HealthStream Inc (HSTM) 2016 Q3 法說會逐字稿

Good day, ladies and gentlemen, and welcome to the HealthStream third-quarter 2016 earnings conference call. (Operator Instructions) As a reminder, today's teleconference is being recorded. I would now like to turn the conference over to your host for today, Ms. Mollie Condra, Vice President, Investor Relations and Communications. Ma'am, you may begin.

Thank you and good morning. Thank you for joining us today to discuss our third-quarter 2016 results. Also on the conference call with me are Robert A. Frist, Jr., CEO and Chairman of HealthStream; and Jerry Hayden, Senior Vice President and CFO.

I would also like to remind you that this conference call may contain forward-looking statements regarding future events and the future performance of HealthStream that involve risks and uncertainties that could cause actual results to differ materially from those projected in the forward-looking statements. Information concerning these risks and other factors that could cause results to differ materially from such forward-looking statements are contained in the Company's filings with the SEC including Forms 10-K and 10-Q.

So with that we will begin. I will turn the call over to Bobby Frist.

Good morning. Thank you, Mollie. Welcome to our new Chicago office, Morrissey (inaudible) acquisition this quarter. They are probably a little busy today, celebrating. But welcome, all of our new Morrissey employees up in Chicago.

Let's turn our attention right into the third-quarter earnings conference here. And I'm going to dive right in and look at our three segments and talk about some of the expectations we have and some of the changed expectations we have now.

So first let's take a look at kind of overall. Revenues for the quarter came within our guidance range and operating income fell short of our expectations.

Our workforce development segment saw strong revenue growth. It was led by outperformance in our resuscitation portfolio. And that has a comparatively lower gross margin, on the whole.

Our patient experience segment underperformed to our expectations, and that was due to lower sales and a changing product mix which we're going to talk about in more detail in just a minute.

And then, finally, strong sales continued in our provider solutions segment but revenue trailed expectations due to a growing implementation backlog, which really is an execution issue that we're working through.

So now, with those three generalizations or characterizations, let's go into each segment in more detail. Within the workforce development segment, our resuscitation portfolio -- and I will remind you that it's led by our HeartCode products -- continues to perform above our expectations.

Together, this portfolio includes our NRP solutions, our [HeartSavor] solutions, our HeartCode products and a relative newcomer product which is called RQI. And we are going to need to talk a little bit about RQI to understand what's happening with the resuscitation portfolio.

These products are focused on teaching resuscitation skills to healthcare professionals and they are offered through our partnerships with American Heart Association, Leyerdahl Medical and the American Association of Pediatrics. And continued outperformance by this portfolio of products -- it will likely to continue to pressure the Company's gross margins into the next several quarters or maybe for a long while, as it has a lower overall gross margin profile.

And so, it's something you have to remember. These products are outperforming to expectations, which if you can back up from it enough is a good thing. But they do carry lower gross margin, and you probably saw a little bit of gross margin pressure compared to expectations. That's due to just this continuing shift.

As we noted in prior calls, in Q1 and Q2 it was our highest performing product. And in Q3 it continued to be a high-performing product and now it's compounding a bit on its impact on gross margin.

Now I'll turn our attention to patient experience. This business segment increased by 2% for Q3 compared to last year. That was definitely lower than expected. And that has prompted us to lower our revenue guidance for the patient experience business segment for the full year. And we have decided to lower that expectation to [01%] growth, so essentially flat.

Obviously, 60 days ago we had different expectations of that, growing upwards of 6%. And so that is a change in the last 60 days we're going to need to talk about. So I'll give you a little color on that here.

During the quarter we experienced a greater-than-expected shift from home-based surveys to online surveys, which does have for us a dampening effect on revenue. And so, a little more on that -- two of our top five customers made meaningful progress collecting the necessary contact information like email, cell phones or texts so they could text, and that supports their move to online surveying for non-CMS-mandated patient experience programs.

So for example, in the quarter our largest account was able to transition their CG caps program from phone-based data collection to our online surveying platform. And so these online surveys are contacted at a lower price point. So the short run impact is lower revenue from that particular survey set.

However, it will deliver a lower cost. We can deliver those surveys now at a lower cost. So over time, as the volume shift continues, it should drive increased profitability for that specific product line and on that specific account. But overall, as this trend continues, it will have that dual effect of pressure on topline growth and -- but increased and improved margins and profitability over time.

So finally, we do have to talk a bit about provider solutions. I think we made some really, really good acquisition in the Healthline acquisition, as far back as the SciMed acquisition and the Morrissey acquisition all are very profitable, high recurring revenue businesses with long histories. And we acquired them at fair and reasonable prices. And they continue to perform.

Now, two of those businesses had a culture of slow growth and high margins. And we turned those businesses over to a high-growth-oriented team, and they are beginning to deliver. They have increased the sales organization from 3 to 5 salespeople up to 20, and the new business is pouring in.

On the other hand, it's taking us longer than expected to turn those new sales into revenue. And the reason for that is we are also ramping up the culture and getting them ready to implement and execute the implementation, turning those backlogs into revenue.

And obviously, we are behind schedule on that. We are not turning those into revenue nearly as fast as we had modeled, and in particular again, after a couple of quarters, it has become evident in the third quarter, in the last, say, 60 or so days that the backlog is growing at too fast of a rate.

In fact, on February 1 of this year we had a $2.8 million order value for the backlog. And on September 1 we had over a $5 million implementation backlog. And so this is an execution issue that we are fully aware of and we have a search process in place now to figure this out, work it through. And I'm really confident we will work it through.

But nonetheless, the revenue delivery out of provider solutions in the quarter is light to expectations. And I don't see this backlog resolving in the next 30 days; it is going to take us a little bit of time to adjust this part of the business to keep up with the new sales.

And so, until we improve the execution on implementation for provider solutions, we will not be in a position to recognize revenue from these new accounts. And again, our teams are working diligently. They have a thoughtful plan. And we are having to do a little bit of hiring and also reengineering to do this really well.

Now, we do have good experience overall in HealthStream at figuring these kind of challenges out and executing on them, so I'm confident we will work it through. But for now we are below expectations on revenue recognition, and we have also parlayed that into lower expectations for the next couple of quarters. And that has pressured, again, our revised guidance, which we have now provided.

So for different reasons, the patient experience and the provider solutions segments underperformed to our expectations. And again, they offer different reasons. And some of the reasons are pure business challenges, execution issues where we just -- we didn't execute well. And others are because of the nature of, say, product shifts and a little lower-than-expected sales execution and timing of sales execution and the patient experience business.

So, for real reasons we've had to lower our expectations and again, relative to our size, fairly -- a pretty good move on our declined expectations on operating income, because of those two business segments.

And again, remember this underlying pressure in the primary segment, which is the outperformance of the lower gross margin business as well. We are three quarters into that trend, and that will persist on a go-forward basis if we continue to see that product to do really well.

So I think that's my color on these three segments, some of the challenges we faced in the last, say, 90 days and how some trends are positive and have long-run positive implications, others have several quarters of, now, business execution issues we have to work through. We want you to know management is fully aware of those and well underway in getting them back where they need to be.

Let's turn it over to Gerry for a dive through the P&L -- operating income, cash flow, balance sheet -- and then we will come back and I'll continue with my characterization of what we are doing about some of these situations.

Thank you, Bobby. And good morning, everyone. I'll provide some additional information about our financial results including certain items that impacted the quarter. We will also provide background information on the impact of the Morrissey Associates acquisition, which closed earlier in August of this quarter.

So, for the quarter, consolidated revenues were up 8% to $58.4 million. Operating income was down 70% to $1.3 million. Net income was down 56% to $1.2 million and earnings per share was $0.04 compared to $0.08 in the third quarter of 2015. Adjusted EBITDA was down 17% to $7.8 million from $9.3 million in last year's third quarter.

During the quarter the Morrissey Associates acquisition that we closed in August contributed $841,000 of revenue net of deferred revenue write-downs. The operating loss within Morrissey Associates was approximately $1.8 million including $805,000 of closing cost. Now (inaudible) to the income statement, revenues, gross margin, operating expenses and operating income.

Gerry, given where the microphone is, you might want to speak up a little bit more.

Sure. So revenues -- consolidated revenues were up 8% in the third quarter versus the same period last year. We achieved this 8% revenue growth while overcoming the $5 million decline in ICD-10 readiness revenues from last year's third quarter and the initial impact of deferred revenue write-downs at Morrissey Associates.

So our (inaudible) revenue growth rate excluding ICD-10, Morrissey Associates revenues and the impact of Healthline deferred revenue write-downs was 14.7% in the third quarter.

The workforce solutions segment is comprised of applications and content solutions which are primarily subscription-based and are targeted at improving the healthcare workforce. Revenues from the workforce solutions segment increased by $1.9 million or 5% even with a $5 million year-over-year decline in ICD-10 readiness revenues in the quarter.

HealthStream's patient experience solutions provide valuable insights to healthcare providers to meet deep cash requirements, improve the patient experience, engage with their workforce and enhance [physician alignments]. Our patient experience solutions segment revenue increased by $138,000 or 2% between the third quarter of 2016 and the third quarter of 2015.

Revenues per patient insight surveys, a [serve and] research product that generates recurring revenues, decreased 5% of the third quarter of 2015. Revenues from other products including surveys conducted on annual or biannual cycles and consulting coaching services collectively increased by $500,000 or 27% when compared to the third quarter of 2015.

And as Bobby mentioned, the CG-CAHPS piece of the survey research business is undergoing a shift from a phone-based to online survey modality. Thus, the revenue decline in surveys was partially due to changes in product mix.

These [iconic versions of] CG-CAHPS has both lower revenue and cost of survey components than traditional phone products, but does carry higher margins. Online survey volumes have almost doubled in the first nine months of 2016 versus the same period in 2015.

The provider solutions segment provides software used to validate the professional credentials of potential employees. In the third quarter of 2016 revenues from the provider solutions segment increased by approximately $2.5 million as the Morrissey Associates acquisition accounted for approximately $841,000 of that increase. As Bobby mentioned, this business unit (inaudible) backlog of booked business that becomes revenue in the upcoming quarters.

Our gross margins -- the gross margin was 57.4% this quarter versus 57% in last year's third quarter. On a sequential basis, the gross margin is lower than the second quarter's 58.7%. It is largely due to changing product mix across all segments.

Operating expenses -- this quarter's results reflect our ongoing investment in product development to foster long-term growth and strengthen our competitive position. Product development costs grew by 17% from $6.2 million to $7.3 million in the third quarter of 2016 over last year's third quarter. This increase versus investments in all segments were for solutions, patient experience and provider solutions.

G&A expenses for the third quarter of 2016 were 15.2% of revenues, which is an increase from last year's level of 13.3%. A major factor influencing this quarter's G&A expenses was the Morrissey Associates transaction costs, which was again -- were at $805,000 and included investment banking, legal, accounting and other due diligence costs.

Operating income was $1.3 million in the third quarter was adversely impacted by the $1.2 million of deferred revenue write-downs related to the Healthline and Morrissey Associates acquisitions and a, once again, $805,000 of transaction costs from the Morrissey Associates acquisition. Our balance sheet -- our cash position and overall balance sheet remains strong.

Our cash balance at September 30 was a cost of $101 million and reflects positive cash improvements since June 30, tending to [account our] acquisitions activities. At the end of the second quarter this year, our cash balances were $139 million.

During the third quarter we invested approximately $50 million for acquisitions, including $48 million at Morrissey Associates. Therefore, we generated approximately $12 million in net cash through the last 90 days.

We have no outstanding debt and our flow of $50 million of a line of credit remains available to us. We believe our overall cash position is likely to support our organic and inorganic growth opportunities and support other cash structure optimization and shareholder value of acquisition strategies as may be appropriate.

Before we discuss our guidance, I want to make a quick mention that our effective tax rate in the third quarter, as you may have noticed, was 28%. This was lower than recent quarters and reflects this year's research and development tax credits. We still expect overall annual effective tax rate to be in the 39% to 41% range for the full year of 2016.

Yesterday's earnings release contains updated guidance for 2016 full year, and as has been released and mentioned, we anticipated these consolidated revenues will grow between 8% and 10% as compared to 2015, and the growth in our three operating segments will be as follows. Workforce, 5% to 6%; patient experience, 0% to 1%; provider solutions, 80% to 83%.

In the workforce segment, anticipated revenues from ICD-10 readiness will be $1 million in the fourth quarter and $8.4 million for the full year of 2016. This represents an approximately $18 million (inaudible) decline for 2015 in ICD-10 revenues from $26.8 million.

We anticipate our full-year 2016 operating income will decrease 45% to 55% over 2015. We expect that our capital expenditures will be between $14 million and $15 million, and once again our effective tax rate will be between 39% and 41% for the full year of 2016.

As many of you already know, we held our client summit in October and the official impact is estimated at approximately $750,000, which will be recorded largely in the fourth quarter of 2016, the coming quarter. This guidance includes the anticipated impact of (inaudible) management systems, (inaudible) Consulting Corporation and Morrissey Associates acquisitions (inaudible) impact of any other acquisitions that we make during the remainder of 2016.

Thanks for your time. I'll turn the call back to Bobby.

Thanks, Gerry. I'm going to dive back in and will take a look at the workforce development segment of bit, provide a little more clarity on the patient surveys in the patient experience. So let's take a look at some of the drivers and workforce development segment.

First, the clinical courseware products were a large contributor to revenue growth in the third quarter. Clinical products include content from medical association partners, different clinical skills and procedures products and, of course, the C E Center we talked about quite a lot. Our association content continues to expand and so do the ways we make them available to our customers. The revenue growth from clinical [course] of our products was up 32% year-over-year. So this is an area of good core growth in the workforce segment.

Also just a brief update -- our compliance product suite is also in the workforce segment. And we announced the launch of KnowledgeQ last year. It's an exciting new mobile-enabled solution for hospitals to manage and achieve compliance for regulatory training. And it's our second product, I'll remind you, that follows the one we built with Precise called DNA, that includes our new control center application.

The components of KnowledgeQ include the application, courseware, the assessments in the benchmarking service that's built around the availability internetworks. KnowledgeQ is a data-driven application. It's built on technology investments that were created from our investment in Juice Analytics that we talked about historically.

So it's fun to watch that product begin to materialize into business, which it did in fact do in the last few quarters. We believe that the information and the network effect of having a data-driven product is powerful and has the potential, overtime, to have a positive impact on our business. And during the second quarter we signed over 74 contracts for KnowledgeQ. And I will remind you that this KnowledgeQ product is an upgrade product from our current core regulatory courseware library.

So we are going from having a courseware library to an application, data-driven product. And over 74 customers signed contracts for this new product in the quarter, which is an upgrade. It does cannibalize a bit the old courseware sale, but it adds value, you get a little higher price point and overall the margin of that product is very high.

So it's really exciting to see the KnowledgeQ product really start to take off in the last, say, 90 days with 74 upgrade contracts signed during the third quarter.

Let's switch gears a bit and re-clarify because also, within the workforce segment, are ICD-10 product and the readiness product, and we've talked about this product for well over three years. It had a great upside for a few years and now we are experiencing some of the downside of this product.

We started selling ICD-10 readiness solution over four years ago and it quickly became one of the fastest-growing products in the Company's history, ultimately reaching over $72 million in total contract value. That was driven by an October 2015 government deadline to adopt the ICD-10 coding system.

Now, we saw revenues from this product, the ICD-10 revenues product, peak in 2015, when it reached in that year $26.8 million. So that was in 2015. And with the passing of the October deadline in 2015, sales for the product all but ended and revenues begin to trail off and decline.

So as Gerry mentioned, this year we expect ICD-10 revenue in totality to contribute about $8.4 million. And that's about $4 million of margin. So that's a decrease of $18.4 million in revenue and $9.2 million in margin from the prior year. And that's important because, as we think forward, we need to think about next year.

And unfortunately, the ICD-10 revenue story isn't quite over. So we expect, for example, the ICD-10 readiness product will generate less than $1 million in revenues next year, which, given our $8.4 million this year, would represent yet another decline next year of $7.4 million and a decline of $3.7 million of margins.

So again, it's significantly smaller than the decline from 2015 to 2016. But I just want everyone to make sure they are thinking about as we enter 2017 that there's another $7 million decline that we've got to climb out of and overcome with other growth products, some of which I've already mentioned.

So as I've mentioned on past calls, we have multiple strategies for growth, developing and launching new products. We've touched on KnowledgeQ, pursuing an active M&A pipeline. We actually did three acquisitions in the last 100 days.

We announced in August that we acquired Morrissey Associates, which expanded our proprietor solutions segment and brought in market-leading products on credentialing and privileging. It's a new area of focus and strength for the business. Coupled with our acquisition of Healthline, we believe we are very well positioned to build off the synergies in this business in the future, but this business, as we mentioned, is having the challenge we talked about, about the implementations backlog.

So completing these three acquisitions, we still continue to maintain an active AM&A pipeline although for the next 60 days I'd say we are pretty focused on the execution of some of the challenges I outlined a little bit earlier.

So, as I conclude, I'd like to remind us of all the moving parts. I saw that one of the analysts talked about just the amount of movement going on inside of our business. And it is true; this is a period of great movement and it's hard to see all the moving parts. So let's refresh on what some of those moving parts are.

First, it's the retirement of the ICD-10 readiness products and their impact, which we discussed. Second, these acquisitions we are doing -- there's a little bit of workthrough on them, but we are very confident in them. And they do come with this accounting convention of deferred revenue write-downs. And that accounting treatment will persist over the next several quarters, particularly as we've just completed the Morrissey acquisition.

We want to make sure that everyone is thoughtful to that deferred revenue write-down from an accounting convention.

Third, our PX business is obviously struggling to expectations. And it's not really helping matters that our new higher-margin products also have lower price points, which challenges the topline growth rate into the future. And it's not just the mix of lower price points that affected the third quarter; it is also, in fact, lower-than-expected sales and the timing of those sales, in some cases.

And so we have a good fight going on there. We are bringing in business a little late to expectations. And so we have had to revise guidance down for that segment, disappointingly, to really a flat business this year. And that is having its impact.

And also with that price point pressure and the trend, again, towards higher margins over time but lower revenue growth, that will have a dilutive effect on our overall growth rate into next year.

And finally, none of those operational challenges are going to stop us from investing in improving how we do things and exciting product development pipeline that we have. And so we are continuing to pour investments into these acquisitions to get them where we want them and to build systems and new products and add personnel and R&D to build exciting new solutions that are on our roadmap and that carry great, great promise in the future.

So just because we are a little behind on revenue recognition provider solutions, we are not going to trim our expense run rate. And again, you can see that in our lower operating income guidance expectations.

I think these will prove wise investments over time. They are clearly providing short run disappointment, and as we revise our operating and guidance expectations for the quarter. But we're going to continue to do what's right for the long term of the business, which is to get these businesses and products and exciting new data-driven products into the market.

And so we just want to remind everybody that some of these pressures continue on into next year. And as Jerry mentioned, we've modeled our third quarter to try to model out the noise, organic growth rate is about 14.7%, and some of these pressures are taking root and will continue to affect us into the coming quarters and years. And so we want to just reiterate that when we factor out the deferred revenue right now and some of the other issues we've talked about, the core growth rate we are looking at in the third quarter is 14.7%.

So we will wrap up. I do want to wrap up by just saying that we had an incredibly successful customer summit, over 800 customers came to Nashville. We actually co-hosted two events at once, our normal summit and an [Echo] user group which had about 170 attendees was co-located in downtown Nashville, across the street, actually, with our typical customer summit.

We had over 46 speakers present, 75 breakout sessions, three keynotes, 800 customers. We conducted research and development on exciting new products and launched a few new products as well -- incredibly successful but busy week.

And I want to congratulate all of our employees who worked on pulling off that summit. It was really a great testament to our culture, our customers that came to see our exciting business and our development teams that are focused on new product research while the customers were in town. It was really a great, great week last week.

And then finally, I can go without mentioning as we welcome our new Morrissey employees that the Cubs won the World Series, and they are probably not listening in on this call right now. But we will welcome them later, when they settle down a bit and come to the reality of what the celebration they are having.

I'd like to turn it over. We got a lot of questions. We have some challenges to talk through. So let's get right to the questions.

(Operator Instructions) Matt Hewitt, Craig-Hallum.

This is actually Charlie Edson on for Matt. Thanks for taking our questions. First question I had was related to the survey trend, what you are seeing.

You mentioned that a couple of your larger customers switch to online-based surveys from phones, given that they had more data. Is this something you see as a trend long term? Or could we expect to maybe move back to phone base? Or what are you seeing is the preferred method long-term for customers?

Yes, so a couple things. The core caps surveys you have to conduct by either phone or mail. You can't move them to online or text. And so that will continue on.

That said, for most customers they subscribe to two or three different forms of experience measurement products. And it is a desired outcome to try to move them both for their purposes, if they can more efficiently collect that data, potentially collect a little more data, potentially do it at a lower price point while overall we can do it at a higher margin. That is a desired outcome.

And so for two of our largest five accounts, we saw that shift pick up and continue as they moved, for example, some of the nonregulated surveys to more online or text messaging. And so that is a desired outcome. And like I said, two of our large accounts -- we saw them move that way.

It will take time. It will take multiple quarters to see those improved margins come into play while simultaneously it will pressure the topline overall growth rate the more we have success in that migration. So I would call that a trend that will carry forward for a while now and maybe indefinitely. And it is a desired outcome, but it may rethink -- it may have us rethink and have us focus more on margin in that business than topline revenue growth for that business as we think forward to next year.

Okay. That makes sense, thank you. And then related to your investments in the future and your product development and what you are seeing and how your newer products might be higher margin but lower revenue, and from a product mix perspective that has been an issue, with your products in the pipeline, what are you seeing as far as margins? Should we expect margins to rebound going forward? Just some thoughts on that would be good.

Yes, it's a complicated question because of all the moving parts that affect margin. And so we highlighted one of the biggest trends that have now persisted for three quarters, and that is that within workforce one of our most successful products right now is our resuscitation suite, which has five different products.

All of those products are doing very well. In an absolute sense they are all growing and contributing more absolute dollars to EBITDA, but they do carry a lower gross margin than most all the products that HealthStream carries.

They do carry a lower gross margin than almost all, with an workforce and across the Company. And so we as a team -- we reported in Q1 that we saw incredible sales results on those products. We reiterated in Q2 that we saw strength in those products yet again. And that persisted in Q3.

And so overall the resuscitation suite is becoming more important to the workforce segment and it does carry a lower overall gross margin. So, for that product set, within that segment, we see continued pressure on the gross margin line, in particular.

That said, we noted in our patient experienced business a shift to hire-margin products, albeit with lower price points. So all of these things were push and pull on our gross margins. And as you can see the effect in Q3, we had a dip in the gross margin, a pretty good basis point dip in the gross margin in Q3. That will probably persist in Q4.

And then when we give guidance next year in February we will have a lot more clarity about the mixture of the relative movement of all these parts for next year, when we give more clarity for next year usually around February of next year.

Okay, that's extremely helpful. Thank you.

Richard Close, Canaccord Genuity.

Gerry, I was wondering if you could go over the operating income guide in a little bit more detail for us. How much is maybe related to the revenue adjustments on the provider solutions/patient experience and then maybe the expense lines for the operating income guide?

Gerry is a little further away from the microphone. So let me reiterate a couple of things. Most of the change in guidance is tied to the two business segments. As you noted, I saw it in your pre-note, Richard, the patient experienced business and the provider solutions business, both of which underperformed on the topline roughly by $1 million each through our internal thinking.

And so, if you play that out all the way down through margins and operating income, those two are the drivers where we missed the topline of those businesses to our expectations and they played out all the way down through the bottom line. And so, it really is a flow-through issue on lower than expected either materialization of revenues from provider solutions, where we have that big backlog that's growing, and the way that played out on revenue expectations and on patient experience, it's probably a little more on the sales side and then a little bit on the revenue mix side, as we talk the move to lower price points that caused that revenue to be lower than expected.

But I would say that the vast majority of the operating income change in expectations is driven by the lower, lower and lowered for Q4 revenue expectations for those two segments. And Gerry can add a little color.

Yes. (inaudible) in the fourth quarter as well. I would get that into that guidance range for the fourth quarter.

Okay. I'm just trying to understand a little bit because Morrissey was done in mid-August and then it's a pretty big change. So I'm just trying to figure out --

Yes, so we are not attributing the change to Morrissey at all. And so you are right; that was reflected in our last guidance, where we took it to negative 10 to 15. And so, again, I would almost wholly attribute it to the shortcomings in revenue from provider solutions and patient experience as segments.

And then secondarily I would attribute it to some of these mix issues. Say, for example, in the workforce, relative to our expectations, the mix continues to shift to a lower gross margin product. So when you are modeling, you need to think about resuscitation products delivering lower gross margin than the blend of our Company.

And so that gross margin line you see more impact, a cumulative effect of three quarters of outperformance of resuscitation product is now compounding into a lower gross margin. And so that would be the third element.

Again, that's not a change in the last 60 days, but it does continue to compound as we had another third quarter of incredible results with that product.

That's the third dimension to this, if I had to list them, would be the backlog, the $5 million backlog in provider solutions not turning to revenue, a shortfall in sales in patient experience and then a slight shift in the mix there that we talked about, lower price points, and then third I would say the compounding effect of continuing outperformance of resuscitation at a lower gross margin than most everything we hear in the Company.

So those three items, Richard, wholly explain, in our view, the need to revise guidance and expectations and also to be thoughtful about how you are modeling next year as well because some of those are going to take us, in the case of provider solutions -- that won't be resolved in Q4 and will carry on for a couple of quarters.

Patient experience may resolve over the course of a year. And then workforce will continue to have that gross margin pressure, if resuscitation continues to be a top performer. And so those really are the three reasons. There's nothing more to explain about why.

You just have to model those things appropriately and carry them down to the operating income line, and then it will put you on target with what management is thinking.

Okay. So when we think about patient experience and those two customers shifting, was that a surprise? Does the customer just pick and choose how they are going to do their surveys? So maybe did that change? You didn't realize that they were going to shift to online or --

Well, no. I would say -- so here's the way I would say that. It was not a surprise in that our salespeople are showing these newer products. But it was a decision that is hard to model.

So when we presented it and we changed the contracts for those two big customers in the last 60 days, it was the customers' choice to move to a lower price point, a little bit more data, a lower price point survey process. And that's probably consistent with their desire to collect a little more data at a lower price point and, given some of the macro pressures, it makes it a logical decision if they can get more data and an easier way to collect.

So what I would say is it would be hard to model that decision that the customer made. But it was both a desired outcome and it is a product we are now presenting. We now have the capabilities, which was an exciting announcement a couple quarters ago, to do text surveying. And we've enhanced our ability to do e-surveying just this year.

And so both of those are presented to customers as they come up for renewals or even presented to them proactively so that they can collect more data when they -- remember, and they also have to collect cell phone numbers or email addresses. And so, in some cases, those two big customers -- we showed them these things 6-9 months ago. And they had to begin collecting email addresses and the ability to text message.

And so, once they get enough data, they move their CG-CAHPS survey, we both allow them to and encourage them to. So again, hard to model, not a surprise, meaning we were marketing it as an opportunity. But the timing of which in both those large customer cases occur in the last 60 to 90 days. And it was their decision to make that shift. It's a logical and desire decision, though.

Gerry, maybe if you could comment a little bit on the DSOs? They jumped up 10 days. And I think you attributed it to provider solutions, collections in the 10-Q. And if you could just give thoughts how we should think about DSOs going forward?

Yes, so they jumped a little bit. Our goal is to have those get back to a normalized range, which is roughly 57 to 60 days or so, by calendar year end. One piece of that is also we picked up the balances from the Morrissey Associates acquisition without all the revenue. So that does have a minor effect on the calculation. But the economic substances that we are a little bit higher and we do have plans to get those back down by calendar year end.

Is that at all a function of the slower implementation in provider solutions?

No, because that would not be billed until we begin the actual access to the software. So that's more of a business issue than an accounting and finance issue at this point.

And I'm not a big fan about talking about the macro situation. However -- and so, for example, our sales pipelines were good in Q3 and in spite of what we are hearing about macro conditions in healthcare. But I would say that if I were to say there might be some macro things for us to watch, it might be getting stressed a bit on receivables and payables for [hospital] being stretched. So I think we will put our [macros] in place. We have better collection. As you know, we have better technologies now. We build faster with our new NetSuite products. And so we are making improvements simultaneously.

But I would say, if there were anywhere that I would say there might be some macro things for us to watch, while we are trying to improve the outcomes Gerry mentioned, it would be in this area for hospitals may try to stretch a bit their payables. I haven't seen any material changes in default rates or anything like that that concern me.

But I would say that it is logical right now, given the overall environment, that hospitals may try to stretch their payments a bit with their vendors.

Okay, thank you.

Ryan Daniels, William Blair.

Thanks for taking the questions and all those details so far. Gerry, maybe as a quick follow-up for you, just on the contracted subscribers. I know that was down a bit sequentially. Assuming that was due to ICD-10 only rolling off, so I'm hoping we could get the current number of ICD-10 only that are on the system.

Well, so the count this quarter -- a variety of factors, as usual, some adds, some terminations. The ICD-10 is below 100,000 subscribers remaining on that ICD-only category.

Okay, that's helpful. And then going back to the provider services, I know a lot of color on that. But can you talk a little bit more about the solution to the implementation jam? Is that really more on the technology side, where you want to invest? Is it more on implementation teams and staff? Is it on training there, number one?

And then, number two, are you actively slowing the sales down such that you are not continuing to add to that backlog, and then having to go back to customers and say, well, we can't get you up and running when promised, and risk alienating them?

I would comment on that a little bit. So it is a little bit of needing to add some operations personnel to work through the backlog.

It's also just getting better organized. These were low-growth cultures when we acquired the companies. And they are having to be oriented to having new scale on the pipelines coming at them. And so we probably underestimated the need to add some people and some expertise to help with that process. And so we are doing that now.

And to your question on the sales front, I would say that one thing I know that leadership has done is ask the sales organization to be more involved in the handholding process for the people that they've sold to that are in the backlog. And so I would say we will see a little slowing on sales as the sales team now is part of what we are calling the surge effort -- talking to, communicating with and working with the customers that were sold, to make sure they understand that we are working through these and working to get to them as fast as we can.

So I would say the sales team has been pulled a little bit away from sales, not wholly. We've got a great pipeline. And we are winning business. We have some big expectations there that mostly are being met on the sales -- that they are being met and they are being [exceeded] on the sales pipelines and the new business.

But I would say we have asked our sales organization, that group which has gone from five to about 20 people or more, to slow down a bit and be part of the thoughtful plan we are calling the surge to talk to, communicate with, stay in touch with all the customers in the backlog. By nature, by asking them to spend time a little bit there, they probably will see a little slowing. And I would say that's -- it's a little bit of a desired outcome right now because we need to get operations in parallel and capabilities to the sales team.

Okay, very helpful. And then final question and I'll hop off -- this goes to the patient experience surveys. You may not have this data handy, but it might be helpful.

And I'm curious what portion of revenue there is sold to customers that is above and beyond the mandate, meaning with the mandate they have to do phone or mail, but for the above and beyond they can do the transition to e-surveying. So is that still a significant portion of your revenue, number one, that could be cannibalized?

And then, number two, how much upselling opportunity do you also have as you expand e-surveying in the customers who don't go above and beyond the mandate?

So a derivative of that question is expectation as we think forward. And I would say that management's attention has turned to fixing the margins and profitability of that business. And these are more profitable products.

I would say most customers have business that could be converted to the e-survey text platform, so they do things like CG-CAHPS, which is -- I believe that's one of the unregulated ones that you can move to text messaging or e-surveying.

And so if you went to any of our big health system customers and said, you are doing your CG-CAHPS with phone, you could switch it to e-surveying -- they have a process to undergo to get ready for that, like collecting emails or collecting cell phone numbers. But I think they view it as an opportunity to cut their costs, collect more data, maybe even move more to a census-based approach where we get more data for them and, overall, they spend a little restaurant in. And then our margins would boost.

And so, I think that those are some of the trends we see as we think forward. You are going to see management focus a little more on getting all these customers to use these new modalities. You will see a little more focus sit on top line growth and repair there, on margin expansion.

It will take us several quarters to see that, though, because the rate of shift is such that it will take time to materialize. So, second half of next year we should be seeing important margin expansion in that business, which I'm excited about.

I know it's hard to say because this strategy dilutes our growth rate overall as you think about next year. But it just -- it's time for that business to be profitable and get the data people want at the scale they want it. And these new modalities allow for that -- for them to get more data, get the data they want, get it faster.

And it makes us more competitive, frankly, in our service offering. And so these are all desired outcomes, but they will pressure that topline growth. And so I'd say almost all customers have some business that we should be moving to this new modality.

Okay. Makes sense and very helpful. Thank you.

Nicholas Jansen, Raymond James.

Just following up on Ryan's question about the patient experience, it does feel like your workforce solutions business excluding ICD-10 is growing 20%-plus. A lot of the M&A is tied to the provider solutions segment.

Do you feel like the patient experience business is strategically important in terms of your longer term outlook for the business? Or how do we think about your capital allocation decisions and your product development expenses and the other segments relative to patient experience business, which is on a decelerating track?

Yes. So one of the things to note about it is our new products that we have been building now that we owned another problem that we are almost through now, related to the patient experience business.

And that is, we acquired a consultancy a few years back that had a lot of intellectual property. They were really good and advising how to improve the patient experience.

Now, our vision for that acquisition was not to be necessarily a growing consulting business. It was to build curriculum, online intervention tools from what they knew that would improve the patient experience outcome, the actual [cash] result.

And so, one of the exciting things is that we have, in the last, say, 100 days launched new products based on that IP that have very high gross margins, that can be sold back into all our patient experience customers that are intervention, education and online tools with high gross margin, based on the IPE.

So we built, I believe, set of about 25 courses that we call Develop RX. And Develop RX is an intervention curriculum tool much like the rest of our workforce business that will be sold by our patient experience business unit with a higher gross margin. And part of our long-run vision for that business was to actually help organizations move the needle, not just collect the data in the most efficient way.

Data is one part of the story, but intervening with the workforce development to get a better outcome was another part. And again, it took us way too long to build those kinds of tools. But the good news is that we've launched them. We actually have some of our first sales on that product coming in this quarter, and a good pipeline on them. So another thing for that business that could drive margin expansion next year is that the educationally related projects that are core to our business that relate to patient experience are now in the market and we have good hope for them as well.

So I hope that gives you a little color. We think it is aligned with our core, because it is a problem in healthcare that is rooted in the workforce, meaning there's really no way to get better HCAHPS stores without better training and better developed and better selected people. And so, it's consistent with our business model to have the data about the outcome, which is the CAHPS data and then have the intervention tools that are online, like what we mentioned, Develop RX, in the market.

It's just taken us, frankly, just too long to get those products all together so you can see how it fits our model. But they have launched now, and we are underway. So that's why we have hope for margin expansion second half of next year.

Okay. And then my second question, may be just for Gerry, just trying to true up models on deferred revenue as we think about both the fourth quarter and maybe what's left in Healthline and what's to come on Morrissey as we think about the next year. How do we model deferred revenue? That would be helpful as we square away margins. Thanks.

Yes. So the Healthline piece is pretty much going to be fully absorbed by end of the year. If you go into the back of the press release at the table that shows the quarter, year-to-date impacts of the deferred revenue write-downs, I'd suggest picking up the same relative proportions of deferred revenue you see on the Healthline for Morrissey of being a good approximation. The history will be a good guide to the future.

Okay, I'll leave it at that. Thanks.

Matthew Gilmore, Robert Baird.

Thanks for taking the question. I just had one left, which was to get a better understanding of some of the growth drivers on the provider side. I know you are having some issues implementing, but it sounds like the sales activity has been strong.

So can you maybe describe the competitive environment both on the credentialing and the privileging side? And then also give us some sense for how your platforms are differentiated.

Sure, sure. So we are really excited about that business. And for lots of reasons -- one, the two businesses we acquired had been around for a long time and have very sticky software applications. They are really often considered a source of truth on data about some of the most important people in healthcare, the doctors that generate a lot of the revenue.

And so we are excited to be in the business of managing the data about those people, the doctors. And increasingly, actually the prescribing nurses are being added to the credentialing process.

So if you think overall, having the software in place in about half of US hospitals through the acquisition of Morrissey and Healthline gives us, really, a market-leading physician to manage data and know a lot about the people of healthcare, the workforce here at the providers and the prescribing nurses. And so we like, overall, the strategic position that we are in.

And then from a potential standpoint, it's really fascinating. Some of our advantages I will articulate.

One, you may remember, and if you look back at our history we acquired a company called SciMed. And they had a credentialing in privileging type of solution and what is called provider enrollment solution that they sold to physician practices. And so they are in hundreds, I think over 800 or more, physician practices, and with their solution, which does a little bit of credentialing, a little bit of filtering but a whole lot of what's called provider enrollment, which uses the data about physicians to get them enrolled and revenue ready, if you will.

And so, one strategic advantage we're seeing is the potential bridge between hospitals that want to affiliate with all those practices in getting them all eventually on one credentialing, privileging and enrollment platform so that they are affiliated networks, with our strength in SciMed again now part of the overall provider solution segment, can build a technical bridge to all the hospitals that are on our credentialing platforms.

We see that as a unifying strategy that is also a fairly unique position we are in, because of the way we've acquired into the market.

The investments, though -- so some of this software that we acquired is high-margin and recurring revenue. But it is not fully staff enabled, so we are having to hire tech teams and make real investments to make these products all talk to one another. I'll give you an example of another competitive advantage.

When we acquired Morrissey Associates in Chicago, we inherited a privileging library, which is a form of content that goes into a credentialing system or a privileging system. And so, while we are a market leader in the software to manage credentialing and privileging, we now have what we think is the premier library of information, the privileging library from that, which is Morrissey, which can be cross sold to all the customers of health line.

And so we are working on connecting, and I believe we've got some of that worked out, connecting the privileging library -- again, a form of content -- to the privileging and credentialing systems, and cross-selling that aspect. So another great strength.

Also the thing I love about this model is that data about physicians is very important. We are in a great position there. Privileging is a form of content that's sold to the people that own the software. So it's just like our learning platform creates consumption of courseware, the privileging and credentialing software creates consumption of a privileging library.

And so, we like the fact that there are additional products to cross sell and upsell into that market.

And then, overall, the landscape is not a huge, huge market. There is a handful of other consolidators we compete with that we feel well positioned to compete with in this marketplace of credentialing and privileging. One of those companies was a company called Cactus that was also in the market along with Healthline and Morrissey, that has recently been acquired by a private equity group and rebranded. And so, they would be one of the primary competitors to take a look at as well.

So that's a bit about competitive landscape and again, why overall we are excited about being in this line of business.

Great. Thanks very much.

Scott Berg, Needham & Company.

This is actually Peter (inaudible) for Scott. I was wondering if you could break down the dynamics of what drove your ARPU number up sequentially. I guess expectations on ARPU, taking into consideration you guys (inaudible) would have it number slightly under pressure for the remainder of the year.

So the question is, did the Morrissey acquisition impact that? And if so, can you give us a sense of what that organic number would have looked like?

Yes. So there's no impact from acquisitions on the ARIS because the Morrissey Associates -- these numbers are in the provider solution segment, and the ARIS is going into work for segment. I think the thing to look at on the ARIS for this quarter -- one, is the revenue for that solution-based revenue, that portfolio, was up about 5%. If you look at the subscriber [card], it's roughly flat. And so therefore, to get [reinvest in your dynamics] for the increase.

Does that help answer your question?

Yes, great, thanks. And then most of my questions have been answered. So if you look into 2017 next year, any changes that you see in terms of spending patterns across all your product lines that could change the makeup (technical difficulty) ?

Yes, let me take that one. So as most of our analysts have been with us for a long time no, we provide detailed guidance about 2017 when we get more clarity. And we are just not through our processes yet of getting a Board-approved budget. We came out of our retreat with a lot of great ideas, and throughout this December we will get a Board-approved budget. And then in February we will provide detailed guidance about all the decisions we make and also, obviously know more about how the fourth quarter played out.

And in February we will give incredibly detailed information about all that you are asking here. I would say, though, that in the third quarter we have tried to be careful to explain that the organic -- our view of the organic growth rate was 14.7% when you factor out a lot of the accounting noise.

And I've seen a lot of models that keeps talking about 20% organic growth rates. And I just think, again, we don't have enough clarity to provide full, advanced look at next year. And we look forward to when we have clarity on the fourth quarter and when we have the resultant decisions we've made about investing by finishing our budget process.

We haven't finished our Board approval process for our budget, so our expense categories -- we haven't decided yet exactly, fully how to ramp up each of those areas like sales and marketing and tech. We will continue to invest in those areas, though, commensurate with -- as we've done in past years.

But I would say that some of these trends we've noted have continued pressure on topline core growth. For example, the shift in patient experience business is one that you need to be thinking forward about next year. And if we are successful in these migrations to more online surveying, that growth rate which we have now moved to nearly flat with more of a focus on margins will continue to be diluted to our overall growth rate at its core.

And so just a bit of thinking forward about that overall core growth rate will continue that pressure.

And then on the margin side about all we can provide right now, because it's all we know, is that this resuscitation portfolio is also providing great financial opportunity. But it's pressuring gross margins. And we don't see any letting up in that product right now. I hope and expect we will have another good fourth quarter. And that sets up a little bit of margin pressure for next year as well.

And so I think that -- again, I know it's a tough position to be in. But we don't have all the data to give the guidance about next year. We need to wait until February. We will make a lot of actual decisions that impact that final decision on overall investment rates, as you've asked.

But I do think we have enough signs now about some of the items we have clearly listed out today to think about that growth rate. And there will be some pressure on that core growth rate next year.

Great. Thanks (inaudible).

Frank Sparacino, First Analysis.

We can talk off-line, for the sake of time. So I'll drop out. Thanks.

Richard Close, Canaccord Genuity.

Just a quick couple questions here. With respect to PE and the margin improvement, understand it's in the back half of next year. What do you see as the long-term margins in that business, once the shift occurs from phone and paper to the online format?

We are not prepared to give long-term guidance or outlook or margins, so we can only note the trends right now, which is that it will improve, based on the shift, where the cost of goods is much, much lower when you do e-survey and text messaging. So we are not in a position to comment on that question.

Okay.

Thank you. And with no further questions in queue, I would like to turn the conference back over to Mr. Robert Frist for any closing remarks.

Thank you, everyone. Look, some challenging trends in here but also some very good ones that you have to look through to the future and think through.

Everybody on the HealthStream team is working really hard and set a great trajectory of new product introductions and exciting new offerings to take to customers. So we look forward to continuing our reporting. Probably the next time we get together we will be talking about our guidance for 2017 in great detail. We will have a lot more clarity on that. So we look forward to our next earnings conference call with all of you. Thank you and we will talk to you soon.

Ladies and gentlemen, thank you for your attendance at today's conference. This does conclude the program and you may all disconnect. Have a great rest of your day.