Hanger Inc (HNGR) 2008 Q3 法說會逐字稿

At this time I would like to welcome everyone to the third quarter earnings conference call. All lines have been placed on mute in order to prevent any background noise. After the speakers ' remarks, there will be a question-and-answer session. (OPERATOR INSTRUCTIONS)

Mr. Kirk, you may begin your conference.

Thank you, Operator, and good morning to all of you. Welcome to Hanger Orthopedic Group's discussion of our third quarter results. This is Tom Kirk, and I'm joined with George McHenry, our CFO, and Ken Abod, our Vice President, Treasurer and Director of Investor Relations.

Before starting with our remarks, let me take a few moments 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 current views of management.

However, various risks, uncertainties and contingencies could cause actual results or performance to differ materially from those expressed in or implied by these statements, including the Company's ability to enter into and derive benefits from managed care contracts, the demand for the Company's orthotic and prosthetic services and products, and the other factors identified in the Company's periodic reports on Form 10-K and Form 10-Q filed with the Securities and Exchange Commission under the Securities Exchange Act of 1934.

The Company disclaims any intent or obligation to update publicly these forward-looking statements, whether as a result of new information, future events or otherwise.

Now let's go back to our quarter. Overall, the quarter contained several noteworthy points. As a total entity, our sales grew by about 10% and net income was over 35% compared with the same quarter last year. This makes the 11th quarter that we have met or exceeded first call estimates. We continue to see the benefit of the programs that we placed into operation over the last several quarters, and the results of our people's efforts. Due to these factors, all of our operating units generated substantial improvement compared to the third quarter of 2007. Our balance sheet and liquidity are strong. We have $53 million in cash on hand, and $38 million available on a revolving credit facility, which we validated during the quarter.

Let me turn it over to George, who will review with you our financial results and balance sheet changes in more detail. George?

Thank you, Tom. Good morning, everyone.

Q3 was a solid quarter. As Tom mentioned, we exceeded our sales and earnings goals and our strong cash flow also exceeded our strong expectations. On top of that, our EPS grew at roughly three times our sales growth, so we continue to demonstrate good earnings leverage on our sales growth.

Now to my detailed comments. For the quarter, sales increased by $16.4 million or 10.1%. Our patient care centers had another greater quarter, reporting a same center sales increase 7.% or $10.5 million. SBS also had a strong quarter, reporting a $2.9 million or 15.9% increase. The balance of our sales increased was attributable to our acquired entities, it was $2.8 million. Cost of goods sold as a percentage of sales decreased by .03 of a point to to 49%due to lower material costs.

Our labor costs increased by $3.7 million in the current quarter, due principally to the impact of merit increases, an extra of pay during the quarter which was a holiday, so it didn't benefit our sales but cost us about an extra $600,000, a $1.3 million increase in healthcare costs, and the impact of acquisitions. As a percentage of sales, labor costs increased by .03 of a point to 19.1% of sales, due principally to that extra day and the increased healthcare costs. Material costs, on the other hand, while they increased by $4 million compared to the same quarter last year, they decreased by 50 basis points as a percentage of sales. A $16.4 million sales increase accounted for about a $4.9 million increase in material costs, and that was offset by a $900,000 weight benefit.

Our material rate is comparable to last year, when you factor in last year's favorable book to physical adjustment that was booked in the fourth quarter last year. SG&A increased by $6.7 million in Q3, principally due to a $1.6 million increase in the accrual for incentive compensation due to our improved performance, a $2.6 million increase in personnel costs primarily related to healthcare costs and the extra day of wages, which this category accounted for another $400,000 in expense, and $1 million due to acquisitions, $800,000 in merit increases and $700,000 in other costs.

Our be EBITDA was $24.6 million, and increased by $2.1 million or 9.2% compared to the prior year, due to the factors I mentioned previously. Our margins decreased by 20 basis points from 13.5%, due principally to the additional day in payroll costs, that was 66 versus 65 days, of which was about $1 million dollars in additional costs, and an additional $1.7 million in variable compensation accrual, which together accounted for a 150 basis-point swing, so we still were improving our margins because we will get benefit from that extra compensation accrual in the fourth quarter.

Through nine months EBITDA margins are up 40 basis points, which is still at the high end of our goal for the year to increase our EBITDA margins by 20 to 40 basis points. Interest was $1.3 million less than last year, due principally to the impact of lower variable interest rates. We mentioned at the end of Q2 that we had operated our leverage down below 4 for the first time in recent memory. Our total leverage as calculated under the Term B now stands at 3.74 times trailing EBITDA, so we were able to reduce it by almost another quarter turn since Q2. Income taxes, our provision for the third quarter was 40% of pretax income, which is consistent with prior quarters. Based on that, our EPS was $0.23 compared to $0.18 in the prior year, at 27.8% increase.

Moving onto the year-to-date results, sales increased by $51 million or 10.9%. Comp sales in our patient care centers increased by 6.9% or $28.6 million. SPS outside sales increased by $9.4 million or 21.1%, and our acquisitions accounted for the final $12 million in sales increase. Our cost of goods sold as a percentage of sales decreased by .03 of a point os sales due to a decrease in labor costs, which are relatively fixed. Labor costs increased by $8.2 million, due to a combination of increased healthcare costs, merit increases and acquisitions. Our material costs were increased by $15.2 million, and that's due entirely to the sales increase as our com rate was identical for both periods.

SG&A increased by $19.3 million for the year, due to a $2.3 million increase from acquisitions, a $4.5 million increase in the accrual for incentive compensation, $2.2 million due to merit increases, a $4 million increase in personnel costs, $2.5 million in healthcare costs, $2.1 million invested in our Linkia and [Innovative] growth strategies and $1.7 million from other costs, principally rent and occupancy. Based on all that, our EBITDA was $68.6 million, and increased by $8.3 million or 13.7% compared to the prior year. Our leverage, as I mentioned before, increased by 40 basis points. Interest was $3.5 million lower than last year, principally due to the impact of lower variable rates, and our income tax provision for the nine months was 40% compared to 41.5% in the prior year, so we have been able to reduce our income tax rate somewhat.

Moving on to the balance sheet, AR decreased by $3.3 million since 12-31-07 despite a $51 million increase in sales, and our DSOs decreased to 50 days compared to 56 days a year ago. Bad debt expense was 2.3% compared to 1.9%, that's for the quarter, and our AOR over 120 days, a measure of quality of our receivables, was 12.5%, which is the lowest it has ever been. So we have good quality in our receivables. Our inventory increased by $3.4 million to $85.6 million since year end, and that balance makes sense compared to all our other business trends.

CapEx for the second quarter was $4.2 million compared to $4.3 million in the prior year. For the year, we spent $12 million compared to $13.4 million last year. Cash flow for the quarter was excellent. As I mentioned before, we generated $22.3 million in the quarter compared to $10.1 million last year, an increase of $12.2 million. For the first nine months, cash flow from operations is now at $34.9 million compared to $30.2 million last year, so we have exceeded last year's number and we have reversed that trend that was caused by the change in our payment of our bonuses, and we do expect to generate more cash than we originally predicted for the year.

As I mentioned before, the decline in Q2 was due to the frequency of advanced payments on practitioners' incentive compensation. Since we are at $35 to $45 million for the year, we expect to be more in the -- that's about $10 million more than than our previous projection. Liquidity, to discuss that, in late September in response to uncertain credit markets Hanger drew $20 million on its revolver to prove the availability and to determine if Lehman would fund their share of the commitment. Lehman did not fund, and we netted $15.3 million on that draw. After the draw, the company had over $53 million in cash on its balance sheet at the end of the quarter, of which $42 million was invested in a money market backed by government securities. The Company also has $36 million in remaining availability on the revolver, after factoring out the Lehman commitment. Hanger is also generating positive cash flow from operations. We will consider repaying the draw once some sense of normalcy returns to the credit markets. In the meantime, we have adequate cash balances to conduct our operations and execute our growth plans, so we feel very safe in that regard.

Moving onto guidance, the company is confirming its existing guidance for Q4. Full-year guidance was not changed, but obviously if you just do the math we did $0.60 for the first nine months and consensus is $0.23 for Q4, so we should come in at about $0.83 for the year.

That's it for the financial results. I will turn the call over to Tom Kirk now, our CEO.

Thanks, George. I will take a few minutes and add a little color on our business drivers from an operations perspective, and go division by division.

First, let's take a look at our patient care division, HPO. This business achieved about a $10.5 million increase in sales or a 7.3% same center sales growth for the quarter. The performance for the quarter is partially attributable to the rollout of the 2.7% CPIU increase which we received January 1. That impacts about 35% of our business. This combined with the rollout of last year's 4.3% increase to our commercial book of business translates to about 2% of the 7.3% increase. If you remember we have told you historically, and it is still true today, it takes about three years for a rate increase to work its way to our commercial book of business.

The balance, or about 5.3% of the 7.3%, is attributable to volume, which is roughly 75% of the 5.3% in mix at 25%. The programs that impact our volume and mix, in other words how are we able to achieve those improvements, I will go through and we will discuss briefly. The first is the continued improvement in our Linkia book of business. Let me remind you again that HPO, our patient care division, is the primary vehicle for the delivery of most of the services under our Linkia contract, which are two forms, preferred and exclusive.

On an overall basis, the revenue from the Linkia designated contracts was up over 13% for the quarter, and that brings us to about 12.8% or almost 13% for the year. The second driver on volume and mix is our continued emphasis on our high-performing products such as microprocess or prosthetic hands, knees and feet components. For the quarter, the revenue from the delivery from these products was up about 27% compared to the comparable quarter last year. Year-to-date, this figure is running at 31%, so it is a nice addition to our overall product mix.

Now the third driver on the volume and mix are our patient evaluation clinics, we call these PECs. If you recall, this is where we bring our patients back in so that we can check the fit and functionality of their devices. These PECs produced approximately $5 million in incremental revenue for the quarter and over $13 million for the year-to-date, good for patient care and good for business.

Last but not least are our sales, marketing and public relations efforts by our practitioners and those that support the practitioners in identifying opportunities specific to their local businesses, and then implement the activities to translate these plans into results. Maybe some of you have seen the results of our most recent PR effort in the upper extremity are on the Today show, where our Vice President of Upper Extremity was working with one of our patients on a brand new high-technology articulating hand. The young man had lost his arm in an alligator attack.

Let's talk about overall the strength and the solidness of the business. Thus far we have not seen any evidence that the challenging financial environment is translating into patient care delays; in other words, delaying our patients from getting in when they need to have our services. However, we do recognize that if workers lose their jobs and unemployment goes up, and they don't find another source of benefits before their COBRA expires, we may see some stretching out of the time between their visits. We did have some evidence of this many years ago in Rust Belt America, but to date we have not seen any of that.

Normally, we would expect to see some increase in our maintenance procedures as this would start to occur. In other words, people would be coming in for more repair and maintenance procedures rather than replacement. But to date, we have not seen any of that, but we certainly are mindful of what is going on out there and watching these trends very closely. As you all know, one of the states that is particularly hard-hit these days is Michigan, and we are under-represented in that area, so perhaps that is a good thing.

Also, turning our attention to another subject near and dear to our heart is the legislative front. We continue to support the Amputee Coalition of America on educating state legislatures on the issues involved with reimbursement caps, and how these deprive our patients of quality care and really doom them to lower levels of mobility. Thus far, there are 11 states that have passed parity and almost 30 more are working on parity legislation. We would expect to see those become more active next year. On the Federal level, a bill was introduced into the Senate for national prosthetic parity during this quarter to complement the House version. While it is unlikely that there will be any substantive movement on these bills this year, we hope to see them included in any healthcare reforms when the new Congress commences in 2009. So we are really trying to lay the groundwork for the installation of those kinds of considerations.

As I mentioned during our last call, in early July the Department of Labor Statistics posted that the CPIU increase for 2009 would be 5%. This should be the fee schedule increase that we see next year, absent any definitive legislative action to prevent implementation, and thus far we know that the folks inside the beltway seem to be concerned with a lot of other matters, and we have not heard any rumors to the effect that there was going to be any blocking kinds of legislation. So as we look into 2009, we are expecting to see that 5% increase.

Let's turn our attention to our distribution business, called SPS. Their outside sales are up approximately $2.9 million or almost 16% compared to the third quarter of '07. Success in continuing to build sales in SPS's core business is attributable to three major areas. First is the continuing of the leverage of the new location in the northeast. The new warehouse was opened in July of '07, and it continues to be a vital factor in SPS's ability to provide quality service and timely delivery into that northeast corridor.

Second is their superior customer service and training, which is really the impetus for their gaining some new large customers during the quarter. And third is the addition of some new standard and high-tech products into their portfolio of products, and just during this quarter we can see evidence of that as they picked up a new line of modular componentry, which is already starting to help with their book of business. If you recall, last year at this time we acquired a company called SureFit. We have been working with SureFit in the integration of them into the Hanger family, and we are happy to say that the improvements that we have made in workflow and manufacturing logistics are paying off, and on an overall basis their sales are up 5% compared to the third quarter of last year, and the implementation of the new IT system to make it totally compatible with SPS has been completed.

Let's move on to our third unit, Linkia. Linkia continues in its dual mission of one, building its share of the key health companies book of business and two, negotiating a fair price for the services provided by the providers within the Linkia network. This network consists of the Hanger patient care centers and independent providers. The independent provider number has grown from about 300 during our last call to 306 today. As I mentioned earlier, Linkia continues to increase their business as a provider of network management, as insurance companies recognize the Linkia value and trim their network back. Their book of business is up almost 13%, as I said a little earlier in the call, so it is working, they are providing benefits through their value proposition. On the marketing side, Linkia is continuing their discussions and negotiations with the key national and large regional healthcare management companies, as well as the firms in the workman's compensation segment.

Last but not least, let's discuss a little bit about Innovative Neurotronics. Innovative Neurotronics had a good quarter by increasing enterprise revenues by almost 50% as compared with Q3 of last year. While the absolute amount of their sales revenue was slightly weaker than the quarters in the first half of the year, which of course we remember were so strong due to the wonderful coverage that we had on Good Morning America, nevertheless they continue to win key accounts and continue to establish and build market share and presence in the the functional electrical stimulation market. Currently, they are wrapping up their clinical studies at the final three test sites, we still have three of our test sites open, and admissions to those sites will be closed in mid-November.

Now, we opted to keep the enrollments open just to make certain that we had a sufficiently large enough sample size for our evaluations. Once we have the closure of those sites, we will begin the final analysis of the data and prepare the submissions to CMS, and we expect those submissions to go into CMS in early 2009. We recognize that this is about six to eight weeks later than our plan, but we think the time was well spent to ensure we have the proper number of fully evaluable patients.

It was our intent to have this wrapped up and to begin to do the analysis in early October, and we chose to keep this open so that again our sample size would be significant enough so that we would be able to have statistical significance in anything that we sent in. For the patients that are just going into the trials, as I said we will keep the admissions open until mid-November. They will be matriculating through the process and and won't be complete until out into 2009, but we don't need all of those patients. We want to continue to study those patients. We know that once we shut those trials down in mid-November, we will have had a sufficient number that will be complete to give us the end that we need.

Finally, a few words on acquisitions and our other developmental projects. We continue to pursue strategic acquisitions, and as George had mentioned on an overall year-to-date basis we have accumulated about $12 million in sales. With respect to O&P, we continue to look for those tuck-in candidates that have strategic value to us in the form of location, quality practitioners and/or favorable product/service mix. During this past quarter alone, we announced several new additions to the Hanger family, and we are happy to have them with us.

On the developmental front, we have made some additional progress on our developmental projects, and are preparing to complete our pilot studies in Q4 and move them into commercialization in Q1 of next year. So the next time we speak with you , we will give you more color and transparency into those, but those are going along according to plan.

In closing, the results of this quarter demonstrate that our programs continue to generate positive results. However, we certainly recognize that in this environment of volatile commodity and financial conditions, we have to be extra vigilant with respect to generation of revenues and certainly cost management.

That concludes our formal remarks. I would like to turn it back over to the Operator for the Q&A session. Thank

(OPERATOR INSTRUCTIONS)

Our first question comes from the line of from Brian [Sattino] of Barclays Capital. Your line is now open.

This is Brian Sattino on behalf of Adam Feinstein. I know in Q4 '07 you guys saw some variable comp increases due to strong cash collections in 2007. With this quarter reporting such strong cash flow, can you provide us with an update for your expectations for cash flow and variable comp in Q4?

Well, from a cash flow standpoint, we have -- as I mentioned previously, we revised our internal estimates. We originally thought we would generate $30 million to $35 million in cash flow this year, and we will be more in the $40 million to $45 million range. That is probably conservative. We are ahead of where we were last year in terms of our incentive compensation accruals, and they will not be as heavy as they were last year in the fourth quarter. So we should actually improve our EBITDA margins in the fourth quarter over the prior year pretty significantly in the fourth quarter.

We will have a substantial accrual because it is a good quarter from us from a profitability standpoint. But - the quarter also will not be influenced by the - anything like the $4 million inventory book to physical adjustment that we had last year. That was a benefit. That also influenced the accrual. So those two things shouldn't happen this year, and with where we stand with the accrual this year we expect to have a more normal accrual in the fourth quarter.

Okay, great. Thanks for the update. Can you also kind of comment on how your plans for CapEx are for the remainder for 2008, given kind of the lack of capital available in the market, and just give us an update there, if you can?

Sure. Well, first of all, I would say we are not constrained from a capital standpoint in terms of making the investments that we need to make in this business. That is part of the reason we did a draw on the revolver, just to assure that point in case things got more volatile in the financial markets. We originally budgeted about $20 million in CapEx for the year. Our year-to-date spend through three quarters is a little bit behind where we expect it to be, so we will probably have a little heavier spend in Q4. We do have quite a few projects that are culminating in that quarter. I think we will probably be a little under the $20 million budget that we had. We will probably come in more in the $18 million or $19 million range.

Okay. Great. Thanks a lot.

Our next question comes from the line of Larry Solow with CJS Securities.

Good morning.

Good morning, Larry, how are you today?

Good. How are you guys doing?

Very good, thank you.

Good. Just one quick question. I assume - you kind of reconfirmed guidance and sounds like you will slightly beat it. I can assume that your 680 to 690 on the revenue side, I imagine you probably feel you'll beat that too because the high end would only be just about flat year-over-year, so I assume -

Yes, we will probably be revenue-wise in the $695 million to $700 million range.

Got it. And then just to touch a little more on the SG&A. Can we expect, just on a margin basis, kind of you running in a low 37% range, and you have been accruing for some compensation already, would you expect that to kind of remain there or maybe increase a little bit in Q4 on a margin basis?

On a margin basis, it should be right around where it has been. It might be slightly higher. It might be a point higher.

Okay. And then just on cost of goods, I see you kind of had some benefit already this quarter, and I imagine - it seems like prices have come down even a lot more towards the tail end of the quarter and continue this quarter. If they stay at these levels and stabilize a little bit, can we assume that can be a benefit going out into 2009?

I would say the principal area where we saw pressure was in freight. Our transportation cost was definitely up. I don't know if we saw much benefit in Q3 because the decrease in oil prices hadn't really hit. We should get some benefit in Q4.

But keep in mind when you look at -- look more at our year-to-date com rate, we are practically level with the prior year, it is possible we could be a little bit below 30% in Q4 with the freight costs coming down but -- and, you know, your guess is as good as mine in terms of where oil prices will stay in '09. But right now it looks like things will stay fairly level going forward.

In terms of [walk-ins], I guess you file early 2009 and would it be fair to kind of say it will be a late '09, maybe 2009 late in the year, would be upside and kind of view it as a 2010 event?

I think it will be 2010, Larry, before we see a full year effect by filing in early '09. The nice thing about where we are for coverage, as differentiated from other phases of CMS, is that they can entertain our filing whenever it is submitted. So they will review it, and we expect that it should take no longer than about 90 days, unless they come back with sort of like a second request. So if all were to go well and they would accept our data and the health economic study that would support it, it will not take us to the end of ' 09. It should be certainly somewhere around Q2. Hopefully we will have some response back by the end of Q1, and Q2 maybe we can be implementing this so that we can have a full second half of the year.

Got it. Okay, great. Then just last is a housekeeping question. I think you said on the high-performing - high-performance products you said $5 million up for the quarter and $13 million year-to-date? Is that right?

No, that was on our patient evaluation.

Oh, that's what's I'm saying the patient [evaluation] was $5 million for the quarter, $13 million year-to-date?

That's correct, yes.

Do you happen to have the percentages that those equate to?

Percentage of overall sales, you mean?

No, percentage of the gain, the gain percentage?

They were up slightly compared to Q3 of last year, single digits, around a 5% to 6% increase.

For the quarter and for the year it is up --

For the year, it is about a 10% increase.

Got it. Okay, great, thanks a lot.

Our next question comes from the line of Mike Petusky.

Good quarter. A couple questions. One - if you commented on this, I missed it. Did you talk about - did you have any weather impact from the hurricanes? I didn't see anything in the release. Did that impact you at all?

We did. As a matter of fact, we took a rather severe hit with Ike in the Galveston area, specifically our Galveston office. We are still looking for it - we're trying to rebuild that. On an overall basis, what we have gone through Mike is really charted all through the quarter all the storms and compared them to last year, and just assumed a modest rate over last year. And when you add them all up, it comes to about $1.5 million of sales that we did not see in -- we went office by office in those specific offices. So sort of the two extreme events that happened this time, George alluded to one, was the way the days fell certainly in terms of the costs that we occurred and didn't have comparable revenue, and the second was the loss of about $1.5 million of revenue based on our assumptions. It's a good question, though.

Okay. In terms of the - Innovative, you said the revenues were down slightly sequentially, do you have those by any chance handy?

We saw the revenues - enterprise-based revenues of about $3 million in the first quarter, 2.8 million in the second quarter, and in this quarter $1.8 million, 1.8 plus some change. So the 1.8 is more along the lines where we thought it would be, but we recognized that we had just an outstanding benefit early in the year resulting from the Good Morning America show, and some very favorable penetration into a couple of our international markets.

Okay. I just want to make sure I understand. You wrap up the clinical somewhere in mid-November, and then you will have 75 evaluable patients when you wrap those up, in addition to the ones you are going to let continue go on, but essentially is it 75 patients that you will have fully evaluated?

That's correct and actually the number will be a little bit higher. When we finish the evaluation and crunching all the numbers, we hope to be more like 85 to 90. And we wanted to add a little more into the end just to make sure that we had proper coverage.

Then just a final - I guess a couple bigger-picture questions, and then I will get back in the queue. Do you guys hope to have any new Linkia contracts say between now and the end of calendar '09, and in terms of any potential new Innovative Neurotronics opportunities between say now and the end of '09?

Certainly in terms of our Linkia book of business, we are making proposals. For example, one company right now, we have revised the proposal three times in an effort to try and get their business. So we don't offer that kind of speculative prospective view into the Linkia book of business, simply because it is pretty difficult to predict exactly what they will be able to achieve, and history has taught us that lesson very well, that the sell-in time and the lead time and the sell process is pretty lengthy. We have some very interested people that are in the final stages of negotiation, so we would expect that we would have some additional Linkia customers between now and '09.

But let me just qualify that, so we don't actually create an expectation that we can't achieve. We don't see those customers as being huge blockbusters like some of the ones we have. They would be more in the category of what we would call some large regionals that we would be working with. So it would be incremental.

Of course, the other thing Linkia does is negotiate favorable prices based on the value that the insurance companies see, and for example on one of our contracts we have just received a 3.5% increase this past quarter that went into affect. So that, in combination with the additional volume and the favorable price increases is allowing us to go ahead and move forward in terms of building revenue, but we also recognize that it is not all just gravy out there. There are certain areas, for example the State of California or the State of Tennessee is taking some measures to reduce their spend on the Medicaid side, and to try and pull some of that back down. So it is a constant battle with them trying to manage with the revenues they have in states which are short of revenues versus our trying to get full value for what we do.

Tom, actually let me jump in with a quick follow-up to that point you made. How much of your business is Medicaid-related?

Medicaid is about 5% to 6% of our overall business.

Okay, thanks. Then just that final question, do you hope to have any new IN products or anything under development in the next year or so?

We are talking to some people with some IN end products on the functional electrical stimulation side. I think it would be premature, Mike, to say that we would actually have another product, and certainly we know - even though we like to get late-stage products, we know that it does take a while to get them commercial. But I alluded to some developmental projects that we have ongoing. Some of these are with other manufacturers that are on the outside that would report into our patient care business. So we have some of those developmental projects out, and we have some of those projects on test. So while we don't have a definitive new product for Innovative, we do have some other products that we plan to introduce into our patient care business early next year.

Thanks, Tom.

Thank you.

Our next question comes from the line of Greg Williams with Sidoti & Company. Your line is open.

Thanks for taking my call. Can you talk a little bit about the delay here, the eight-week delay in [market]? Specifically, did you anticipate more enrollees this fall and didn't get them, so now you're waiting for that, or you just felt like you didn't have enough? Maybe you could provide us some insight there?

Throughout the process -- I think we might have mentioned this earlier -- it's been - we have been constantly battling against defections, and when some of the people came into the program, and the way the arms are actually worked out, they have to buy their own unit, so they buy it and then let's say the arm is six weeks on the walk aid, and then it is six weeks on an AFO, and then six weeks back on the walk aid, we expect them to take a $4,500 device they just bought and go back to a current treatment that is not nearly as satisfactory. So we have had some defections. Throughout the process, we have been worked very diligently to try and keep our patients into the overall process. So our original expectation is that we would have completed the trials, as I mentioned, as we were saying late summer, we certainly thought by third quarter we would have had - our target number was 75.

As we started to wind down in the trials we thought it may be prudent, just to ensure that we get the analysis based around the proper end side, to let it run for another six or eight weeks and grab up some of the patients just to make sure we were okay. So it was really sort of the ounce of prevention instead of the pound of cure, because once you start doing all the analysis and do the calculations, you are there.

What is so tricky about this is when you do those evaluations and you see the results, you have to be very careful that those results don't spill back into any of the remaining tests. By that, I mean you could bias the outcome in either the way you select the patients or the way you put them into the arms. So we just wanted to let it go under the normal conditions and grab up a few more people, but you don't really get to go back at a second bite at the apple.

We just thought it was prudent, just to make sure that statistically we were okay, we had people from the right populations in, in terms of those that were critical immediately after stroke and those that were sort of continuing after their initial recovery. So we wanted to make sure we had the right kind of patient populations into this thing. So it was really, as I said, just to make sure that we could get this analysis done the right way.

It sounds like these folks were six weeks on and didn't want to go six weeks off, so from a functional perspective, that is sort of a nice problem to have then?

Pardon me, Greg, I missed - the phone cut out just for a second.

I'm sorry. Just saying that these folks were on it for six weeks and a lot of them didn't want to get off of the walk aid and go on to an AFO brace?

That was one of the initial issues that we had, and then it was a nagging issue throughout the entire test. So all the ones that just bought their new walk aid were forced to give it up a very short period after they achieved some benefit. So that side was somewhat under-represented, as you could well imagine.

So we did a number of things. We started working more closely with the principal investigators, we started to maintain a little - have them and some of our clinical folks maintain more contact with the patients without biasing the studies, just to make sure that they understood the real value that they were creating, not only for themselves but for those that came after them.

Of course, in the meantime we are still continuing to sell these units, so it is not as if the world is standing still. We are -- our targeted sales force, which we call RSSs, is 12. We are down a little bit because of - we are down two and are refilling those positions. So we'll continue with our sales and marketing efforts throughout the period.

And Tom, you did a great job discussing the economic impact or the macroeconomy on your volumes and sales going maybe more towards maintenance. But can you maybe see if we face a downturn here, some folks going downstream in terms of product mix, maybe not going for the high-end processor devices?

That is always a possibility. However, for those that qualify for the high-end device, what - typically they have higher performance levels and higher demands. In some cases, they can't get that level of performance and stability out of some of the lower-end devices. That's why there is this stratified level of technology devices out there. So we may see some of that happening more on the orthotic side, but I think people that are prosthetic patients, I mean this is their life, that leg is their mobility. So I would expect to see less downside -- or downturn into the lower kinds of products on prosthetics. I would expect to see some stretch out, in other words, on the maintenance side or trying to figure out a way to live with an existing socket by putting additional [applies] of socks on when they have had a weight change, instead of getting a new one. I think that would be the key on the prosthetic side. Perhaps on the orthotic side - now remember, these are lower price point products, so you are not going to save a whole lot in moving from a custom to - let's say a custom-fabricated device to custom-fit device. You will save a little, but perhaps on the orthotic side you may see some downward movement on the product scale.

Great. Thanks, guys.

Thank you.

(OPERATOR INSTRUCTIONS)

Our next question comes from Daniel Owczarski with Avondale Partners.

Good morning, and congratulations on the quarter. Tom, you started touching on a topic that I was going to ask little bit about, and that was on the orthotic side. Is that typically a 20% co-pay as well? I guess I was thinking that - is that - trying to figure out how much of that business is discretionary, thinking it is more urgent in nature and really would be isolated from economic pressures. Is there any other color that you could help us get our hands around just that piece of the business, how that could be impacted?

Sure. That's a great question, Dan. I think we should break our orthotic business perhaps into two pieces. One is the custom, where you absolutely have to have the custom-fitted kind of brace or body jacket, and that's - some are congenital and they are in braces for life, others after surgery need stabilization, and so they really don't have a choice because in order to do the job, it has to be custom and has to be high-end. And furthermore, if it is part of their treatment, the protocols for their improvement and functionality and rehabilitation, they will have to have it so they can't delay it and make it discretionary.

The second part is probably more of what we would call custom-fit low or off-the-shelf. Now probably the first thing to keep in mind is that we are probably under-represented in that business. A lot of that business tends to be fit either by a doctor right in the doctor's office, sometimes by a physical therapist. So the off-the-shelf or the low-end [codes] are a very small percentage, less than 5%. We went through - when Medicare was contemplating at one point including that end of the orthotic spectrum in competitive bidding, we went through and did an analysis and it was less than 5% of our orthotic business.

So that low end, perhaps people may decide that gee, I can go maybe just over to the med supply store and buy an Ace bandage or buy some other low-end type of device, and rather than going to see the doctor and then going into the Hanger store if I have a problem with my elbow or shoulder or knee, they can buy an Elastomeric kind of brace and figure out they can just get by with it. That's probably the portion of the population that you are referring to, and typically they don't -- we see some of them but that is not a big piece of our business.

But the rest I believe certainly is part of protocol. If they are going to proceed with the procedures that their doctor has outlined for them, they will have to come and see us. Now to the extent that they would opt to delay elective surgery or something, then of course we wouldn't see them until they do get that procedure or that surgery with the implant or replacement. So there is a number of moving pieces to this, and certainly you are right, Dan, in thinking about some of it may be delayed, but it will probably be only if they delay on elective surgeries.

Very helpful. Thank you. Maybe a similar question, just when we think about you and how you acquire or target new centers. In this environment are the independents finding it more difficult to operate in this economy, and does this kind of make it favorable to you when you go out and try to tuck in?

I believe it does. I think these days of uncertainty, as George was commenting, of seeing some rises in material costs, the volatility on the fuel surcharges that we are seeing, their inability to really have the kinds of volumes that we have, so that they can leverage back against the manufacturers and some of the freight companies, really hurts them. That volatility is a killer. And as George has said also, that when this year finishes out he fully expects, and we all agree, that probably our cost of materials will be almost equivalent to what it was last year, which is a great tribute to the practitioners in the field and the way they use and fabricate the devices, as well as SPS and they way they bought. The mom and pops don't have that luxury. So that is number one.

Secondly, the insurance companies, if you are not in the Linkia network, we know that their world has gone topsy-turvy here in the last year or so, so they are starting to get pretty aggressive around the kind of discounts that they are seeking. And then last but not least you have the states that are in the relentless search, like [MediCal] and Tennessee, trying to figure out how they can save some money. So all of those factors combined make it a more favorable market for us to work with the high-quality practitioners that are out there. They want to do the clinical work, but they just get a little bit tired of the uncertainty and the volatility in their earnings. So I think we make them a nice package, and they are more than willing to come under the umbrella and we are more than willing to have them.

Thank you.

Our last question in queue at this time comes from Henry Reukauf with Deutsche Bank.

Good morning, Henry, how are you today?

Good morning, Tom and George. Doing just well, congratulations on your quarter. Really fantastic results. Just two quick questions. One, you mentioned the Rust Belt, I guess it is probably 25, 30 years ago now that you -- that we saw the weakness out there that you are referencing. But how much was it, if there is any anecdotal evidence or memory of how much the weakness was there? And then secondarily, just on Linkia, with the HMOs topsy-turvy in terms of their performance, have you renewed all the Linkia contracts and are you seeing pricing that is comparable to last year or some sort of an increase?

Let's take those one at a time. We saw -- you are right, there was a major shift back in the Rust Best about 20 years ago, when many of the support and Tier 1 and Tier 2s to automotive got hit. But even more recently, if we just go back into the early 2000s really, we saw some activity again at the 2001-2002 period. In terms of -- I guess it is one of the good things of diversification across the country, because even when we experience some softness in western Pennsylvania and Ohio, and as I mentioned before we're under-represented in Michigan, those turndowns in those areas or those parts of those areas were maybe in the 5% range. For the most part, people will stretch and do whatever they have to do to try and get the device that they need.

So it wasn't as if it was catastrophic and the bottom fell out. What we saw was there was a lag, because people when they did lose their position, they lost their immediate benefits but then they went onto COBRA and then they started looking for other companies to find employment. So we saw probably in some of those pockets maybe a 5% turndown, which on our overall basis was less than a percent. So there is always that presence of revenue deterioration that can occur. I guess that was number one.

Secondly, with the HMO kind of turnaround they have been negotiating very aggressively, particularly with the mom and pops. What we have seen though is because -- and I go back to using probably this word too much, the value proposition of Linkia that really saves them administrative costs, and gives them what we call clinical simplicity, in that we measure customer satisfaction, quality and ensure certification, Linkia has been able to increase prices, not off the charts but commensurate with the kind of value they are delivering.

So while we know that it is a tough environment, that we fundamentally are seeing that the Linkia deal really works out -- it is a win-win for both sides. So we have seen - Linkia is renewing the contracts, and they are coming up continuously. Some of the ones that were signed last year have provision in them for three-year terms and increases each year, and then at the end of they are going to link back and take the the then current Medicare fee schedule, so we will capture those benefits.

So we think that of all the folks that are out there in the profession, Hanger is perhaps best suited to weather these kind of storms just due to the diversity of our locations and the value we can bring through the Linkia provider network. And we really want to be partners with these HMO companies, to make sure that what we are bringing enables them to go out and sell to the employers of the US because, after all, they have to market those services, and satisfied employees is what it is all about. So we try to encourage our people to keep a good focus on patient care and customer satisfaction, and we know that will pay off for us.

Okay. Thanks so much.

You are welcome. Thank you.

At this time there are no further questions in queue.

Thank you very much, Operator. I want to thank everybody for joining us. We certainly know that there is some good hard work to be done out there over the fourth quarter. We will be back with you in February to report our year-end results, and since we won't be talking with you, I just want to wish all of you a very happy and safe holiday season. Thank you.