Hanger Inc (HNGR) 2008 Q2 法說會逐字稿

Good morning. My name is Crystal and I will be your conference operator today. At this time I would like to welcome everyone to the Hanger second quarter earnings conference call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there'll be a question-and-answer session. (OPERATOR INSTRUCTIONS) Thank you. Mr. Kirk, you may begin your conference.

Thank you, Crystal, and good morning to all. I am Tom Kirk, President and CEO, and I am joined with George McHenry this morning who is our EVP and CFO, and Ken Abod, who is our Vice President, Treasurer, and Director of Investor Relations.

I'd like to welcome you all to Hanger Orthopedic Group's discussion of our second quarter results. But before getting started, let me take a few moments just to review with you our declaration on forward-looking statements.

During this call, management will make 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 document reflect the 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 demands for the company's orthotic and prosthetic services and products, and other factors identified in the company's periodic reports on form 10K and form 10Q 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.

So with that out of the way, I think there's a few noteworthy points from this quarter. And let me just briefly touch on those, and then I'm going to turn it over to George McHenry to talk more about our financial results, and I'll join back in to provide a little color later on.

As a total entity, our sales grew by 13% and net income was up by 57%, making this the tenth quarter where we have met or exceeded first call estimates. Due to our peoples' dedication and the investments we've made in prior years, all four of our operating units exceeded their performance target. I'll have more to say about the reasons for this a little bit later in the call.

As a result of this performance and other actions initiated during this year, we have increased our full-year sales guidance range by $10 million and our full-year EPS range by $0.05 per diluted share, yielding earnings growth from 25% to 28% compared to last year.

And finally, our strong common stock performance triggered an acceleration of the preferred stock dividend, which will translate into the conversion of the preferred stock into common, thereby simplifying our capital structure, as well as providing other benefit.

Now I'm going to turn it over to George who will describe this event in detail in addition to reviewing all of our financial results.

Thank you, Tom, and good morning, everyone. I'd like to talk about the preferred stock conversion and dividend acceleration first and get that out of the way as it impacts the proforma EPS. In late June, the company stock price hit a milestone which accelerated the payment of dividends on our preferred stock through May 26, 2011. That stock is owned by Ares Management. It was paid in the form of a PIC dividend on the preferred. And the most important part of this milestone for us is this event allows Hanger to immediately convert the preferred to common stock, and we have notified the holder of our intention to convert.

While the acceleration did add almost 700,000 shares to the calculation of EPS, it eliminated the payment of cash dividends, and a conversion both simplifies and strengthens the company's balance sheet.

Hanger exceeded its first call estimates by a nickel, including the extra shares. For GAAP purposes, the entire PIC dividend is included in the quarterly -- the quarter's calculation of EPS in the first six months. So you'll see that in our filings when we make those in a week or so.

For the purpose of my performance discussion, I will use proforma EPS, assuming the additional 700,000 shares I just mentioned were outstanding at the beginning of the year. We believe the proforma calculation represents some more meaningful measures, since it does measure the long-term impact on EPS of the conversation and the company has already acted to convert to preferred.

Turning to the results for the quarter. Sales increased by $20.8 million, or 13%. Our patient care centers had a great quarter, reporting a same center of sales increase of 8.9%, or $12.7 million of that total for the quarter. SPS had a strong quarter as well, reporting a $3.2 million, or 20.6% increase. Acquired entities accounted for $4.9 million of the sales increase.

Cost of goods sold as a percentage of sales decreased by a half a percentage point to 48.7% compared to the prior year. Labor cost increased by $2.1 million in the current quarter due principally to a slight increase in headcount and the impact of merit increases and an increase in commissions. As a percentage of sales, however, labor cost decreased by 1% to 18.2% of sales due to the sales increase.

Material cost increased by $7.2 million compared to the same quarter last year. Approximately $6.3 million of that increase was due to the $20.8 million increase in sales and $900,000 was due to a combination of a slight change in mix and increased freight costs.

SG&A increased by $7.6 million in Q2 due principally to a $2.6 million increase in the accrual for incentive compensation due both to increased sales volume and timing of the accrual. $1.8 million of the increase was personnel costs, primarily related to healthcare and benefits. $1.4 million due to acquisitions, $800,000 related to merit increases year-over-year, an additional $600,000 was invested in our -- in growth strategy, and we had a $1 million increase that was mostly professional fees and some other costs.

EBITDA, as a result of these changes, was $25.7 million, a $4 million, or 18.4% increase compared to the prior year. I just -- and that's due to the factors I just mentioned. EBITDA margins increased by 70 basis points from 13.5% to 14.2% this year, so we showed excellent leverage on our fixed costs.

Interest was $1.1 million less than last year due principally to the impact of lower variable interest rates due to both our improved results for the trailing 12 quarters and the reduction in interest, our total leverage is calculated under the terms of our Term B loan now stand at 3.97 times trailing EBITDA. That's the first time in some time we've been under 4 times levered.

Income taxes, the provision for the quarter was 40% of pre-tax income. As a result of all this, our EPS for the quarter was $0.25 compared to $0.17 in 2007. That's a 47% increase.

Keep in mind, in evaluating our performance that our proforma EPS calculation used, on average, over 500,000 more shares than used in -- by analysts in their estimates. GAAP EPS, which includes the dividend that I mentioned previously, was $0.11.

For the first six months, our sales increased by $34.6 million, or 11.4%. Top sales in our patient care centers increased by 6.7%, or $18.2 million for the year. SPS outside sales increased by $6.7 million, or 23.5% compared to last year. And acquisitions accounted for $9.1 million of the sales increase.

Cost of goods sold as a percentage of sales decreased for the first six months by 0.4 of a point, principally due to decreased labor cost, which is relatively fixed. Labor cost in dollars increased by $4.6 million due to a combination of increased healthcare cost and the impact of the sales increased on some variable costs like commissions.

Material cost increased by $11.2 million versus 2007. Approximately $10 million of that increase was attributable to a sales increase and $1.1 million was due to the combination of mix and inflation.

SG&A increased for the first six months by $12.6 million, and that's due to $2.9 million from acquisitions, a $2.8 million increase in the accrual for incentive compensation for the same reasons I previously discussed when I talked about the quarter. $1.6 million due to the merit increases, $2.8 million in personnel cost, principally healthcare and benefits. $2 million invested in our Linkia and [NA] growth strategies, $800,000 in advertising, $300,000 in other costs such as professional fees, bank and credit card fees, all of which were offset by a $1.1 million decrease in our bad debt cost.

EBITDA at $44.1 million increased by $6.2 million, or 16.4% compared to the prior year. And our leverage for the first six months increased by 60 basis points, which is at the high end of our internal expectations.

Interest was $2.2 million lower than last year, again due to the impact of lower or variable interest rates. From income taxes, we recorded a provision of $7.7 million for the first six months compared to a $4.9 million provision last year. The effective tax rate was 40% compared to 41.5% last year.

Moving on to the balance sheet. Our AR decreased by $1.4 million since 12/31/07, despite the $34 million increase in sales. And our DSOs decreased by five days, from 57 days to 52 days this year. At the same time our bad debt expense dropped to 2.3% compared to 2.9% last year. And the quality of our receivables, which we measure based on our over 120-day-old receivables was really good. Our percentage of 120-day-old receivables was 12.2%, which is the lowest it has ever been. So we have excellent quality of receivables. We're collecting well as evidenced by our DSOs dropping and our bad debt expense at the same time has dropped. So a very good result there.

Inventory decreased by $1.3 million to $83.5 million, compared to last year end balance, that's the 12/31 balance of $82.2 million. The inventory balance makes sense compared to all our other business trends.

CapEx for the second quarter was $4.7 million compared to $5 million last year. For the first six months, our CapEx was $7.8 million compared to $9.1 million. Both of those numbers are in our -- line with our expectations and we still expect to spend about between $19 and $20 million for CapEx for the year. So we should have slightly higher expense CapEx in the second half.

Cash flow from operations was $20 million compared to $18 million in the prior year, a $2 million increase. For the first six months, cash flow from operations $12.6 million compared to $20 million last year. The decrease, as we mentioned, when we talked about our first quarter, was due principally to a fluctuation in advance payments on our practitioners' incentive compensation plan which were impacted by the increased -- the improved performance in 2007. So that impacted our first quarter payment. We still expect to show $30 to $35 million in cash flow from operations in 2008.

Tom Kirk already talked about the guidance. As he mentioned, we're moving up the range of our expectations relative to sales, by $10 million to a range of 680 to 690. We're adding a nickel to our range for EPS. That is now between $0.80 and $0.82. So we have moved that up by a dime this year. And we are, in essence, reaffirming guidance for the second half. And you should note that we are absorbing the extra shares when we affirm our guidance that we just talked about in terms of that acceleration of the preferred. So we are really moving up our guidance slightly when you consider that fact.

That's the end of my comments on the quarter and the year. I'm going to turn the call over to Tom Kirk to talk about some more color on the results.

Thanks, George. Let's take a few moments and talk about the business drivers from an operations perspective. First, HPO, our patient care division, achieved $12.7 million in increase in sales or 8.9% same center sales growth for the quarter. It's outstanding performance, and the performance is principally attributable to three factors. The first is price. On January 1, 2008, we received a 2.7% CPIU increase, which on this first year will impact about 35% of our book of business. This, combined with last year's increase, which you'll remember was 4.3%, translates to about 2% of the 8.9% in same store sales growth.

Now, the balance of the growth is attributable to two other facts, the first of which is volume, and the second of which is mix. Let's take a look at the drivers on that end of the business. And the reason that we were able to see some additional translation is that on that 4.3% that we received last year, as we've told you previously, it takes about three years for that to roll all the way through our book of business, so it's the second year picking up on some of that.

Okay. Back to the volume and mix issues. First, we continue to see improvement in our Linkia book of business. And let me remind you again that HPO is the primary vehicle for the delivery of most of the services under our Linkia contracts. On an overall basis, the revenue from the Linkia designated contracts for this quarter was up 16% compared to the comparable quarter last year, and on a year-to-date basis, they are up 12%. So that's a very nice increase in revenue that is flowing through Linkia from the preferred and the exclusive contracts. And most of that, as I said, goes through HPO and results in an increase in volume for us.

The second factor is our continued emphasis on our high-performing products such as our microprocessor, prosthetic hands, knees, and feet components. For this quarter, the revenue from the delivery of these products is up about 30% compared to the comparable quarter last year. Now, year-to-date, the figure is also up about 30%. So you can do the math and see that we're running about 30% first quarter and second quarter, and these products not only provide additional functionality to our patients, but they also help us in improving our margins and taking a look at our revenue.

The third are our patient evaluation clinics. And if you'll recall, this is the methodology that we use to ensure that our patients come back in on a timely visit schedule so that we can check their fit and functionality. And for this quarter, those clinics have produced approximately 10% more revenue compared to last year and almost 40% more revenue for the year. Now, you also recall that these clinics performed very strongly in the first quarter of this year on a comparable basis, and that's because they really got off to a rather slow start in 2007, so the comp was not as difficult. I would say that year-to-date at 40% they're performing now inline with normal projections.

And the fourth area are our sales, marketing, and public relations efforts by our practitioners and all of those that support them in identifying local opportunities in their business communities and assist them in implementing these activities to translate plans into results. Basically, this is the blocking and tackling at the grassroots efforts that enables us to compete and to take market share and increase our volume.

I want to now switch to our legislative front. Some interesting activities have gone on in this arena. We continue to support the amputee coalition of America on educating state legislatures on the issues involved with reimbursement caps and how these deprived patients of quality care and doom them to lower levels of mobility. Recently Louisiana became the 11th state to pass parity, and there are 29 others that have introduced parity legislation. On the federal level, a bill was introduced into the house for National Prosthetic Parity, and a bill is expected shortly in the Senate.

In mid-July, the Congress passed the Medicare Improvements for Patients and Providers Act of 2008, better known as MIPPA. One of the features of this bill was a competitive bidding for DME suppliers was delayed by 18 months, providing additional time for CMS to review the process. Even more significant was the fact that O&P was not viewed as part of DME and, therefore, did not have to bear the cost of delaying the competitive bidding actions. We're very pleased with that. We worked very hard to ensure that the legislators understood the difference between O&P and DME. And also in early July, the Department of Labor Statistics posted that the CPIU increase over the last 12 months was 5%. This should be the fee schedule increase that we see next year, absent any definitive legislative action to not implement that fee schedule update. So we think we've got some good visibility out through 2009 on that front.

Now let's turn our attention to SPS. Their offsite sales were up approximately $3.2 million, or almost 21% compared to the second quarter of last year. And this is excluding the SureFit business, which we purchased in the beginning of July of last year. Their success is in continuing to build their core business by focusing on three major areas. First is continuing the leveraging of the location provided by the new warehouse which was opened in early July of '07. It's in Pennsylvania, and this provides a great conduit into the northeast market. Second is their superior customer service and training, which has really been the impetus for their gaining some new large customers during the quarter. And third is the addition of some new products into the portfolio, some of which they have on a sole distributor basis.

I just want to make a few comments on SureFit. You'll remember that this acquisition, as I mentioned, was made last year in the beginning of July, and it really is opening up a new entre into the podiatry market with some custom designed foot orthotics. We are in the process of integrating SureFit into the Hanger family, which has included improvements in their workflow, their management schemes, and in their sales force. And their sales are up about 5% over the comparable quarter last year.

Okay. Now let's turn our attention to Linkia. Linkia continues its dual mission of, A, building its share of key healthcare companies book of business, and, B, negotiating a fair price for the services provided by the providers within its network. The network consists of the Hanger patient care centers and independent providers. And, by the way, the independent providers has now grown to 301, as of today.

As I mentioned earlier, Linkia continues to increase their business as a provider network management company as insurance companies recognize the Linkia value and trim their network. In addition, Linkia is exploring other dimensions of service that they can incorporate into their model. And on the marketing side, they are continuing their discussion and negotiations with key national and large regional healthcare management companies, as well as to firms in the Workman's Compensation Segment.

And last, but not least, Innovative Neurotronics. They had another successful quarter, almost as good as the first quarter, which you'll recall contained a feature on the Good Morning American on WalkAide. So that was -- gave us a tremendous push.

We're continuing to complete our clinical studies and we still expect to file for coverage and reimbursement on a schedule to hopefully have resolution of coverage and reimbursement by the end of 2008, or early 2009.

And finally, a few words on acquisitions and our other developmental projects. We are continuing to pursue our strategic acquisition program. With respect to O&P, we are looking for (inaudible) of candidates that have strategic value to us in the form of location, quality practitioners, and/or favorable product-service mix. And on the development front, we've made some progress preparing to move our developmental projects into commercialization later this year.

So in closing, the results of the quarter demonstrate improvement over the first quarter of last year in terms of sales. But we also improved our leverage of fixed costs by about 70 basis points. And when George reviewed the SG&A categories for you, that actually contained some one-time costs. So we expect, as we go through the year, to continue to see improvement on this metric.

But we also recognized that the environment in which we operate continues to contain challenges. And this is why we're stepping up our efforts on revenue generation. We're continuing to invest in our developmental companies and some developmental projects. And while we're continuing to insist on stringent cost management so that we can leverage our fixed costs.

Thank you very much. That concludes my comments. I'd like to go back to Crystal now and open it up to any questions.

(OPERATOR INSTRUCTIONS) We'll pause for just a moment to compile the q-and-a roster. Your first question comes from the line of Larry Solow with CJS Securities.

Good morning, Larry.

I asked this question last quarter. I'll throw it out there again. Are you seeing any impact at all from the economy and maybe does the Linkia growth, are maybe providers maybe turning more to Linkia because of kind of a tightening financial fiscal environment without any impact?

I think there's two sides to this. There's the revenue and the cost side. On the revenue side, we've not seen any impact. We've monitored this closely. We are under represented, as you know, in some of what I will call the classic industrial heartbeat of America, Michigan, et cetera. But we continue to see the opportunity to use our scale and size to grow our revenue through all those mechanisms that we spoke about. And Linkia, certainly, I think has provided an opportunity for the insurance companies to manage their administrative costs. And also, Linkia, as you know, provides high quality, it measures customer satisfaction. So it's just a good deal all the way around. So from that perspective, as opposed to the economic or the economy perspective, I think Linkia has a good value proposition. So haven't seen any negatives, and we continue to watch that very closely.

The other portion of the economy that I alluded to would be on the cost side. We're recognizing that inflation seems to be going up. And certainly anything to do with energy, although that seems to have mitigated a little bit in the last few days, but we're seeing fuel surcharges and some increases from some of our suppliers on the material side. But we're doing our best to manage through those, consolidate our buy wherever we can and try to use all the tools that our scale will give us in order to manage through that.

Nothing disastrous at all, as evidenced from our results, but it is something that we are looking at every day really, Larry.

Okay. And then in terms of WalkAide, you had spoken that there were some publications expected, I guess from the early results out of Alberta. Is that still scheduled for sometime this year, or?

Yes, it is. The inventor has put together some research. He's got several research projects that have concluded. He has submitted those drafts. I mean, one is on the physical side. One is on a thing called neuroplasticity in terms of enhancing brain activity to actually have the brain retrained so it can do the job that the damaged part no longer is capable of providing. They are in two magazines, and it's our understanding that the magazines have made a few comments back and he's cleaning those up. So we would expect that this year, as you've suggested, that we're going to see those publications out on the market.

Good. And then, lastly, I know you had kind of a -- sort of a short-to-mid -- or a mid-to-longer term target of -- on your leverage, bringing your debt EBITDA down to four times. Now that you're kind of just below four, can we expect that to kind of continue to fall, maybe even towards 3.5 or lower?

Well, (technical difficulty) another half turn's a pretty big jump. We think we can keep it down under four, over time operate it down to 3.5 times, probably -- that would probably be an '09 event. But we feel good about our leverage right now.

Okay. And then just I'll throw in that I'll congratulate you guys. I saw you're the first ones to -- or you're doing some work on putting a prosthetic into a raccoon. I don't know -- so congratulations on that. Thanks a lot.

Thank you.

Your next question comes from the line of Adam Feinstein with Lehman Brothers.

Good morning, Adam.

Good morning. Just wanted to ask a few questions here. Just, I guess just first, you maybe just clearly showing big revenue growth here, this is for the best same store revenue growth you guys have reported in over a decade. This is certainly a very strong quarter. So I know in your own guidance you're being conservative and thinking more of a 4 or 5% going forward. But for the growth to really continue at these higher levels, what are some of the things that would need to happen, I guess just trying to understand in terms of what led to the upside here. You talked about all the programs and initiatives you have in place. But just curious to get your thoughts as you think about the ability to sustain this accelerated revenue growth, what are some of the things you would need to happen?

Great question. Great question. As you picked up on, there really is no one silver bullet that we attribute to the sales growth. It's sort of a potpourri of a number of the ongoing projects that we've had for some time. But I think in direct answer to your question of what's going to allow us to actually go a bit higher than the 4 to 6% that we've had out there, I think there's three things. Number one, Linkia's had outstanding performance for the quarter, 16% is really off the charts. It's almost double what they've had over the last three years. So what's happening there is that the insurance companies are continuing to reduce their network and bringing business into the -- into the Linkia shop through their network management. So I think that's the first thing, that the insurance companies have to remain dedicated and continue to see the value administrative and quality-wise. And certainly we are working with them on a weekly basis to make sure that we understand their needs and we're capable of providing that kind of service.

The second thing, we've again reported strong performance on our high-end, high-tech products of 30%. If you would have asked us at the beginning of the year, relative to what we achieved last year, would we see that kind of growth? I think the overall average response would have been not nearly as strong as we have been able to demonstrate. And I think what's happening there is insurance companies are recognizing that microprocessor componentry is here to stay. It certainly is not experimental. The manufacturers have stepped up. They've begun a number of clinical studies so that they can statistically demonstrate the efficacy of this device. The use of our proprietary PAVET, which is a patient evaluation tool, that we put all the patients through now, has been accepted by the insurance companies and actually some of the insurance companies have licensed it on a non-royalty basis. So they're insisting that all patients receive this and those that qualify on their scores are getting the devices. So I think what we're seeing is an acceptance of the high-tech products as a very efficient modality and a way through life-cycle costing to defer costs. So we continue to reinforce that with all of our payers.

And last, but not least, I think is the basic blocking and tackling that's going on at the grassroots level of being able to use our scale and size and to go in and convince people that we've got the range of skills, we've got the range of technology, and, therefore, whether they want it better, whether they want it faster, or whether they want it as the right economic value, that Hanger is the group that can provide that. Now, that's breaking patterned care and breaking all kinds of relationships, and that is one of the biggest reasons that we've been able to increase volume and, of course, the more successful we are there, the more that helps Linkia. So it's a combination of all three of those things that we've got to keep a focus on in order to sustain this growth above the 4 to 6% that we expected.

Okay. Very good. And just a follow-up question here. I guess just as we think about just the cost leverage and obviously margins are moving the right way, G&A expense in the quarter down to 37.1, you're showing big improvement there. But looking back, G&A used to be in the 36% level back in 2003.

So just curious, as you think about longer term goal, do you think there's the potential to the extent revenue is growing at these higher levels, that you could get the G&A leverage so you could get back to a 36% type of number over time?

I think over time, Adam, that we can move towards that. We've -- you recognize the fact that we have made some substantial investments that affects our SG&A and things like WalkAide and the clinical trials will be concluding soon, that cost will go away. We are -- we're getting price increases and that helps us with our leverage, and good comp growth, comparable to what you saw in 2001, '2, and '3. If you remember back then, it took us three years to get to that --

Right.

-- that number. And I think we're moving towards that. But it's going to take probably another year and a half to get -- to move towards those kind of levels.

Okay. All right. And then just a final question. Before he was talking about -- it was a question about the impact from the economy. I just wanted to follow up. What sort of co-pay does the patient typically have in terms of a typical managed care type of a patient? And just any commentary there as we think about that.

On average, Adam, it's about 20%. Sometimes the patients actually have backup insurance, they have supplemental insurance that will handle that and sometimes they have to come out of pocket for that. And certainly, as we have discussed historically, patients do need this care. This is their mobility. It's often not discretionary. Now, they do have some discretion around timing, and they can delay. And that's why our patient evaluation clinics are so important, to make sure that their devices stay in tune, that if it needs any maintenance, we can get that done. But that's, as you're probably suspecting there, that's the area of vulnerability, if somebody doesn't have the co-pay, then how are they going to -- how are they going to get this done. We haven't seen any weakness in that area. It is something we watch and certainly we watch our repair and maintenance codes to see if they're going up relative to historic levels so that we can monitor those kinds of trends. But we haven't seen anything that leads us to believe that that economy is going to impact our ability to try and make sure that they get the right -- the right device and the right service.

Okay. Great. Okay. Thank you. Great quarter.

Thank you.

Thanks, Adam.

Your next question comes from the line of Dawn Brock with JP Morgan.

Good morning, Dawn.

Morning, guys. So I just wanted to see if we could dig a little bit more into WalkAide. It's -- it sounds great that you appear to be getting the literature that you need by the end of the year. Can you just go into the time line again for us and just where you sit with it and when we can kind of expect this to really take off?

Sure. I think there's probably three pieces. There's the clinical trials and there's all the filings that utilize the data coming out of the clinical trials, and then there is the government's decision-making process once they receive the application. And as we've said before, we absolutely need to demonstrate the efficacy of the device. We can all see it empirically, and Good Morning America was certainly a great anecdotal piece of evidence as to how the device works, but the government needs statistics. So we have been running clinical trials at a number of highly regarded rehabilitation in hospital and university settings around the country. And those trials are scheduled to be completed in late August. And by complete I mean that we think we will have put through a sufficient number of people so that when we do the statistics, the sample size will be large enough to give us significance.

There's no doubt that we will probably continue measuring other variables to demonstrate more effectively the overall case for WalkAide. But once we get what we consider to be the statistically relevant sample size, what we will do then, take all those results, and, by the way, we're monitoring these things. I mean, a lot of -- a lot of the patients have already completed the trials and we have the data. Each patient generates almost 75 pages of data throughout their entire experience here. So we, along with an outside consultant that we are working with, are monitoring that data to diagnose any trends and, obviously, to begin to formulate opinions on just how well the device works on a number of metrics. And by working, we talk about avoidance of bad things. We talk about avoidance of cost and we talk about improvement of quality of life.

So as the -- as the data continues to come in, it is continuing to validate and verify what we've seen on our early results. And we are then taking that data as it's coming in, formulating opinions and beginning to say, "What would a high-quality research document report really look like?" So we're building those outlines and we're working with the principal investigators in the university to make sure that we're doing that in real time. And when that data's finished, we will complete those research reports and they will be submitted by the principal investigators to the appropriate magazines for peer review. At the same time in working with -- and that should be occurring at the latter part of the summer, early fall when we've got those things compiled.

We're working with our outside consultants to put together the necessary applications to CMS on two fronts. And the first will be what we call coverage. And that is nothing more than the device does the job from an efficacy perspective that it's supposed to do and the second front will be from reimbursement with a suggested reimbursement amount that is based upon a health economic study which is all those things that I mentioned.

So we'll be putting those applications together. And then once they are complete and the peer reviewed articles are out, we will be submitting all of this to Medicare. Now, we may choose to do this on a regional basis or we may choose to do it on a national basis, whichever gives us the best strategy for moving forward. And it's our expectation that we'll be able to make those applications by the latter part of this year, and then we're in to the government cycle.

Now, the good news is, with coverage and reimbursement, it's not an annual event as it is with coding. You can submit these things and the government has about a 90-day timetable that they operate on and they will review them. They have the opportunity to ask immediate questions or to delay a decision until they get that information. But we would hope, and based on experience and what our consultants are telling us, that within about 90 days after we've submitted this, that we will have a decision from the government.

And so that's our overall timetable and that's why we say we hope to have resolution by the end of the year or early 2009, as all of those pieces come together. And then once the government would come out with a coverage and reimbursement decision, then obviously we'd take those and go to work with the independent insurance companies and try to demonstrate the efficacy to them. There is nothing that is preventing us from, once we get the evidence, to beginning to work with the independent insurance companies and the Veterans Administration to begin preliminary discussions and start talking to them. We don't necessarily have to wait until Medicare renders its decision. So we're trying to really parallel process here on a number of tracks.

So that's -- sorry for the lengthy explanation, but --

No, that's excellent. Let me just ask a quick question. Is it correct, and I thought that we saw this about a month and a half or two months ago, that you actually did get a preliminary coverage determination?

What we received was a preliminary -- a code --

Right.

-- designation. We had been applying for a very specific L-code designation, and Medicare came back, and, rather than a miscellaneous code, they gave us a very specific E-code designation.

Right.

And they -- there's some subtle differences between an E and an L code. But, suffice it to say, that this was a major step forward, because the descriptor on this specific E code designated the device as a functional electrical stimulation device. Heretofore, the others that were out there were like TENS units, they were therapeutic instead of functional. So the government did recognize the uniqueness of the device in the functional area, which is -- which means one restores functionality, whereas the other's therapeutic that tries to rehab and build strength.

So that was a major step forward to give us that designation. But since no one has filed for coverage, which is demonstration of efficacy, there were those little tag lines on there that there was a national decision not to reimburse because nobody has provided any information on coverage. So that's why we are so laser-like focused on getting these studies done.

But what we received was a code as -- but coverage and reimbursement are still out there until we get our clinical trial submitted.

Excellent. Thank you. And my next question is on cost of materials. Can you just run through with us how you're mitigating and/or what you're seeing as far as fuel charges on freight? I know that it's going to be in both divisions, but it doesn't look like it really impacted you all that much in the quarter.

Well, maybe George has --

Well, if you look -- if you look at our margins, our margins did widen, but it was principally because of leverage that we got in our labor. We -- we're up about 0.4 of a point in terms of our [com rate] for the first six months, and that's principally due to the impact of the fuel surcharges on our airfreight and our ground freight. The air freight, I believe was up about 30% and ground freight's up about 8%. So it has had some impact on us. But it -- and that was to be expected.

Going forward, we are somewhat protected with -- in that a lot of our large vendors are doing business with us through contracts and we have set pricing. That gives us somewhat of a protection for this year. We will see higher freight costs continue. But that has mitigated somewhat. The surge in oil prices has slowed down a little bit. The -- but we still expect to be able to continue to lever our results despite that. We'll get some leverage out of our SG&A going forward and we believe they can continue to lever the labor component because that is, other than the commission fees, that's pretty fixed. So we think we can mitigate it with the sales growth and with the pricing component of that sales growth as well.

George, maybe you can just go into a little bit more on the labor side. A couple of years ago there was a lot of competition. I think there was a lot more concern over some of the practitioners being able to kind of defect, go hang up their own shingle, possibly put the pricing in jeopardy in the local and regional markets. That doesn't seem to be as much the case anymore. Is that true?

Well, we still have that same condition, Dawn. The barriers to entry are, indeed, low, so that someone can go out and hang up their shingle, and, from time-to-time, that does happen. I think what we're seeing, and our understanding just in talking to some of the folks that we encounter, and the primary mechanism, again, is our acquisition program, is that the regulatory complexities of what's going on are really a huge distraction from the clinical side of the business, which most of these people got into because they wanted to be good practitioners.

So as a result, I think people are taking the time to say, "Is this what I really want to do is to go out and get into the economic and regulatory fray of trying to compete and survive in this world on a day-to-day basis?" And so we have had some people come to us and saying, "Look, buy me out, because I've just had it. I don't want to deal with the complexities. I don't want to deal with the uncertainties. I really just want to take care of patients." So while that trend is still apparent, some people just don't want to put up with the hassle. I think that's number one.

Number two, I think this economic environment is a bit frightening to folks. Certainly, if they have to go out and get any kind of loans on their business, that's not the easiest thing to do today, particularly in view of the fact that they don't have the scale and size. We are very grateful to SPS in terms of their ability -- they're really the purchasing arm to HPO, and their ability to use their scale and the staff that they have is so experienced, that they can really manage the cost, as George has just talked about, whereas, the single vendor -- or I mean the single practitioner, he doesn't have the time to go through three or four different books and try to compare and price shop so he can get the best deal in the face of the environment that he's in. So I think the complexities of going out on your own these days, particularly as a small entrepreneur, make it extraordinarily difficult.

Now, having said all that, we still have some people leave. But it's our contention that life is getting a little more difficult to be the small entrepreneur out there, and that that is working in our favor.

Excellent. Thank you very much.

Thank you, Dawn.

Thank you, Dawn.

Your next question comes from the line of Mike Petusky with Noble Research.

Good morning, fellows. Great quarter.

Good morning, Mike. Thank you.

Well, I'll tell you what, what I really want to find out about is raccoons and whether you can leverage what you're doing there in rabbits and squirrels, but I'll save that for maybe a two- or three-hour phone call with George one day.

You've done a great job in going from dolphins to raccoons.

Let's talk about a couple things. The first thing, and I'll just follow up the previous question in terms of guys going independent. With the difficult economy, I'm wondering -- and the materials cost rising and all the rest, are you guys seeing more guys willing to sell your -- sell their business to you? I mean, what are you seeing on the acquisition front?

I'd say it's increased a bit. And remember, for a couple of years, we got out of the business of acquiring. When we were in the freeze, we decided that let's just stay focus -- stay focused on what we were doing, and, particularly, we didn't want to be using valuation techniques in the absence of knowing what the fee schedule increases were.

So I think we have reestablished ourselves over the last couple of years and that, as a result, has started to have more people approach us. Incidentally, rarely do we go out and call anyone up. I mean, we certainly have a short list of the folks that we would like. But we have found that people come to us through our relationships.

So I would say the answer to your question is yes, for two reasons. One is we've reestablished ourselves out there. But then secondly would be some of the complexities of doing business today. So there -- there are more people knocking at the door. But as I alluded to in my comments, we're really focused on what makes good strategic sense to us. And there are folks that knock on the door, but, frankly, don't fit with our plan. So we're not very aggressive, nor sometimes do we even get interested, and we just be candid with them.

Couple more. One revolving around WalkAide. Have you guys signed any additional agreements internationally? And, if not, can you just kind of give us, I guess a reminder -- or give me a reminder of where you guys have signed agreements?

Sure. We haven't signed any new ones. We still have seven, seven distributorships and then a joint commercialization agreement in Japan. And those agreements are in Canada, several of the countries in Europe, and a couple of locations actually in the Mid-East. So what we've done is take the time to -- when we get overseas, there is -- there's a language change. And trying to support our folks, meaning our new distributors and dealers, is our primary care, and that's what we're really going for. So we've taken the time to develop the brochures to support them, to give them the training, to make sure that they certainly know what the device is all about and they can support the local practitioners over there.

So we have really been focusing on developing those. We've put a lot of time in with our partner Teijin in Japan and have received almost the equivalent of what we would call the FDA certification in Japan, Teijin did that. But we work closely with them. So we're making progress. And any time you go into a highly regulation country, they almost have the same kind of hurdles that we do in terms of FDA, as well as their equivalent of Medicare.

So we're taking this one step at a time, but it is paying off and we're moving devices over in that direction as well. But we have a lot of applications from folks that are anxious. We've got a director of our international sales, and he spends a lot of time outside the country in trying to recruit and to select the people that are making the right call points. So that business is coming up. But it takes, as you can imagine, a little foundation work to get it there.

Actually, let me just follow up real quick with a heartbeat of that question. In terms of Japan and what you're doing with Teijin, I assume that revenues, your sense is revenues still are at least a couple, two, three years away?

Yes, that's correct.

Okay. And last one. I'm pretty sure I've heard you say that what's been put out there by CMS is a 5% cost-of-living update. That's correct, right?

That is right, yes.

Okay. In terms of the election and I guess the lame-duck Congress and administration, for that matter, is it -- does that make it more likely, less likely that Congress will come in at the last minute and make a change or try to take some of that back or reverse it? I mean, do you guys have any sense of that?

Well, I wish we did have a crystal ball. I just have a personal opinion. The legislation that was just passed, the MIPPA --

Right.

-- was extraordinarily complex and had a lot of politicking going on because the doctors were involved, competitive bidding was involved. And I -- personal opinion is that that's probably the last piece of healthcare legislation that we're going to see under this current administration. And, actually, you know they overrode the President's veto on that.

So I think all eyes are going to turn to the election and they're not going to be thinking about new kinds of healthcare legislation. It gives me some comfort around our fee schedule increase, and, as you know, it's, by law, we are scheduled to get it, unless there's some overt action taken. I just don't see the constitution of the Congress in getting back into healthcare debates at this point in terms of trying to save or enhance budget or other kinds of characteristics. I think they're going to be willing to say, "Let's let that ride on to the backs of the new Congress. We've satisfied the doctors, which was the pressing issue. We've satisfied the complaints from the DME folks which was the other pressing issue. We're going to let that monkey ride on somebody else's back, I think.

So I think we're in good shape. But I always have to put the caveat, who knows, when you're dealing with the legislators.

Absolutely. Well, guys, listen, again great job. Thanks. Appreciate it.

Thank you, Mike.

Thank you, Mike.

Our next question comes from the line of Greg Williams with Sidoti.

Thanks for taking my call.

Good morning, Greg. You're welcome.

Hi, Greg.

Hi. Just had a quick question back on the WalkAide. After your trials, you can choose to go to CMS regionally or nationally. Just wondering, in that process, does CMS already have the dollars budgeted for new produces in the '09 pipeline, or should they approve WalkAide, have to find the funding and cut elsewhere?

I don't profess to be an expert, Greg, on understanding the funding mechanisms for CMS. But I don't think that they develop a bottom up kind of budget in terms of adding up all the things that they're willing to pay for and, therefore, saying, "That's the total amount." I think that they do a topside on this. And so I -- I don't think they go through that granularity in deciding whether to approve or to fund something. I think their job in the -- in the reviewers of this encode its uniqueness in coverage, its efficacy, and in reimbursement healthcare and health cost economics. And I think they let the budgeting go to the other guy sitting down inside the beltway.

So I don't think they're looking at this from that perspective. If you satisfy by law, if you satisfy those three criteria on those three dimensions, you get code coverage and reimbursement, and it's up to someone else to figure out then if there's sufficient money to handle it or are there other things that, perhaps, are less qualified on code coverage and reimbursement that they don't need, haven't demonstrated, therefore, it's going to be a factor in consuming funds. So I don't -- I don't get the sense at all that the adjudication process is biased by how much funding's available.

Okay. Great. Did you -- I don't know if you -- I missed it. But did you mention how much in WalkAide sales you had this quarter?

We alluded to it. If you remember, last time I think we mentioned we had $3.2 million in enterprise sales --

Right.

-- and we were not quite as strong as that. We got up close to $3 million this time.

Okay. Still a great number. Can we just change gears, talk about the near-record DSO levels. I mean, what are you doing there, prescreening patients or more aggressive collections? And how do we look at the DSOs going forward?

Well, Greg, really nothing's changed. But what we found is that when it comes to collections, you have to have good systems and then it's -- and process is the most important thing. And we have a good process. We haven't really changed anything. The -- basically what we do is like what happens in any doctor's office when you go into -- to get care, we collect our deductibles when we deliver the device. And when you look at the device itself, the other 80% that either Medicare or a commercial payer is paying for, 90-plus percent of those devices are pre-approved. So there's really no reason why we shouldn't collect. Our real exposure is on the co-pay. And as long as we continue to do a good job and our people become more and more comfortable with the process, they're able to collect because the value to the patient is there. When we have trouble is when we let the collection go to after the device is delivered. So we try to avoid that wherever possible.

On the DSOs, 52 days is, I think is one day higher than we were at the end of Q1, which is a good result. Q1, with the lower sales, we usually see slightly lower DSOs. We think low 50s, and possibly high 40s is where our DSOs will stay, given our current level of technology on the systems side. But we are working on a new billing system that's probably a year and a half away that we think could enable us to bring that down lower because we'll be able to do more electronic billing. But for now we think high 40s, low 50s is a very good result, especially with the 2.3% bad debt expense.

Okay. Great. Thanks. Great quarter.

Thank you.

Thank you.

(OPERATOR INSTRUCTIONS) And your next question comes from the line of Amrit Nagpal with YCM. I mean WCM.

Good morning, Amrit.

Thanks for taking my question. Mine was more of an accounting question. George, I think you mentioned that you have some accrual in the period for incentive comp. And I remember last year you had a big sequential increase in the fourth quarter of 2007, for incentive and variable comp and bonuses. So are you approaching that accounting differently? Should we see a more smooth SG&A this year? Or if performance is good, will there -- will there be a similar bump up in that fourth quarter?

No, I think you'll see a more -- a more smooth accrual this year. And the reason is the discretionary pool doesn't -- and that was -- that was about half of the catch-up last year. That doesn't get accrued unless we meet our internal goals. And given our EPS performance, we're able to accrue that according to our policy and we shouldn't see a catch-up on that in the fourth quarter.

Okay. That's helpful. Thanks a lot, guys. Nice quarter.

Thank you.

Thank you.

At this time, there are no further questions.

Well, I'd like to thank you all for joining us, and, particularly those that asked questions for taking the time to do the work to understand our company. We look forward to the challenges in the second half of the year and look forward to joining you after our third quarter. Thank you very much and have a good day.

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