benefit on a few of the contracts, but all-up, all-in, it will be about 40% in year 1; and then we would expect the other 60% to migrate over in the subsequent three years. Our contracts on average are three years. We have some, that of course are shorter, renew annually. Others that renew on about a three-year cycle.

So I think for figuring purposes, I would take 20, 20, 20 of the remaining 60% and just space it out over three years, and almost build something comparable to a depreciation table as that would phase in, or a revenue increase table. So about 20% of the volume we will get a benefit in '08; another 20 in '09; and another 20 in '10.

Okay, all right. Then just maybe a final question for me. Van, I don't know if you have any update in terms of Washington with the competitive bidding. and what is going on there with some of these demonstration projects, and what we should look for going forward.

I don't have a lot of intelligence on that, Adam, in all honesty because they are still pushing for I believe it is an April launch in 10 MSAs. It has been rumored that Miami is sort of the number one hotspot to do this. It is still limited to the best of our knowledge to those off-the-shelf 30 or so L-codes that are small, medium, and large type items.

As far as the demonstration projects, the recommendation from the independent folks who analyze that was that the government should not go forward with this, because it was going to end up not being worth the squeeze, so to speak. The juice is not going to be worth the squeeze.

But I suspect there has been no change, or none that I have heard of. I suspect the government will launch in April. They have identified the agencies that will accredit the participants. Of course, we qualify in all of our locations to be accredited for that. We have accredited personnel, etc.

Of course, we believe that with our buying power and cost structure that we will be a participant; and also the fact that through Hanger's 600-plus locations, and now an additional 150 and counting independents on behalf of the Linkia network, we will be a major player in that competitive bidding process.

Okay, thank you, everyone.

(OPERATOR INSTRUCTIONS) Matthew Ripperger of Citigroup.

First question I had is just on the acquisition opportunity. What are your current restrictions on how many acquisitions you can do per year? Maybe if you could give a sense on what types of multiples you're seeing out there in the market today.

We don't have a restriction on the number that we can do under the terms of our indentures. We have a restriction on the amount of capital that can be deployed on that. That target for the year is $40 million.

Currently, we're looking at acquisitions, I think it is safe to say, in three buckets. The primary one is building out an identification in the classic O&Ps; we integrate those very well, and that is our history. Within that, we would be looking at the 4.5 to 5.5 range of EBITDA. We think that that makes a lot of sense for the seller. It certainly make sense for the shareholders as well.

Second area we are looking at it is you're certainly aware that through Innovative Neurotronics, that we have got a little bit of a device and technology play here. If there's ways to build that out, to enhance that footprint, we will look at those from both a technology and a financial perspective.

The last area is looking at Hanger's participation in the broader rehab sense. As we look at that we are looking at things that might support SPS, and might also be great adjuncts to our HPO division.

We have some pilots under way in what we call the [stealth] business, namely Elite Care and TotalCare, where we are bundling products and delivered through a fast, efficient delivery mechanism. It gives us the ability to get crossreferrals on the custom side back into our core business, so we are looking at building that out.

So third area is supporting SPS through the distribution business, and then the extended continuum of care play that might crossrefer back into HPO. But bounded by $40 million in terms of total acquisitions.

Just to clarify, on the rehab side are you talk about outpatient rehab clinics and actually owning the assets?

No, no. Not to go to the rehab clinic. We're looking at other ways to deliver these services. If you think of what we have referred to in the past as bundled products and services, our Elite Care, this is nothing more than a different delivery mechanism to put what I will call the lower-end, more off-the-shelf or custom-fit low braces on postsurgical patients; to deliver pain pumps, bone stims, and all those things that our doctors order for those patients when they complete surgery.

Instead of waiting for them to walk into our facility, we have started a couple of little business in terms of delivering that bundled product mix directly to them on a postsurgical basis, either as they are leaving the outpatient clinic or perhaps even in their home. Continuous passive motion machine. What we have seen is it builds relationships with doctors; it is much more efficient; and it is better patient care.

But it is not the PT standalone rehab business that we know is sitting out there. But we are not in that business and don't intend to pursue that.

Okay, great. Then the second question I had is just related to WalkAide. Without getting in the specific numbers about next year, can you give a sense of how that potentially could start to ramp up in terms of unit sales; and what the current sort of unit price is per product? When you step back and look at the total market opportunity for this new device, how do you sort of frame up what the opportunity is?

Sure, great question. Right now, the WalkAide unit retails out at about $4,500. We are obviously anxious to proceed and get the coverage and the reimbursement level set by Medicare. We filed on the code. There's three pieces -- code, coverage, and reimbursement. We will have to see where Medicare comes down and what their actual reimbursement allowance is.

But we certainly would expect it to probably come in a little bit less than our usual customary because they always do. So in terms of the ability to push it through our HPO unit, we are looking at the $4,000 range or perhaps a little lower, whenever Medicare finally comes with the reimbursement level.

But keep in mind that we have got a number of distribution channels here. SPS is selling the unit to the independent, so it is being sold at a lower price point out of SPS, because they have got to install it, and therefore they have got to make a margin on it.

Then the last distribution channel will be on the international side. Of course, we will be working very closely with our distribution partners to help them secure reimbursement in their respective country. Those units will be priced at a different level. So we are really looking at about three different levels as it comes out of Innovative Neurotronics in terms of the channels that it can pursue.

On an overall basis, what we have seen is that it takes a little bit of time to get traction, for two reasons. One is the training and establishing all the necessary support systems within a provider. The second is part of the patient mentality; and by that I mean today they are accustomed to having the government pay for everything.

Over time, and what we have seen that we are capable of doing here is telling them that, just like LASIKS and some other things, that at least in the near term they have got to look at mobility and their quality of life as being one of the necessary items. To assist them in this, we have set up a deal with an outside financial agency called CareCredit, so that they can offload a portion of that upfront number and pay it over time. We subsidize that by making it interest-free for a period of time.

We expect as reimbursement gets into play, and as people start to understand the benefit of this device on their quality of life, to see improved traction. We expect to see the sales of Innovative probably run the this year 5 to $6 million, somewhere in that range on an overall basis, recognizing that that of course has three different price points in it.

We expect that when we get the reimbursement code by the end of this year, that in fact, it should -- I hate to use the work take off; but it certainly is going to be able to appeal to a lot more people. We would expect to see a significant ramp on a go-forward basis in '08 and '09 and '10.

We really have high hopes for this device when the clinicals are all in and we publish the stats around it. What it does is just remarkable. So we think we are going to see a lot of demand increase.

Okay, great.

Probably overall market size, when we think of the patient population -- and I guess this is the exciting part -- just within the United States, 750,000 stroke patients a year; 500,000 survive; and we estimate that probably 25% of those would qualify. That is 125,000 new patients each year just from stroke.

The device also works on MS and CP and a number of other indications; and that is just the new patient flow. The existing legacy market is very large, numbering into the millions. If you keep in mind that we treat 120,000 patients a year with an AFO device, and a significant percentage of those are receiving that device because they have Drop Foot, and as a result they too could be candidates if they have got the right neural pathways for this device.

So we probably have a legacy market of about 1 million patients out there in the United States alone. Then when you look at the new entrants, that is over 100,000 a year. So we see the potential as being very significant.

We know that competition is going to come to the party. We have got one competitor already. But we believe and we have been told that our device functions better than their device, and it prices out at a lower price point. So we are very, very optimistic about the potential of this device.

Great, thanks very much. The last question I had is just going to Linkia, two questions. One is, are the Linkia contracts in any way tied to Medicare rates and what Medicare does with the L-codes?

Then secondly, could you just comment on how we should look at the economics of Linkia for sort of centers that you own and operate yourself versus out of network centers, and what the difference is?

Sure. Well, the Linkia contracts -- as is the entire industry -- are tied to the Medicare fee schedule. They are tied in different ways, meaning they may translate directly and immediately to the existing Medicare fee schedule. Or they may have a lag. They may, for example, if we're negotiating a contract in '07, be based on the '06; and that may renew annually with a one-year lag, or perhaps even a two-year lag.

So it is inescapable, based upon the way our industry operates, to escape the Medicare fee. Now several things happen. In some cases, they negotiate depending upon volume; they may negotiate a discount to the Medicare fee schedule. In other cases and on certain indications, we may get carve-outs for certain procedures that we do; and they may price out at equal to or greater than the Medicare fee schedule. So those contracts end up being rather complex documents.

But in general, Medicare fee schedule with some up or down to that schedule dependent upon the specific L-code, which means the specific procedure we are doing, and the number, and the volume. The number of members that are going to be dedicated to this contract. So that is sort of the structure of the fee schedule.

In terms of how it works, you have heard me say that to date most of the Linkia business is coming right through HPO. If we think of it this way, it is a contracting agency for two things. The first is on a preferred basis HPO participates as the deliverer of the services on all of the Linkia business. On the second basis, HPO is a participant on some of these exclusive provider network management contracts.

So HPO has a significant percentage of the business, but we are joined by a lot of independents. Maybe that is a 50-50 split, maybe it's a 60-40 split, but in all cases HPO is a participant to some degree, going all the way up to 100%. So while Linkia has the contract, the business goes right to HPO and is recorded on HPO's books in terms of how that revenue is recognized.

And HPO actually does the billing. They may use Linkia as the mechanism to do the billing, so it can be done electronically. But some subtle nuances there between the preferred contracts and then the exclusive provider network contracts. Does that help?

Yes, and as the out of network part of the business grows, the underlying margin on that will be lower?

Well, as the out of network -- and I am assuming you mean the business that goes through the independent?

Yes.

Okay, as that goes through, the independents are going to charge the normal fee schedule, in terms of whatever is provided by the contract. What Linkia will pick up in terms of revenue -- they may, according to accounting, book it all. But then a significant percentage of that will be returned back through -- if you think of it almost as an outsourcer or subcontractor -- will go right back to the independents. So Linkia will in effect see a small fee remaining on their books.

Okay, great. Thank you very much.

Dawn Brock of JPMorgan.

I just have a quick question on a payer mix shift. I was looking at the breakdown of the payers for the quarter. It looks like there was about a 100 basis points in a sequential shift toward private pay, mostly coming out of Medicare. Can you just talk to that a little bit and whether or not that is a trend, whether or not you expect that to continue going forward?

What was the actual number, George?

We had a swing of about 50 basis points.

50 basis points. I would not characterize that as a trend. I think this is just the normal fluctuation of where our patients came from in the fourth quarter, whether it was Medicare or whether it was commercial pay. I wouldn't read anything into that as a trend.

I think it is somewhat typical, because at the end of the year people have already used up their deductibles. Sometimes that is a good time for them to make a big medical purchase, because they don't have any co-pay.

Right.

Sure, okay. Thank you very much.

Arnie Ursaner of CJS Securities.

Can you give us your expectation or views of WalkAide revenue for '07 and how you expect them to ramp during the course of the year?

Well, I think we had mentioned before that, in terms of the WalkAide overall revenue, that we are expecting to see about 5 to $6 million. We had talked about the three distribution channels. Of course, that means three different price points when the product actually exits our system or our Company.

You're absolutely correct, we would expect as we gain traction among the independents and SPS sells the units that that would ramp up, as would our internal sales to HPO. Then the International distribution business will be the lagger. We have got two distributors that have signed up. We certainly expect to be signing up more from over 40 applications that we have.

But I guess it is safe to say that it will be skewed into the -- hate to sound like the normal hockey stick -- I know every company tells you this. It is going to be skewed into the latter half of the year.

So I would expect to see it ramp up almost in a linear fashion, going low in the first quarter, increasing in the second, building in the third, and then fourth quarter even better. Should we be eligible for that reimbursement level sooner than January, which is very doubtful, that could also have a positive impact on the fourth quarter.

The real utilization of WalkAide, if we are granted a code for this, which we hope we will and fully expect we will by the end of this year, that is really where this product will start to take off. Because right now, it is an out-of-pocket $4,500 and that is a big ticket for somebody.

So it will -- we think we can continue on the same trend that we have been on. As more people get trained out in the independent world, as well as Tom pointed out that some of the foreign distributors will move more product. But the real impact of WalkAide will come after a code is granted; and that is not anticipated until January 1 of '08.

Maybe a simple way to look at that is use 10 as your denominator and do 1/10 in the first quarter, 2/10 in the second, 3/10 in the third, and 4/10 in the fourth as a way to spread it across the year. I don't think it will be too far off.

Got it. In looking at your revenue guidance for the year, I guess in my mind there are four components which I would like you to comment on as specifically as you care to. We just mentioned new products like WalkAide; that is pretty modest in the overall revenue growth.

Three other items I would like you to comment on and try to quantify -- your expectation on same store sales; your expectation on price; and the impact of acquisitions you either have completed or may be building into your guidance?

Well, there's no acquisitions built into the guidance.

Okay, so that's easy. How about the other two items? Same store sales growth expected?

Organic growth, when you consider the price increase in our patient care centers is going to be a large part of our growth next year. As I mentioned when I gave guidance, we are expecting to grow between 3.5% to 5.2%.

Tom talked about the WalkAide. SPS we expect to grow and have modest growth in '07 to some degree, because -- I mean, they had a banner year last year. You can't continue doing that year after year. But there is the a little bit of backlash from our national contract effort going on there; and they should grow between 1 and $3 million.

Really the growth balance of the growth is going to come from a combination of organic growth and the price increase flowing through our patient care centers.

Right. I guess that is what I'm trying to come to grips to -- the same store sales, you have had particularly good growth in Q4, you have had a ramp up in the back half of the year. Are you assuming that will continue into next year?

We are assuming that we will have success. Obviously, the price increase plays a part in that.

My final question relates to -- we seem to be glossing over the $3.8 million drop in labor cost. You had excellent cash collections; and typically when you have had that in the past you have actually had increased bonus compensation expenses. I really just -- I know you have gone through things I cost adjustments, variable labor adjustments, but I don't think you have really nailed where you have gotten this $3.8 million labor cost drop from. And is it sustainable?

Well, in terms of the labor drop, we don't expect to be able to sustain a labor drop. We expect our labor to have modest increases next year, as they had a modest increase for the year. We expect to have inflationary changes. We do expect our sales growth will cause our variable compensation plans to increase in '07. Now all that is baked into our EPS guidance.

But if you look at the fourth quarter, the decrease was about 50-50, split between we used less contractors, we kept our headcount level, we had a benefit in our healthcare cost -- and that was a onetime event -- and the variable comp was lower because, to go back to your question, we didn't have higher sales, but we had a higher COM.

There's three major factors that affect our favorable compensation plan -- the collections, the labor, and the material cost. Material cost is the one thing that did go up, and that caused the variable compensation to go down.

Can you just quantify the onetime healthcare cost benefit you had?

It was about $0.5 million in the SG&A.

Okay, thank you.

Mike Petusky of Thompson, Davis & Co.

Good progress this year. I didn't catch it at the beginning; what percentage of the same store sales were [split] price and volume? The 2.9%, how did that break out?

It is all volume.

It's all volume. There was no price increases until January of this year. And actually we believe that based upon the kinds of events that occurred through the year, that we have sustained probably a 1.25 to 1.5 deterioration in price.

But in Q4, you think it was flat?

In Q4? I think is pretty safe to say that it was probably maybe a little on low side of that, but say 3/4 of a point to 1 point deterioration on price. It was all volume. As I mentioned, if you look at our year average just in terms of the number of transactions, I believe it was about 4.7% overall for the year.

The fourth quarter was slightly a little above 6%. So we continued to get pounded a little bit on the price side, but we were hustling a bit more in the fourth quarter to go out and get more business. That is a combination of those specialty programs that we have talk about and then just some of the basic blocking and tackling that goes on through our business development in the practitioners themselves.

I also didn't catch, what was SPS year-over-year? What was that result? Percentages?

I'm sorry, could you repeat that, Mike?

What was SPS year-over-year, the percentages?

22% in terms of their top-line revenue year-over-year.

Yes, it was a $10 million increase.

Was that for Q4, though? What was it Q4?

Q4 was more modest. They were comping against a tough quarter in '05. They were around 6% for '04.

Did you guys give CapEx guidance for '07?

Our CapEx budget for '07 is $17.5 million.

Then I just wanted to go back real quick on the guidance [side]. I thought basically -- did you guys give WalkAide revenue for '06?

We did not.

It was still a developmental product, and so it was not --.

Was it $1 million? Was it 1 to $2 million?

That is a good range.

Okay, so it sounds like you are essentially saying, well, you will get an incremental $4 million or so in WalkAide. Then I thought I heard somebody say that SPS would be up 1 to $3 million for the year.

That's correct.

Okay. So essentially you're saying SPS probably backs up a little bit ex-WalkAide. Is that a fair way to look at it?

Yes.

Okay, all right, great. Thanks again. Appreciate it.

Ray Garson of UBS.

Just a couple very cleanup items. George, can you just remind us again or I guess give us some visibility on the variable comp accrual that is on the balance sheet at year-end? That gets paid in the first quarter, correct?

(multiple speakers) because we have been paying it out through the year. He wanted to know how much (multiple speakers).

We can tell you how much is on the books at the end of the year, in terms of --

I know historically the first quarter cash flow performance has been much weaker as of result of the payout; and I'm just trying to again factor that in.

We have got about $10.2 million in accruals on the books. I'm sorry, $10.5 million in accruals on the books, which is about $700,000 lower than the prior year. Most of that will get paid out in Q1 in order to maintain the tax deduction.

One thing you should know in our first-quarter cash flow is our bond interest payments used to be Q1 and Q3. They're now Q2 and Q4. So we had a very small accrual on the books for interest, which is why when we report you will see our accrued liabilities were down about $10 million.

The good news is that takes that bond interest payment, which was about $9 million, out of the first quarter cash flow.

Got it, but in terms of working capital from the accrual about $10 million or so; but it seems like it may be spread a little bit more evenly in the year than it has been historically. Is that right?

Yes, that's right.

Okay. Then, just one more follow-up. With respect to -- I know you're limiting your guidance to revenue and EPS; but you did make a comment about margin improvement potential. Is that something that comes in right out of the box in the first quarter? I.e., on a year-over-year basis, 50 basis points potential of improvement because of the pricing increase?

Or is that tied to some of the higher-margin products kind of ramping up? Or can you just kind of help us think about that on a quarterly basis?

On a quarterly basis, that is going to ramp. So it is going to ramp probably pretty close to the table Tom was talking about relative to the WalkAide sales. WalkAide sales is part of it. We will get some because we're getting a price increase right away. That will give us some margin improvement.

But by the time we get to the end of the year, it is probably going to be maybe 80 basis points, but it's going to be lower in the first quarter, maybe 10 or 20 basis points.

Okay, great. You just gave it but I just missed it; the GAAP CapEx guidance for the year, did you say 17.5?

$17.5 million is our budget for '07.

Thanks so much.

[Scott Shemp] of Lehman Brothers.

I think most of the questions have been hit on. Just one quick question. Given the improvement that you guys have kind of seen in your credit profile since you did the recap, any thoughts on redoing the pricing on your bank loan agreement?

Absolutely.

Any idea what kind of timeline we would see for something along those lines?

We're looking at that right now. We want to get the call behind us, and we are going to be looking at that in the next 30 days.

Great, thank you.

Todd Corsair of Bear Stearns.

The question was answered.

[Russ Stiver] of Raymond James.

Good quarter. Most of my questions have been answered, but I have one follow-up on something that you said. On acquisitions you mentioned a $40 million number. Is that an annualized revenue number, or is that the price that you expect to pay for an acquisition?

That is an annualized revenue number.

Okay. Is that a target or a limit?

That is a limit. There is also a limit on borrowings, which is actually close to the revenue number. So we have got a fair amount of room from a standpoint of allowed acquisitions.

Historically, what kind of multiple of revenues have you paid for acquisitions?

Typically in the 4.5 to 5 times EBITDA.

4.5 to 5 times EBITDA? Okay, thank you.

Kevin Richardson of Prides Capital.

I was just wondering, when you mentioned using cash you'd look at paying down some of the debt; but also I think heard earlier on if the stock were higher and it were accretive you would look to raise capital to pay down debt. I was unclear on what you meant by accretive when George mentioned that earlier. Is it accretive to EPS?

Yes.

Okay, thank you.

Kyle Smith of Jefferies & Company.

Yes, just following up on that, when you said it gets to a level where it is appropriate, can you give us a sense of how far above the current stock price? Your stock has been a rocket ship so far this year. Are we within spitting distance of a level where you would consider that?

No, we don't think we are within spitting distance, we think we have a ways to go before a deal would be accretive to our existing shareholder base. We're going to concentrate right now on the repricing that was just brought up. That is something that we are going to look at.

We are happy with the progress we have made in terms of our reduction in leverage. We are going to look at using our existing cash balances to pay down debt. We will be formatting what our approach should be over the next 30 to 60 days.

We are really going to focus on executing our business plan. That is first and foremost.

Okay, with any deleveraging event, would you be focused exclusively on your bank loans? Or would something possibly include the bonds as well? I know there's still over three years of call protection.

That's true. There is a -- we do have the ability in a refi to take if there is stock there we can take some out. There is an equity clawback. But like we just add, we are not looking to execute on that right now.

We sized our senior loan higher than the bonds when we did the deal because we wanted to do have lots of prepayable debt. Obviously that would make that the focus.

Okay; then just two housekeeping things. I don't know if you mentioned these. The dollar amount of the materials cost increases in the quarter, and the amount of the annual inventory true-up?

One second on that. The materials quarter-over-quarter, they increased by $9 million. The inventory true-up was 4.4.

Great, thank you so much.

Thank you. At this time there are no further questions. Are there any closing remarks?

Yes, thank you. I want to thank everyone for joining us today, and we look forward to talking to you sometime in April to report first quarter. Have a good day, guys.

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