Hanger Inc (HNGR) 2011 Q2 法說會逐字稿

Good morning. My name is Chrissy, and I will be your conference operator today. At this time, I would like to welcome everyone to the Hanger Orthopedic Group Second Quarter 2011 Results Conference Call.

All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer session. (Operator instructions)

I would now like to turn the call over to Mr. Tom Kirk, President and CEO of the Hanger Orthopedic Group. You may begin, sir.

Thanks, Chrissy.

Good morning, and welcome to Hanger Orthopedic Group's discussion of our second quarter results. This morning, I am joined with George McHenry, our EVP and Chief Financial Officer, and Tom Hofmeister, our Chief Accounting Officer and Director of IR Services.

Before beginning, let me ask Tom Hofmeister to review with you our declaration on forward-looking statements.

Thank you, Tom.

During this call, management will make forward-looking statements relating to the Company's results of operations. United States Private Securities Litigation Reform Act of 1995 provides a safe harbor for certain forward-looking statements. Statements related to future results of operations during this call 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.

These include but are not limited to the Company's ability to enter into and derive benefits from managed care contracts, the demands for the Company's products and services, and other factors identified in the Company's periodic reports on Form 10-K and 10-Q, which are filed with the Securities and Exchange Commission under the Securities and 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.

Thank you, Tom.

Just in terms of some highlights, overall, the quarter contained several noteworthy points. Our consolidated sales grew by 14.1% over the second quarter of last year. This sales performance, combined with effective cost management, yielded a diluted EPS of $0.45 per share. This puts us in line with the First Call estimates. And if we compare this to our adjusted EPS from Q2 of last year, it yields a growth rate of 21.6%.

In addition, during the quarter, our patient care segment achieved a 4.1% increase in same center sales growth, a welcome improvement coming off the harsh weather we experienced during the first quarter of last year.

Now, let me turn it over to George, who will touch on some of our financial results and our balance sheet changes. George?

Thank you, Tom.

Good morning, everyone. I'm going to address my comments first to the income statement.

Q2 was an excellent quarter for the Company. Comp sales in our core patient care business, as Tom mentioned, were back to expected levels, and we did a good job of controlling expenses.

The important takeaways are as follows --

Adjusted EPS of $0.45 represents 21.6% growth over the prior year, which met Street consensus estimates.

Adjusted EBITDA leverage increased by 190 basis points in Q2.

ACP added 110 basis points to our margins, and our core business added 80 basis points, which is well above the expected range of 20 to 40. That is part of our guidance.

When you analyze that, 20 basis points came from labor, and the balance came from other operating expenses. Keep in mind that ACP makes our -- we look at actual results -- makes our material costs go down relative to the prior-year performance, and it makes our labor costs go up as a percentage of sales slightly. We're really proud of that result for the quarter.

Overall sales increased by 14.1% for the quarter. Comp sales in our patient care centers increased by 4.1%, which was square in the middle of our expected range. WIP was strong at the end of the quarter, so we expect the favorable sales trend in patient care to continue.

Our distribution segment reported a 5.6% increase. Therapeutic services contributed a $15.7 million increase in sales. ACP accounted for most of the increase, and their EBITDA margins exceeded 30%. Their sales were in the low end of our expectations due to noise surrounding the RUGs for giveback, which we expect to get clarified in third quarter.

Overall, we were happy with our progress and the progress of the integration.

Our [com] rate of 29.2% was 1.3% below last year due to the impact of ACP, and it's in line with our internal forecast. Core business was actually equal to last year as a percentage of sales.

We continue to do a credible job of controlling expenses, as evidenced by the growth in our EBITDA margins. D&A increased by $3.2 million, compared to 2010, principally due to the acquisition of ACP.

Moving on to the year's results, adjusted EPS of $0.64 represents 20.8% growth over the prior year. Our adjusted EBITDA leverage increased by 170 basis points in the first six months. ACP added 130 basis points to our margins, and our core business added 40 basis points due to the excellent performance in Q2.

Most of the improvement came from operating expense when we look at the year-to-date results and a small amount of improvement in labor.

Consolidated sales increased by 13.3% for the first six months. Comp sales in our core patient care segment increased by 2.3%, again due to the Q2 performance.

Our distribution segment reported a 6.5% increase in the first half. Therapeutic services, including the new ACP acquisition, contributed $31.7 million increase in sales for the first six months.

Our com rate of 29.1% was 1.2% below last year due to the impact of ACP, and again, it's on target with our internal projections.

When you combine our 13.3% sales growth and effective expense control, we were able to leverage our sales growth into 27.3% growth in EBITDA.

D&A increased by 6.2 million for the first six months, and again, that's due to the acquisition.

Moving on to the balance sheet and the cash flow -- our AR balance of $121.7 million at 6/30. We continue to do a commendable job collecting our cash. DSOs were 50 days, which is in the range we expect. We're comfortable with our reserve for doubtful accounts.

Inventory increased by 4.4 million to 102.7 million from 98.3 million at the end of the year. Inventory turns were 4.2 times, which is consistent with prior period. And as I mentioned before, we still have a strong sales backlog.

Our CapEx for the quarter was 8.7 million, which was a $2.9 million increase over the prior year. For the first six months, we were at 14.1 million versus 13.7 last year, so we're slightly ahead of last year. And we still anticipate that our capital additions for the full year will be in the 40 to $50 million range, probably in the low end of that guidance.

Cash flow provided by operating activities for the quarter was $22.1 million, a $2.5 million improvement compared to $19.6 million in 2010. For the year, cash flow provided by operating activity stands at $10.6 million. That's a $3.1 million improvement over the prior year.

The Company currently has -- continues to have strong liquidity. We have total liquidity of $116.1 million. That's comprised of $19.5 million in cash and $96.6 million availability on our revolver. We did repay a $10 million draw on the revolver that was made in Q1 during Q2.

Our total leverage per our bank calculation improved to 3.27 times. It's well below our covenant of five times, an improvement over Q1, and it's actually the lowest the calculation has been since the acquisition and the recap of our balance sheet back in December.

Moving on to guidance, we are reaffirming guidance for 2011 that was established back in February. We expect net sales in the range of 945 to 955 million. That's a growth rate of 7.2 to 8.5%.

Based on the results of the first six months, we do expect sales to come in at the low end of that range. Included in the sales growth is the assumption that we will increase comp sales and patient care by 3 to 5%. We're back in the range we expected, as discussed in the first quarter discussion, and as I mentioned previously, we have strong WIP.

Our goal remains to improve adjusted EBITDA leverage in our core business by 20 to 40 basis points, and obviously, after the results of the first six months, we expect to be at the high end of that range or over it.

Full-year adjusted EPS guidance remains in the range of $1.66 to $1.71. We are also guiding to between 85 and $95 million in cash flow from operations and 40 to $50 million in capital additions.

That concludes my comments, and now I'd like to turn the call over to Tom Kirk, our CEO.

Thanks, George.

Let me take a few moments and add a little bit of color on the business drivers from an operations perspective.

Concerning patient care, this segment got back on track and achieved a 7.4 million increase, or a 4.1% same center sales growth rate for the quarter, compared to Q2 of 2010.

We have to keep in mind that it's now been two years since CMS has granted the O&P industry a fee schedule increase. While we have benefited from the roll-through of the 2009 price increase as it moved through our third-party payer contracts, we're just about at the end of that. We're looking forward to next year.

If we look at the calculation from the Bureau of Labor Statistics, it would indicate that the CPIU is up 3.6%, but we do know that the government imposes a productivity adjustment, which historically has been about 1.2%, which would bring us down to an anticipated price increase of 2.5%. But we really can't comment on that until the government makes it official, which will probably come sometime toward the latter end of Q3.

So for the most part, in order to generate any growth, we had to rely on our programs that positively impact our volume and mix, so let me give you a little bit of rundown on what some of these are.

First program that impacts our volume is within the 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 the Linkia contracts.

On an overall basis, the revenue from Linkia and their designated contracts was up about 6.5% compared to Q2 of 2010, which is a significant improvement compared to the 1% that we saw in Q1 of this year, which was primarily due to the weather-related activities, and I'll have further comments on Linkia in just a little bit.

Second program is educating our referral sources on the enhanced life-like features of our high-performing products, such as our advanced suction systems, our microprocessor prosthetic arms, hands, knees, and feet components.

For Q2, the revenues from these product lines were up about 8% compared to Q2 of 2010. This is primarily due to the introduction and the promotion of some new products and programs and the saturation of those programs into our patient population.

The third area that we stress are our patient evaluation clinics. And in these clinics, we call in our patients for an educational session on their fit and function. We bring them in front of some of our best prosthetists and orthotists so that we can examine their fit, function, and make recommendations on how to improve their prosthesis or orthosis.

This is just a great example of good patient care that provides incremental revenues. The revenues from this source, which are reported obviously in our overall revenue numbers, were about $6 million this year during the quarter. So that went into our volume base.

And fourth are our sales, marketing, and public relations efforts by our practitioners and those who support them in identifying opportunities specific to the local businesses. Examples of these would be the opening of satellite offices and the launching of very targeted marketing programs.

And so those four efforts combined really attribute all the improvements that we've made in volume and mix and are a major contributor to the 4.1% increase in same center sales growth.

On a different note, just to give you a little idea of the environment in which we operate, our practitioners continue to offer assistance as needed to our patients. Now, the issue here is some of the patients have difficulty in identifying other sources of financial assistance to help with their reimbursement, coinsurance, and copays, and this is primarily due to the unemployment situation.

At the end of Q2 2011, the unemployment rate was at 9.2%, which was up from the 8.8% at the end of Q1 of this year but down slightly from the 9.5% at the end of Q2 of last year. It is a stubbornly high rate that is beginning to impact people because I just heard on the news that some six million of the 14 million people that are out of work have been out of work for over a year, and this really does impact them on their ability to manage their financial responsibility, and it imposes a hardship on some of our patients.

We work diligently to try to find alternative sources of funding, whether that be charitable or vocational rehab, and you can rest assured that we will continue to do everything in our power to help our patients get through this sluggish economy.

Also on the environment in which we operate, let's take a look at what's going on in the federal level.

We continue to advocate for our patients and for fairer regulations. We were successful in having the parity bill, which is now referred to as the Insurance Fairness for Amputees Act, reintroduced into the Senate, and we're continuing to line up sponsors for the House. After August 15, we will have 20 states that have passed parity. This is once the governor of Delaware signs their bill into law, which we expect to happen on August 15. So we continue to make progress and get traction at the state level.

The Veterans Bill of Rights has been reintroduced into the House, and we have also been successful in re-introducing the Medicare Improvement Act into the House, and we're close to securing sponsorship in the Senate. However, as we all know, the full attention of the Congress for the past several weeks has been on this debt ceiling situation.

Our efforts are tireless in terms of trying to get the attention of folks regardless of these other kinds of distraction, and as I mentioned, we are making progress.

We're not alone in this battle. We've been working with the Amputee Coalition, the American Orthotics and Prosthetics Association, the National Association for the Advancement of O&P, the O&P Alliance, and all of the member advocate associations, such as the MS and Diabetes Association. We are really united in this front to ensure that our patients receive quality care and they're not denied access to this care.

We also have faced some challenges at the state level. State Medicaid has been undergoing quite a change. Healthcare providers that are servicing under state Medicare are facing challenges as the states struggle to balance their budgets. At present, we're working with each state on an individual basis in terms of education, communications, and public relations in order to support our patients. Here again, we're working closely with all the patient advocate associations to ensure that those patients receive the care they deserve.

Now, we've had some success. In California, we managed to turn around their efforts to reduce payments. The same in Nevada and Minnesota. Just last week, we entered into the record justification for not reducing the reimbursement levels for the state of Texas in their Medicaid program. We don't know the outcome of that yet.

And we've launched a national public relations effort using PSA-type advertising, which really stresses the cost-effectiveness of the services we provide. The theme of this national program is that limbs are not a luxury, and for those of you that are in the New York area, you can even go to the Times Square area and you'll see up on one of the buildings an advertisement for "Limbs are not a luxury, and don't deprive people of the limbs they need."

Okay, let's turn our attention now over to SPS. Their outside sales were up approximately 1.3 million, or 5.6%, compared to the second quarter of 2010. SPS is promoting their new expanded product line via a new 750-page catalog. They've also completed beta testing on a new purchasing software system that is utilized by almost 200 of the independent O&P facilities.

So in addition to their own ordering system, this new system that they're bringing online that is part of a modular system that some of the independents use will give us a second avenue for booking online so that we can make it more convenient for those practitioners to order from SPS.

SPS also expects to begin shipping from their new Midwest distribution center in early August, and this will permit SPS to reach most of their Midwest customers within one day, which further reinforces SPS's service commitment.

Within SPS, the Sure Fit business continues to gain traction with the Hanger practitioners, the independent practitioners, and the podiatrists. For the year, sales are up about 9% over 2010, and during this quarter, they advanced some discussions with retail companies to handle portions of their product line.

Okay, let's talk for a moment about Linkia. They continue to execute their dual mission of building volume while negotiating a fair price for the services and the value they provide to their customers. Their book of business, as I mentioned before, is up about 6.5% for the quarter. In addition, they were successful in securing additional business on three contracts and have several more in the pipeline under negotiations.

You've heard me speak in the past about some pilot programs that Linkia has been running, and now they've advanced these pilots into commercialization. They offer other services that complement their model and provide benefit to the payers.

One of these two pilots involves post-mastectomy services. It's been undergoing network construction, and to date has about 250 facilities, with Hanger accounting for almost 85% of these. And you can see this play. It's working with the insurance companies to ensure quality care for post-mastectomy patients by identifying those facilities that have the right kinds of practitioners and know and understand this business, and it's being very well received by the insurance companies.

They've also signed three companies to participate in their second pilot program that's into commercialization, which is a prosthetic and orthotics claim review service. And as I've mentioned, we've already signed up three companies on this. And the payers are telling us that they recognize the value that Linkia brings to them in helping them control costs while ensuring good clinical care and high levels of customer satisfaction in the base business, as well as in these new ancillary services.

On the marketing side, they're continuing to have discussions and negotiations with key national and large regional healthcare management companies, as well as with some of the firms in the workmen's compensation space.

Now, let's talk about our therapeutic solutions segment, which consists of Accelerated Care Plus and Innovative Neurotronics. Sales for this segment were up by 15.7 million compared with Q2 of 2010, which was due principally from the acquisition of ACP.

ACP continues to market their unique value proposition and to emphasize the clinical and the technology sides of their offering, and we've talked to you about that. They are quite unique in what they do.

Now, recently, certain portions of ACP's customer base, notably the SNFs, have been affected by CMS's announcement in early Q2 that they are considering reducing the reimbursement rates for certain physical therapy services, and this all has to do with the new RUGs for rules that went into effect October 1. It's a bit quirky in that CMS just adjusted these rates upward October 1 of 2010, and here six months later, they've just announced that it's not working out the way they planned, so they may have to make a downward adjustment.

It's been suggested that that adjustment could be as high as 11%, but we won't know the final number. We're expecting to get more information on this in early August. But obviously the SNFs are trying to determine where this could end up and how this could affect them.

ACP's growth notched down as a result of this announcement, but they still grew in excess of 10% in spite of that announcement, and they are making the appropriate enhancements and service additions to their offerings to cope with the situation.

ACP is truly a partner to the SNFs. They recognize this changing situation, and as a result, they are designing some products and services tailor-made to the specific SNFs so that we can fit into this equation.

Now, we believe once the uncertainty of this CMS announcement is resolved, which should be in Q3, we expect their business to return to the anticipated growth levels we set during the announcement of the acquisition. May take a little while for this to bake into the system, but we think ultimately we'll get back to those levels, but we are going to have to get through this period of reimbursement adjustment and get some certainty around this.

Now, we have launched two pilots, and I mentioned these during the last call, to determine the best method of capturing the synergy between our patient care division and ACP. One of these is in Arizona, and one of these is in Florida.

We've advanced these pilots during the quarter, and we're gaining great information, which is going to guide our national rollout, which will occur toward the end of this year. We believe there's significant juice between ACP and the orthotics side of our traditional business and a little bit of spillover even into prosthetics, and this is all about how best to market it and how best to deliver these services, and these are the learnings that we're picking up.

The other part of therapeutic solutions segment is Innovative Neurotronics. During the quarter, they launched their new pediatric FES system, along with their new WalkAide Pediatric System. This is unique. This system is tailor-made to fit on smaller people, children, pediatrics.

They've also come out with a revised version of the original WalkAide, which has higher reliability and greater simplicity. One of the knocks on this system was it was difficult to set up, and we were getting this feedback from our practitioners. So, in ink, Innovative Neurotronics went in and simplified the system, made some further improvements, and we're not hearing any of these kinds of comments. As a matter of fact, both of these developments, the pediatric system and the changes on WalkAide, have been very favorably received in the field.

Within Innovative Neurotronics, we're continuing to work with the clinical sites to go through the IRB and the contracting process for our InStride Pivotal clinical trial. In total, we intend to be working with 30 institutions, and the enrolled patients are increasing. We still anticipate sufficient patient enrollment by the end of 2011 or early 2012 to analyze the data to pursue submission for the coverage decision with CMS in 2012.

And at the same time, we're continuing to work with third-party payers to gain authorization for our patients. To date, we've been seeing about a 70% success ratio. So, basically, of the ones that get through the system, get to the decision point, basically seven out of every 10 results in a success and the other 30% may be denied, in which case we have to go back and do a little more homework.

Finally, a few words on our acquisition program. As you will recall, we pulled back a bit on O&P acquisitions in Q4 of last year due to the ACP acquisition.

During Q1 and Q2, we've rebuilt our pipeline and have made several acquisitions during the first half. Based on the strength of this pipeline, we anticipate exceeding our normal target of 20 to 22 million of annualized sales for the year.

As we've said in the past, the strategy is to look for tuck-in candidates that have strategic value to us in the form of location, quality practitioners, and/or favorable product service mix.

In closing, let me say again that we operate in a changing and challenging environment with issues like high unemployment rate that retreats very slowly, energy and food inflation, states trying to close budget gaps, and federal regulations concerning healthcare reimbursement.

We've regained our momentum during this quarter following a very tough first quarter, and we've held the line on expenses, allowing us to meet our earnings expectations. We're optimistic concerning our growth opportunities in the second half of this year.

Thank you. I'll now turn it back to Chris, who will open up the line for questions.

(Operator instructions)

David MacDonald, SunTrust.

Hey, Tom, can you just give us a little bit more detail on the 4.1% growth? Can you actually break the pieces out into how much of that was mix, how much of it was volume, and how much of it was pure price?

All right. Let's start maybe in reverse order. Very little of it was price. We're seeing the only price impact that we have, as I mentioned, is the roll-through of the 2009, which is out into its third year of '9, '10, '11.

So when we get a price increase in from CMS, rather immediately, we pick up about 30% of that benefit right in the CMS contracts. We get another pretty quick VA and sometimes the Medicaid, which can account for another 10%. So within a reasonably short period of time, we get 40% of it.

The remaining 60% bakes in depending on how our contracts mature over three years because that's the average length of the contract. So of that 60%, we're probably only -- when we get out into the third year, we're probably getting about 10% of that benefit. So we're seeing very little coming from price.

Now, along the way, as you know, Linkia does go out and tries to negotiate volume increases, as I mentioned, and some price enhancements. So Linkia has been good with some of their national providers in picking up a little additional kind of inflationary adjustment kinds of price increases.

So if we step back from it all, price really accounts for probably about 0.5 percent. In some of the years past, it was up around as high as 1.5%, but now it's about a 0.5%. So if we take that out of the 4.1, that gives us 3.6.

In terms of the mix and the volume, we believe when we look at the numbers it's about a 50/50 split, Dave, and the mix occurs largely -- that's why we talk about our high-performing products, and that's where we believe that a patient can perform better in a high-performing product instead of a lower-performing product, and so that's really -- they're going to get a leg anyway, but it's one where we can give them greater functionality by stepping up. It's a higher price point product, but it delivers higher functionality, and we think it's probably about 50/50 between volume and mix, and certainly, we see additional volume that comes from Linkia, we see additional market share gain from our marketing programs, but 50/50 is about as close as we can nail it down. So about 1.8% coming from volume and maybe 1.8% coming from the mix side.

Okay. And then can you guys just provide a little bit more detail on the WalkAide, kind of if you're comfortable going there, how many of these facilities are signed up now, how many of those facilities actually have patients enrolled, and kind of moving forward? Just something there. And then I think you said the end of 2011 is still a good date in terms of full enrollment?

Yes. Well, as I mentioned, we're working with 30 organizations, and we expect to probably within the next month be up around having, in terms of people signed up, probably about two-thirds of those in terms of just overall locations because we're working on some in the pipeline now that we'll be signing up in the next couple weeks. We're right at the cusp of it.

So suffice to say that we've got a good base of operations out there. We are recruiting patients into these. But as we've learned and as others have learned, that's a very time-consuming process to get people in and to make sure they satisfy the requirements and to get them to the point where because it's a sort of a double-arm test where they have to be in a WalkAide and then they have to give up their WalkAide and go into an AFO.

So we expect to load those up, and Dave, what we're doing is that as we go through this, we should fully anticipate when we get out to about the midpoint, we're going to take a look at what this data looks like, which we're allowed to do under the terms of our agreement with FDA and CMS, and we're going to make a decision then in terms of -- it depends on what the data looks like, but we'll have to look at the standard deviation, make sure we understand the sample size, and see if the data is robust enough, which we always are hoping for and we believe when we look at it empirically, that we can go ahead, gather up the information, and make a submission to CMS, and certainly would rather -- would hope to see just the way the pharmaceuticals do is to see the results as being so outstanding it would give us the opportunity to go ahead and even file a little bit earlier than perhaps waiting until the entire trial is completed. But we'll have to see what that data looks like. But we expect that we're going to be in that position by year-end or early '12. We're going to know exactly where this thing sits.

Okay. And then just on the acquisitions, I think you mentioned you've done a couple. I would assume these were small because they haven't been announced, but can you give us a sense of the timing of them? Have they been recently, where we haven't really seen the revenue impact and then you're going to start to see it show up obviously much more meaningful in 3Q and 4Q?

That's correct. They've been spread throughout the quarter. I mean the first one really came at the beginning of the year, and then there was a little bit of a dry spell through Q1, where we were rebuilding the pipeline, and now we've recently ticked off some others, but we've not seen the full impact of any of those yet, and we will expect to see those in Q3 and Q4. And we've got a very full pipeline, so we expect to be adding in some others as the year moves on.

Okay. And then just last question. With the conversations you guys have on the ACP side with the SNF customers, I mean do they understand that if reimbursement does get cut or when it gets cut, that ACP probably becomes more critical because of the cost savings that it generates?

They absolutely do, and in case that they don't, ACP has developed a comprehensive marketing program to reinforce that point, and they've gone out and gathered blind information because we're not going to reveal who the companies are, again, reinforcing the value that ACP can bring to the revenue line, the productivity and the outcomes on the patients, and how all that translates down into the bottom line to generate profit.

We want to make sure that as they consider the various options, if in fact their reimbursement is reduced, that they fully know and appreciate. Then we take that model and we customize it for each customer. We fit very exact data into it and show them in a template-like fashion, "Here's the programs you have to be employing, and if you're using the ACP modalities, here's what you can expect in the way of improved productivity and patient outcomes."

So it's customized, and it's a whole new marketing program that's largely in response to this announcement because this is throwing all the cards up in the air, and a lot of people are very concerned.

Okay. Thanks very much, guys.

You're welcome, Dave.

Brian Sekino, Barclays Capital.

Just a question here quickly on the guidance. You mentioned O&P kind of rebounding from Q1, getting some strong same-store numbers, and then the -- you're getting acquisitions a bit quicker than you had expected. So I guess the lower expectation on the top line, is that really just some caution around ACP for the remainder of the year?

I think it's a combination of two things, Brian. One is we certainly recognize what happened in the first quarter, and we didn't get all of that back. We had hoped we would, but we've seen over the years that it doesn't always come back the way you think it is. So we realized that we're dealing with that deficit from the first quarter, and you might say it's a little bit of conservatism as we look to the future.

We expect the patient care segment to be performing in line with budget, so I guess it's a little bit of conservatism around ACP and a few other things that makes us feel like we might be closer to the bottom end of the range.

Now, certainly, having some upside in terms of a few acquisitions or we're working on a couple of other things, as I mentioned, through Linkia, etcetera, if those all hit, could be a different story, but we want to sort of tell you the way it is and be as honest as we can with you.

Okay, and just on ACP, you mentioned the cost savings and I guess the patient outcomes, and as I think about you mentioning new products that would be tailored to fit after this potential RUG for giveback, is it that you're focusing more on trying to deliver the message of the cost savings to nursing homes now that their margins are going to be under pressure, presumably from the cut?

Well, you're right in the sense that it's more of a customized program. By going into each facility and understanding their needs, certainly, we want to do the marketing to show them what the ACP program can yield. But we all recognize that these facilities have different kinds of patient populations, and some of those populations might need a lot more care, some of them might need less. And so what we're attempting to do is to make sure that we have customized the offering in terms of the products, the education, and the consulting services to actually sync up with the needs of that facility and their patient population.

So if they need a little bit more, we'll offer them a little more robust program. If they need a little bit less, we're going to offer them sort of the skinnied-down version. So it's all based upon exactly what their needs are to service that patient population.

So I mean a number of companies and industries have gone through what has classically been called segmentation. Years ago, there was one kind of tennis shoe. Today, you have running shoes, you have tennis shoes, and it's a bit like that. We're trying to segment the market so that we can tailor-make the product offering and the service that backs it up for each of these individual SNFs so that they can achieve the profit levels that they need.

Okay, and then -- yes, that helps. And on the national rollout that you mentioned, the pilot programs going into effect, I guess, next year, can you give us a little detail in terms of how -- what exactly you need to be doing? Is it that you're going to your referral sources for your patient care centers and just trying to build up your marketing efforts there and awareness about the ACP products? Just any details you could provide would be helpful.

Sure. It's a reciprocal program, but let me start from the other side because, day one, we're actually working the other way. Our traditional orthotics business has been under-penetrated into the SNF area. We know that there's work within the SNFs. Certainly, the kinds of devices that that population can use could benefit by having an orthotist that could come around occasionally because the PTs in the facility are all about restoration of mobility and functionality. They're not into fitting devices.

And so we recognize that of those 15,000 SNFs that are out there, there's a great opportunity, and historically, we've been under-penetrated.

One of the reasons that we were so fascinated with ACP is that they've got a very strong position and great relationship in those facilities. And so, day one, what we're doing is that we are leveraging ACP's position in the SNFs to bring in the orthotic side of our business and even prosthetics because, let's face it, there are diabetics that are in there, and they suffer amputations.

So the two pilots that I mentioned, one in Florida and one down in Arizona, have gone and identified, well, what's the basis for the sale? What do we want to go in and actually sell? Is it contracture management? Is it stroke recovery? And we're going through that, say what makes sense? Where do we see the greatest kind of patient population?

Second area we're looking at is we know that ACP and their clinical program managers are in there on a routine basis, so how do we sync up with them? How do we provide that orthotic coverage? We're exploring two mechanisms. Do we use our traditional orthotists that are inside our patient care centers and expect them to sort of come out and be available to support the clinical program managers? Or do we go out and hire a certified fitter who works a territory and goes around on a regular schedule and visits the SNFs?

And so we're trying both of those methodologies. We've also put together the collateral materials to stress what the combined entity could do, which is a little bit broader. I mean we're bringing in things like the WalkAide, saying maybe if you've got someone that's recovering from stroke, they could benefit from a WalkAide, as well.

So it's the marketing, it's the delivery of the services, and it's the identification of which indications we can be most successful with.

Now, we don't want to ignore the other side either, and that's where we have a relationship with some doctors' groups or perhaps even some SNFs where ACP is not involved, and of course then, we're bringing them over.

But day one, we recognize, based upon the input we receive from ACP and the kinds of requests that they see for orthotic product, that there's a significant demand out there, and as I said, historically, we're underrepresented as being filled by everything from med supply houses, and in our mind, that's not the way to provide good patient care. We think we can do a better job.

So we're going to test those things out. As I mentioned, we're getting good learnings around that. And as we look to the end of the year, we'll roll it out nationally, and it will also tell us just what kind of demographic we need to make this successful. I mean does it only work in the urban area, etcetera? How do we identify which pieces of geography it makes sense?

Okay, great. And just one last one for me, and I'll jump back in the queue. You mentioned the CPIU coming out at 3.6 and you get the potential for a productivity adjustment, but I guess these days we're hearing rumblings from every area that's for Medicare reimbursement that could be impacted by cuts to reduce the deficit for debt ceiling legislation or even a doc fix later in the year.

So I guess, based on what you're hearing out of Washington, how do you feel about O&P reimbursement and being kind of immune to some of these cuts for 2012, beyond whatever productivity adjustment you may or may not get?

Sure. Brian, I wish I had an answer. I mean that is the $64,000 question. When people are talking about $4 trillion' worth of cuts, you have no idea where all this could go and what kind of horse-trading could go on in the back room.

But we have been frozen for two years. We don't think it's the intent of the government to put us out of business, and we have to remember that 75% of the provider population are little mom and pops. I mean these are the small business guys that everybody talks about.

That's why I sort of caveated that whole thing, saying we'll have to wait and see where the government comes out. I can't handicap this thing in terms of what is likely to happen, but I don't think they want to put us out of business.

We also know that we are allied with the Amputee Coalition, the MS and the Diabetes Association, and these are strong groups with strong lobbying, and I'm not trying to suggest that lobbying will be the answer, but I think they've got a lot of patients within those associations that are absolutely dependent on care in order to have mobility and in order to function.

And I think that there's probably no congressman out there that really wants to see these group of people rally in either his home office or in Washington saying, "I can't get my brace," or, "I can't get my prosthesis because of these cuts."

So I wish I knew where it would all end up, and I'm not sure that we'll be immune. Got my fingers crossed, and we're doing everything we can on the government relations front to make sure that people know and understand, and that's part of this whole PR campaign. If you get a chance, I think it's up on the website on the AOPA, American Orthotic and Prosthetics Association. You'll see that they have this PSA movie where a patient comes into a government office. He's told he has to give back his leg, so he actually takes his leg off and hops over on one leg to the counter, turns it into a government employee, and they give him in exchange a crutch. And it's a rather heart-wrenching experience.

But we're trying to make the point that limbs aren't a luxury. There's just no alternative to getting good care. So we'll just have to wait and see, Brian. I don't know. I don't have the answer on that one.

Okay. Thanks for taking my questions.

You're welcome.

Larry Solow, CJS Securities.

Could you guys just talk a little bit more about just impact of -- as the economy and sort of the unemployment market languishes, I know you have a lot of initiatives to sort of offset this, but just anecdotally or are things getting worse? Are they getting better? As people come off COBRA, are things maybe getting even a little worse? Or any more color on that would be real helpful.

Thus far, we've not seen any deterioration in terms of it getting worse. Alternatively, it's not getting any better. So if I were to describe it, I would say it's sort of sustained flatness and that we're still seeing people coming in still struggling, and "Gee, you know, how can I afford this?" We work with them, and what it does is it really presents an extra burden on our practitioners, trying to write up information so that these folks can get the care they need.

We are seeing -- we have an arrangement with a financial provider that if the credit conditions of the folks is suitable, we can actually get them financing that we subsidize at a very attractive rate, and so each one becomes a struggle. It's not really getting any worse, but we certainly would've thought by this time and this stage of the recovery that it might be getting better, but we've just not seen this.

So it's almost like business as usual for the last three years, and it's still -- as I say, it presents a lot of extra challenges to us, but our people, they feel for the patient, they want them to get the products, so we're working each one individually. But, hopefully, we could see some restoration of normalcy so that this could go away.

Okay. And then your cost of materials obviously was down as a percentage of sales, and I realize ACP is driving a lot of that. Is this a number that's sort of a sustainable level, or do you think -- or does it move around a little bit on a quarter-to-quarter basis?

The margin number should remain relatively in the same neighborhood that it's in today because you're seeing the impact of ACP, or as I mentioned in my comments, our core business was pretty much flat versus prior year, so what you're seeing is principally the impact of ACP, and their margins should stay relatively constant for the rest of the year.

Okay. And the slowdown at ACP, it doesn't seem like it was very significant, but do you think that in the short run, this could get a little bit worse before it gets better, or any view on that? And has any particular customer slowed down more than others?

Well, we see, in general, just a great deal of uncertainty. The result has been some hesitancy to put in some new installations. We have seen the cancellation rate run up a little bit higher. That's why we've intensified our marketing efforts. We've talked to you in the past about the OmniVR. That had a couple of technical issues that needed to be resolved, and so we've fixed those, and we intend to bring that product out around the beginning of September, and that has good acceptance, so that should help.

And I would say there's no real pocket of problems. It's just sort of spread throughout the entire population. In some cases, it manifests itself a little bit differently. As I said, we saw some cancellations. We were coming back to try and reinforce that message.

We've seen some firms that historically would go in and put the first complement of products in there, that suite of products, and after a short period of time, they may come back and order another Omni cycle, for example, saying, "We can get greater productivity if we get a second new cycle in here." We're seeing some firms that are a little hesitant to do that. Again, this can be overcome by marketing and making sure we understand their patient population.

So there's just little spots of this all around, which when you add it up, even though, as I mentioned, they're still growing in excess of 10%, it certainly complicates the marketing approach, and we don't think this is going to clean out until we find out, which is going to be Q3/Q4, exactly what the new reimbursement level is, how does it compare to the levels prior to October of '10 when the RUGs for all went in -- I mean maybe they can still be better off than they were in, say, the Q2 timeframe of '10.

So that uncertainty has people sitting on the fence, and it's not going to get blown out of the system until people get a look at what the reimbursement level is. And keep in mind, Larry, it's not just the reimbursement level and are we going to take this down by 11%, but they're also talking about changing some of the other metrics around what you can do, and that's concurrent versus group kinds of therapy.

And so it's that confusion and how it actually relates to their specific patient population that has people sitting on the fence so that they don't know, gee, if I can't get group paid for the way it was, then I'll have to do something differently, and that, of course, will relate to the kind of program and the products they want to use.

So that's sort of the issue, but we do think that probably by year-end, we'll have a lot more visibility into this, and hopefully, we can get this out of the system in time so that we can get back to more normalcy in '12.

Got it. Okay, great. Thanks.

You're welcome. Thank you.

Brian Tanquilut, Jefferies and Company.

Tom, just a question. You guys put up a 1.8% increase in volumes, and you talked extensively about how it's challenging for your patients given the difficult economic environment. So I was just wondering, how are you able to drive 1.8% growth given that backdrop when most other healthcare providers or healthcare sub-sectors are struggling with volumes?

A couple of methodologies. One, Linkia. As I mentioned, that's a key contributor. They're up 6.5%. Their overall book of business this year should be north of 140 million, which is going to be up from the 130 they had last year. We'll have to wait and see how it ends up. But as they work the insurance companies and we become a bigger participant in their programs, we're going to have more dedicated customers out there from the payer perspective, which I don't want to say it's an entitlement, but it gives us a much broader license to hunt as we pick up more and more of the insurance companies' business and it flips into us, either as a preferred or as an exclusive provider. I think that's one way that we get volume.

The second is we're very sensitive to following the demographic trends. So if we're working in Phoenix, Arizona and a doctor's group is expanding and putting an office in Scottsdale, as an example, we'll go out there and put in a satellite.

So we're moving into new geographic areas, allowing us to better service the docs in the hospitals so that we can be adjacent to them because we're not going to let that patient population escape.

Satellites are an important mechanism that we've used for years to go out and capture new business. They may start small, where it's only open, say, one day a week, expanding to two days, but as that area matures, we will staff it up so that we can get that business. And time and time again, what we've seen, not only will we be able to get that doc or the hospital that sort of took us into that area, but once we establish a presence, we can start pulling in other patients that we didn't historically have because they -- in this example, they didn't want to drive from Scottsdale into Phoenix.

So the two primary mechanisms on volume are the Linkia contracts and geographic penetration, and that's how we pick it up.

Now, probably the third in terms of overall volume, we talk about our patient evaluation clinics. I mean we make a very concentrated effort, just as your dentist does, to make sure that you're getting back in on a timely basis. Ultimately, we might see those patients, but it might take a whole lot longer for them to come to the realization that their device isn't fitting properly.

But when we bring them into a patient evaluation clinic and we educate them on how their device is working, we actually are stimulating the volume because we will give them a note to take back to their doctor with the assessment saying, "Go back and talk to your doc about this. If he agrees, come on back with a script and we'll get into a new socket, or we'll change the way your brace is fitting." Whatever it is, that's stimulating volume that might appear two, three years from now, but if we take this over the long term, it's a great mechanism to pick up more business and to take better care of patients.

So there are the three primary mechanisms for volume.

Hey, Tom, to that third point, as a follow-up to that, do you guys track compliance rates among your patients in terms of how -- their replacement cycle, I guess. Obviously, these devices need to be replaced every three to five years. Is that something that you can track?

And, also, is there an ability on the patient's part to delay her placement? And if you can remind us, the mix between replacements and new installs in terms of your volumes?

Sure. About 50% of our business is replacement and 50% is new installs. Patients can control. Number one, if you take care of a device, you keep it lubed, you keep it oiled, keep it clean, you can prolong the life of the device. I mean some of these things are electromechanical, so it's a bit like your car in how you take care of them. So they can sort of extend it out.

For a patient that's undergoing volumetric change, it's more difficult because as you expand or as you contract, the device has to fit on you personally. So they're almost forced to come back in. Now, they can, of course, put on more plys of socks if they lose some weight. The alternative doesn't work, though. If they gain weight, they can't.

So patients do have a role just in terms of how they take care of the device, how it's used. I mean somebody that's on it, that's installing HVAC equipment or something like that, I mean that device could get some real severe wear.

So patients can control some of this to a certain extent, but ultimately, I mean we want them to be in a device that fits because that's where they get maximum benefit, and that's the whole point of the patient evaluation clinics.

Okay. And then, George, on ACP, you mentioned that margins were above expectations for the quarter, and it seemed like volumes were on the soft side. So what is it that you guys have exactly done to get margins higher in that book of business?

Actually, it's pretty simple. When we saw that we were under a little pressure from a sales perspective, we just went on the offensive in terms of cost and made sure that we controlled cost and that we weren't -- any investment we were making was something that made sense from a return standpoint.

So that's both for your core business and ACP, I guess, right?

Yes.

Okay. And then last question. Tom, inflation obviously is an issue that we are concerned with, and it seems like pricing is flattish. So how do you drive margin growth going forward given the inflationary environment?

Probably the key area where we've seen inflation rear its ugly head has been on the energy side, and so we work with our freight company, try to give them more volume in exchange for better pricing.

An example of that is we've just recently rolled ACP's shipments into SPS's base contract, which gave the carrier more volume, but we extracted a price reduction out of that.

So we're constantly -- and that's probably the biggest is in the volume price trade-off. As we can work with our suppliers, narrow down the number, we can offer them better volume, which they need, in exchange for price reduction.

Now, we've not seen where we've had runaway inflation on materials or alloys, but we've been managing to control the polymer cost. Our alloys and metals are pretty stable. We've not seen any influence there.

But we know as we look to the future this is going to be a continuing challenge, and we're just going to have to find ways to push through this. And, hopefully, if inflation does rear its ugly head in any significant way, we would hope to be able to capture through price increases some of that as it would be manifest in the CPIU.

Got it. All right. Thanks, guys.

Thank you.

(Operator instructions)

Mike Petusky, Noble Financial.

I just want to get a clarification around what you said about Linkia. Did you say you added three new contracts or you expanded three existing contracts?

We expanded three existing contracts. We picked up more of their business.

Okay, all right. But no new contracts in the quarter?

We're working on some, and we hope to have some to report to you next time.

Okay. All right. And then I just want to real quickly hit back on the, I guess, the CPIU issue and the productivity -- potential productivity adjustment. The 1.2 you cited, I mean basically that was the productivity adjustment or roughly the productivity adjustment from this prior year, correct?

That is correct. And in addition to that, when the pronouncement came out from CMS about the changes in the RUGs reimbursement for SNFs, they were, I guess, in line for a 3.7% increase, as I read that.

And the speculation, or what CMS had said, is that there would probably be a 1.2% giveback on productivity, netting them to 2.5. So that number -- and, by the way, that pronouncement only came out at the beginning of this quarter -- so that number seems to be bantered about as the accepted amount of the productivity adjustment, and it is what we saw last year, too.

Okay. All right. Well, then that -- I would certainly view that on a net basis as a real positive.

Okay, so let me -- I want to hit one issue dead-on that I've heard here recently in the marketplace. There was a rumor that ACP had lost either Kindred in its entirety as a customer or in a material way. Can you guys just comment on how much of that is truth and how much of that is rumor?

Well, we never comment on specific customers, but we have not -- I mean Kindred is a very important customer and one of the largest customers we have, and there have been -- let me just put it this way and say of our large customers, there's been no wholesale defection.

We work with them on an individual basis to recognize their issues. They've made a recent acquisition, and we're working with them to help integrate that and see how ACP can be in a position to better service their needs as they integrate that acquisition.

All right. But is it fair to say they remain a significant customer and you expect them to continue to be in that category?

Yes, we do.

Okay. All right. And then I guess given what you said about the M&A, both the pipeline and what you've closed but not announced, is it fair to say that maybe -- historically, now, 2010, I actually saw was slightly up sequentially Q3 from Q2, but in the years prior, there'd always been a little seasonality that Q3 would sometimes be down slightly versus Q2.

I mean are you fairly comfortable saying given what you said about M&A that likely we're going to see sequential increases, both top line and bottom line in Q3 and then in Q4 following?

Yes, I would say as we look at Q3, I would expect it to be equal or greater to Q2 and then with some improvement coming in Q4 over Q3.

And you know that Q3 situation often is impacted by weather and vacations, but certainly, it doesn't present the kind of challenges that Q1 does, and so we hope that we've got a good situation from storms and hurricanes and things that are traditional factors that can impact us in Q3.

We expect, Mike, our sales to be higher in Q3 than Q2 because of the effect of the acquisitions, but as they're being integrated, it'll initially generate a lot of profits, so we expect our profits to be pretty close to Q2.

Okay. All right. Okay, very good. And then sorry for this. I was momentarily distracted when you were talking about price, volumes mix. Did you essentially say that price was up like a 0.5% or very slightly? Is that what you said?

That's right, yes.

Okay. All right. That's all I've got. Thank you.

Thank you, Mike.

There are no further questions in queue. I'd now like to turn the call back over to Mr. Tom Kirk for any closing remarks.

Well, I want to thank you all for joining us this morning, and thank you for your continued support. As George has just mentioned, we expect Q3 to be equal to or better than Q2, and so we understand the challenges that are out there, and as I mentioned in my closing comments, we are laser-like-focused on increasing our sales and controlling our costs so that we can meet the projections that we've put out in our guidance.

And so with that, I'll sign off. Have a good summer, and we'll look forward to talking to you at the end of October as we report on Q3. Thank you.

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