HealthStream Inc (HSTM) 2017 Q3 法說會逐字稿

Good day, ladies and gentlemen, and welcome to the HealthStream Third Quarter 2017 Earnings Conference Call.

(Operator Instructions) And as a reminder, this conference is being recorded.

I would like to introduce your host for today's conference, 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 2017 results.

Also in the conference call with me are Robert A. Frist Jr., CEO and Chairman of HealthStream; and Gerry 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 the actual results to differ materially from those projected in the forward-looking statements. Information concerning these risks and other factors that could cause the results to differ materially from those forward-looking statements are contained in the company's filings with the SEC, including Forms 10-K and 10-Q.

So with that start, I will now turn the call over to Bobby Frist.

Good morning, everyone, and welcome to our Third Quarter 2017 Earnings Conference Call.

The call is packed with detailed information buried inside of each carefully written sentence. So everybody, here we go. We got lots of great details for you this morning.

Our third quarter performance, if we look at core financial metrics, it was a solid quarter. It was a good quarter. Compared to the third quarter of last year, quarterly revenues were up 9%, and that was a record for our corporation at $63.6 million. Operating income was 210%. Net income was up 116%, and adjusted EBITDA was up 41%. So really good measures of also free cash flow and strong cash balance. These results also showed sequential improvement over last quarter, which gives us confidence in our expectation of leveraged operating income growth for 2017.

In our Workforce Solutions segment, third quarter revenues were up $1.6 million over the same period last year in spite of the $1.2 million quarter-over-quarter decline in ICD-10 revenue. Primarily driven by sales of KnowledgeQ, which is one of our newer compliance solutions, that led the workforce segment with a 26% growth in quarterly revenues over the same quarter last year. This performance in that segment, the workforce segment, was followed closely by our resuscitation solutions, which we're kind of in second place in the Workforce Solutions segment.

Although the third quarter revenues in our Patient Experience Solutions segment were down 1% from the same quarter last year, our efforts to improve margins continued to deliver improved operating income leverage. So we saw some nice improvements in the patient experience business based on actions taken earlier this year.

In our Provider Solutions segment, third quarter revenues were up 58% over the same period last year. This increase reflects a lot of components: the inclusion of revenue from Morrisey Associates acquisition, so not really a comparable period and so it shows up in the -- for the full quarter of this year; a lower amount of acquisition-related deferred revenue write-downs, and Gerry will give more detail on that; a onetime adjustment related to a few customer contracts that were reviewed; and organic growth of about 15%. So there are many components in that 58% growth in Provider Solutions, but it includes a nice balance of organic growth.

In last quarter's call, we mentioned that sales from our workforce development and Provider Solutions segment were less than expected. So now we're talking about the sales organization and productivity. We gave some concerns around the productivity in the quarter, again relevant to expectations internally. This quarter, we did see a recovery, in the third quarter, recovery in sales orders from those same segments, but we note that macro conditions generally continue to be challenging for our client base as we enter the fourth quarter. So maybe a little less certainty around sales velocity as we enter Q4, but Q3 was a good catch-up for us in sales order value and contract value, so that felt pretty good.

In February of '17 conference call, we introduced some new product concepts. And we -- at the time, we commented that they were very exciting concepts but that they wouldn't be contributors in '17, either from revenue or profitability. What's exciting is that we've recently begun to market and sell some of those products. In fact, all 6 products have shown revenue on some sales orders in this quarter, which was great; again, very small but a nice start. And I'll give you an update on a couple of them: first, our new award-winning Nurse Residency Pathway, which is a blended learning program designed to address the challenges that are faced by new nurses as they enter the workforce and work in acute care settings. We were excited to see that -- in the third quarter, CHRISTUS Southeast Texas hospital, St. Elizabeth's, nurse residency program. So that's a mouthful, but one of our customers was running their nurse residency program with HealthStream's Nurse Residency Pathway as infrastructure. Well, that program achieved ANCC accreditation just recently, and so now we're pretty excited because that helps us in the marketing of that brand-new solution this year. That solution, by the way, carries a higher price point than most everything in our portfolio because it's a great blend of content assets and subscription to many of our SaaS products that deliver the learning and education. So that's an exciting breakthrough for the Nurse Residency Pathway. The second update is with regards to our OB Risk program. At one point, we represented a third-party product in this area. We saw that it's going to be successful, so we ended up codeveloping with one of our large health system partners. That's MedStar-SiTEL. We codeveloped an OB Risk program that we co-own now, which will result in a higher-margin profile of this product over time. That program is focused on reducing risks by providing staff with knowledge and skill to identify early warning signs of maternal and infant distress, so it's in a high-risk area in the clinical settings. At the end of the third quarter, we're really excited because one of our largest customers in our entire customer base selected our OB Risk program, the one we co-own and codeveloped with MedStar-SiTEL, for their OB risk program for system-wide deployment in a multiyear agreement. So kind of an exciting breakthrough on the OB Risk program. I'll provide update on some of the other new products as they develop into next year. And we're pretty excited about those 2, anyway. We've seen some early preliminary indications of success.

By the way, that same account that purchased the OB Risk program from HealthStream MedStar, it also happens to be a top 5 account, renewed its enterprise-wide use of our core platform. And it's an early renewal, about a 1-year early renewal. And they added 4 years to that early year, so it's essentially a 5-year contract, again, 1 year early. And in the process, they added some additional new products, for example the KnowledgeQ product. And I mentioned just earlier that, that solution group within our workforce segment was the leading contributor in the quarter from a sales standpoint, the compliance group; and KnowledgeQ being one of its hotter -- it's a newer product, but it's (inaudible) this year. So a KnowledgeQ product, data-driven product, was also subscribed nearly the same time as the OB Risk program and in conjunction with the 5-year renewal in a top 5 account for HealthStream. So there's a lot of exciting pieces to that part of the equation as we move one of our largest accounts on to our newer technologies.

There's a lot to dive into the detail of the numbers. There's a mixture of things that contributed to the relative outperformance of the third quarter. And so it's important to listen to the next section as we detail some of the onetime events that helped Q3 be exceptional and maybe give a little context to why essentially we have a little bit of sequential decline, although we were able to raise our guidance for the full year, a little bit of sequential decline as we head into Q4. So listen carefully as I turn it over to our CFO, Gerry Hayden.

Thank you, Bobby. Good morning, everyone.

Here's a summary of our third quarter results.

Consolidated revenues were up 9% to $63.6 million. Operating income of $4 million was up 210% versus operating income of $1.3 million in last year's third quarter. Net income was $2.5 million. And earnings per share was $0.08 per share versus net income of $1.2 million and $0.04 per share in the third quarter of 2016. Adjusted EBITDA was up 41% to $11 million from $7.8 million in last year's third quarter.

Now let's look at 4 areas of the income statement: segment revenue, gross margin, operating expenses and operating income.

Revenue. Revenues from our Workforce Solutions segment increased by $1.6 million while overcoming a $1.2 million year-over-year decline in ICD-10 readiness revenues in the third quarter.

Now let's take a quick look at the workforce development ARIS. In the third quarter of 2017, HealthStream's Workforce ARIS was a record $38.37, which is up sequentially over the prior quarter. It's important to keep in mind, though, that ARIS does not include a complete look at our business as 2 out of our 3 business segments, Patient Experience and Provider Solutions, are not included in ARIS at all. We continue to evaluate new metrics that encompass all of our business and, for these reasons, may retire the ARIS metric entirely in 2018.

Revenues for our Patient Experience Solutions segment for the third quarter of 2017 were $8.8 million compared to $8.9 million in the third quarter of 2016. Revenues from Patient Insights surveys increased $105,000 and continued to trend towards greater adoption of online patient surveys which carry lower price points than phone surveys but produce higher margins for us. In the third quarter of 2017, the volume of phone-based patient surveys declined 28%, while online patient surveys increased by 42% for the same period. Revenues from other patient experience solutions, including surveys conducted in annual or biannual cycles, decreased by $226,000 compared to the third quarter of 2016. This decrease is primarily due to timing of engagements compared to the prior year.

In the third quarter of 2017, revenues from our Provider Solutions segment increased by approximately $3.7 million, with the Morrisey Associates acquisition representing approximately $2 million of that increase. The balance of revenue increase is made up of a $200,000 reduction in the HealthLine Systems [created as] deferred revenue write-down, a $600,000 of onetime adjustment related to a few customer contracts and $900,000 of organic growth.

Now let's look at gross margins. Our gross margin was 57.9% this quarter versus 57.4% in last year's third quarter. The third quarter of 2017 continues a sequential trend of improving gross margin performance since the fourth quarter of 2016. Several factors contributed to this margin expansion. The patient experience gross margin had increased by approximately 680 basis points over the first 9 months of this year. This margin improvement reflects the successful relocation of our Laurel phone interview operations to Nashville, which we completed in the second quarter of this year. It also reflects the ongoing shifts from phone to e-mail and SMS text surveys. Also notable is a greater contribution from Provider Solutions, the gross margin of which improves as the deferred revenue write-down decreases.

Let's now turn to operating expenses. Operating expenses for the quarter were up 2% over the second quarter -- third quarter of 2016. The combination of capitalized software investments and product development expenses were flat between this quarter and last year's third quarter. However, software development remains a priority, as capitalized software development has grown by 30% on a year-to-date basis in 2017. We've also increased our guidance on capital expenditures to reflect this increased level of software development activity.

Sales and marketing expenses decreased over the third quarter of 2016, driven primarily by a reduction in general marketing expenses. As a reminder, some occurred in the fourth quarter of 2016 but will not take place in the fourth quarter of 2017. In fact, for the foreseeable future, we have shifted to regional meetings and events rather than holding a single large summit in Nashville. Depreciation and amortization increased 14% over last year's third quarter. This increase is lower than prior quarters and reflects the inclusion of amortization of acquired intangible assets from the Morrisey acquisition in both the third quarters of 2016 and 2017. It's important to note that depreciation and amortization still reflects increased levels of capitalized software development amortization as we continue to invest in product development. G&A expenses in the third quarter of 2017 increased slightly but improved as a percentage of revenue to 14.4%, which compares to 15.2% in the third quarter of 2016. Last year's third quarter included transaction costs related to the Morrisey acquisition. However, the third quarter of 2017 does include implementation and compliance costs related to the new GAAP revenue recognition accounting standard known as ASC 606. We anticipate the ASC 606 compliance expenses will be approximately $600,000 in the fourth quarter of 2017.

We have seen an increasing level of payment volatility and credit risk in our customer base this year, as evidenced by a greater number of hospital bankruptcies among our customers in 2017 than in prior years. Our bad debt expense has increased from $340,000 in the first 9 months of 2016 to $963,000 in the same period this year.

Operating income. Operating income was $4 million in the third quarter of 2017 compared to $1.3 million of operating income in the third quarter of last year. This increase in operating income reflects revenue growth, leverage on our product development and G&A expenses while we overcame a $1 million margin loss from the decline in ICD-10 revenues, the Morrisey deferred revenue write-downs and higher depreciation and amortization expenses.

Now let's look at our balance sheet.

Our cash position and overall balance sheet remained strong. Our cash balance as of September 30 was approximately $123 million, a $20 million increase since December 31 of last year. A contributor to this cash balance growth has been improved collections and accounts receivable management. The sequential drop in DSO from 71 days at December 31 to 55 days as of September 30 of this year resulted in a $7.4 million reduction in accounts receivable balances. We have no outstanding debt, and our full $50 million line of credit capacity is available to us. We believe our overall capital position is likely to support our organic and inorganic growth opportunities and support other capital structure optimization and shareholder value maximization strategies as may be appropriate.

Net cash provided by operating activities on our cash flow statement has improved to $36 million for the first 9 months of 2017 versus $15 million for the same period last year.

Before we discuss guidance, I'll describe the fluctuation in our effective income tax rate. The effective income tax rate in the third quarter of this year was 40% versus 28% in the third quarter of 2016. Last year's third quarter income tax rate included more favorable and discrete tax items than occurred in this year's third quarter. However, our full year guidance for 2017 includes our estimates of any discrete tax items affecting the current year.

Yesterday's earnings release contains updated guidance for the 2017 full year. We anticipate that consolidated revenues will grow between 8% and 10%, as compared to 2016. And the growth in our 3 operating segments will be as follows: Workforce Solutions will increase 4% to 6%. We expect a sequential decline in the segment because some of our larger accounts made true-up purchases to satisfy their need for additional HeartCode licenses in the quarter. Clients make these true-up purchases from time to time. What is important for understanding the unique impact on Q3 is that the magnitude of these true-ups was greater than we generally see and will probably not be repeated in Q4. Also worth noting, in workforce we anticipate that revenues from ICD-10 readiness will be approximately $1 million in 2017 versus $9 million in 2016, representing an $8 million decline during this current year.

Patient Experience Solutions will decline between 1% to 3%. This reduction reflects the expectation that 2 large clients have revised their timing for deploying patient surveys, moving them from this year's fourth quarter into 2018. Second, the center for Medicare and Medicaid services, CMS, has deferred the start date for a new CAHPS survey covering outpatient, ambulatory services, or OAS CAHPS. As a result, several ambulatory survey clients have opted to wait until there's more clarity in the OAS schedule.

Provider Solutions revenues will grow between 50% and 54% over last year's results.

We anticipate the full year 2017 operating income will increase 65% to 80% over 2016. We anticipate that capital expenditures will be between $18 million and $20 million and our effective tax rate will be between 32% and 36% for the full year 2017.

Finally, this guidance does not include the impact of any acquisitions that we may complete during 2017.

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

Sure, thanks, Gerry. There's a lot of important facts in there, compliance with the new accounting regulations and a final push to be compliant and so we'll invest over $600,000 in the quarter to get ready for next year. We've been working on that all year. There's just a lot of important facts in there, some onetime pickup in revenues from some true-ups, really important to the workforce segment. That won't be repeated in the fourth quarter. So just thanks, Gerry. A lot of great details in there for people to pick up on and model.

I'd like to take a moment to focus on some of our product lines and business segments from a business development point of view; and report out on our simulation and resuscitation businesses, which are part of our Workforce Solutions segment.

And so first, we're committed to broadening the scope and utilization of simulation technologies as a core part of our future at HealthStream. We believe that there are method -- there's exciting methods of validating a wide range of clinical competencies including and beyond resuscitation skills. Next-generation mannequins, virtual reality, augmented reality, artificial intelligence and machine learning are all among the emerging technologies that can be applied in this innovative field of skill development for the clinical staff of health care organizations. And we are excited to be in development mode to bring all of those to bear to develop a broad range of clinical skills, including resuscitation.

At the end of June this year, we announced our current agreements with Laerdal Medical for the HeartCode and RQI products will expire on December 31, 2018. As we explained, HealthStream retains the right and expect to continue selling HeartCode and RQI for the next 14 months, so through the end of next year, but after that point, we will lose our right to continue selling those products. We can, however, sign contracts up for renewal that extend out to 2020; and we'll service all of our customers with top-class service on those products for those that extend beyond the end of '18, to 2020, all the way to 2020. So that's an opportunity for some clients to renew early and extend through 2020. In preparation for bringing new and improved resuscitation solutions to market in January of '19, once our restrictions on our ability to sell competing products expires, I'm pleased to let you know that we've signed 2 new strategic partners in the last 100 days, the second of which we signed just last week. And we announced the first one in, I think, the prior call. Each of these partners shares our vision of bringing innovation, choice and quality at lower price points to the market and the existing products we carry today. These partnerships will also feature more favorable margins for HealthStream, a better price point for our customers. And importantly, we've inserted more product-level control in historical and intellectual property control in these new agreements than we'd historically had, so we're really excited about some of those developments. Again, 14 months away from launching new products in resuscitation. And throughout the year next year, we hope to be introducing additional and more partners, bringing simulation technologies, as I've mentioned, to a broader set of clinical skills, not just to resuscitation. In the coming months, we're -- we'll -- we're on -- still in active business development mode to bring new partners in around those types of surrounding technologies I mentioned. And we're really excited, but beginning in January of 2019, there'll be a lot of focus obviously on launching products in resuscitation skills.

I'd like to turn a little attention to the patient experience segment. There's interesting dynamic inside of that business. In fact, there's interesting dynamic in a couple of our business segments that does make revenue growth more challenging, but they're all in the spirit of moving towards higher-margin businesses. So in the patient experience business, we continue to see an uptake in new clients purchasing online surveys. The online surveys have a lower price point but a higher margin than phone surveys. So a lower price point makes growing revenue difficult but makes improving and delivering higher profits more -- much more probable; actually, by definition, just higher margin. Existing clients also continue to convert from a phone modality to e-mail and SMS text surveying modality. And so we've now converted almost half of all surveys capable of being converted from phone to online surveys as of this point. We expect this conversion trend to continue throughout the remainder of the year. As you know, we also closed our Laurel, Maryland interview center and moved those operations to Nashville. And both of those 2 developments I mentioned are expected to have a positive impact, a kind of an ongoing impact on patient experience margins.

In our Provider Solutions segment, similarly it has a dynamic in it that will challenge revenue growth in the coming years but not profitability growth. And that is the move from installed software sales to Software as a Service sales. And we're doing lots of things there to improve the cash collections and work through the implementation backlogs. And so in the third quarter, the backlog of unimplemented customers of our EchoCredentialing solution was significantly reduced to levels that we consider to be more routine and sustainable. The backlog challenges currently remain for our Morrisey solutions, but we expect to replicate the success we had at Echo with the Morrisey solutions over the remainder of the year. Also, just this week, a lot of exciting announcements in that business, occurring as recently as last night, as we launch in the future to further blend and merge the product lines of our Provider Solutions segment, so watch for some exciting news there, really around a January time frame of new product introductions and potentially some new branding as well.

As we conclude, I want to take a moment to thank our employees for their hard work and delivering an exceptional quarter. It's really fun. Each year, we conduct an employee engagement survey, and we completed our most recent one a few months back. And it's exciting that 96 of our employees -- over 850 employees responded to our survey internally. 96% of our employees reported being that we're a highly vision-driven organization focused on improving health care, and 92% reported being highly engaged in their work at HealthStream. These are just -- it's an outstanding group of people at our company. We're trying to all grow and go in the same direction, and I'm really excited that I get the privilege of reporting on their accomplishments. And of course, this quarter was a strong quarter. I caution them, as I always do. We don't get too excited when things are great. We don't get too down when things are challenging. As we look ahead, I mentioned some challenges to top line growth but all in the spirit of improved profitability, which you can just see in things, our measures like our free cash flow measures that Gerry mentioned; and general improvements in operating margins that we talked about in patient experience; and ultimately, higher margins in the Provider Solutions segment as well. And so a lot of great news in there. We also mentioned some macro conditions, and so I'm sure there'll be some follow-up questions on that. Gerry noted our bad debt expense has gone up. And so that is an increasing trend we've seen, just increasing pressure on the provider solutions -- the provider marketplace in general. So I'm sure that will be a topic of discussion.

Again, thanks to all our employees that are listening in. It was a solid effort by everyone, and look forward to reporting the next quarter.

Let's go to Q&A now.

(Operator Instructions) And our first question comes from the line of Ryan Daniels of William Blair.

Bobby, I'll take the bait and ask the initial question on the macro environment. I think, last quarter, you kind of indicated it was too early to make a call that the end market was seeing some pressure, but it sounds like now you're definitely seeing that. So 2-part question. One, what in particular is driving that? Is it more margin pressure or just uncertainty? And then number two, how is that changing your sales approach, meaning are you going to more of an ROI-type approach in pitching products and solutions that can save money versus maybe some broader areas?

Yes, sure. So thanks, Ryan. And we've been public for about 18 years, and I've never tried to attribute performance to macro conditions. I always -- there's always a way to grow, and we plan to continue doing that, but we do think it's important because in G&A, for example, right when we were showing leverage and efficiency in our G&A kind of at the scale we're at, we saw an uptick in the bad debt expense, which was disappointing to see. And we feel for the pain on some of our customers. I suppose they're going through a margin pressure period. I don't know how long it'll last. And again, this is a small number of contracts. As we mentioned, the bad debt expense is up from about $300,000, to $900,000, but it's just something -- I haven't seen quite as many, even small, hospitals send letters in for bankruptcy or for (inaudible). So I just thought we should note it, but we don't know -- it's not a -- I don't think it's material overall to our performance, but it's just a trend that I thought that we should call out because it's in our G&A now. And most people are going to expect us to deliver G&A, but along those lines, of course, the shift overall in our mentality in the last, say, 6 months -- and really the products we've been trying to build the last several years are high-ROI tools. In fact bringing data into the value proposition, like KnowledgeQ, helps people tune their compliance program and see the costs of running the program. It's not just a content of the compliance program, as it was in the past. So KnowledgeQ adds a data dimension to analyzing the costs of your program and lets people try to minimize their costs but maintain the knowledge in their workforce on OSHA and safety and Joint Commission requirements. Similarly, attacking areas like OB risk, which is a high area of medical liability, and a lot of these hospitals are self-insured. And so our OB risk curriculum, we were just really excited to see as we built that curriculum out over last year to multiple modules. It's an area of high risk for the organizations that have birthing units and OB programs and directly related to their medical malpractice expenses. And so it was really exciting to see a major health system kind of choose that solution. I believe that they believe it will have a high return on investment because in this area of measuring -- of recognizing fetal distress, calling for assistance on time creates a lot of liability to people who aren't well informed about it. So yes, I think our solutions, by being more -- having a data component, as in KnowledgeQ; or focused on high-risk areas, as in OB risk, position us to make the arguments for ROI and cost savings at our hospital systems and customers.

Okay, that's very helpful color. And then as my follow-up, I'm curious: Since the Laerdal agreement has now had some time to sink into the market, I'm wondering if you've had the opportunity to talk to any of your larger customers about the importance of the AHA card and if that's going to be a prerequisite; or if they are open to and willing to look to other resuscitation programs that involve some novelties like simulation, VR, et cetera; just any updated outlook there.

Well, first of all, we have a great partner in Laerdal and AHA. And we've really changed the industry together. We've moved them from the old models of learning out of books and print together, through a partnership for over 7 years, to a better modality of training. So the first news is that generally we're -- the acceptance of those types of learning, there's a lot of excitement about them. The mannequin-based learning was kind of wave 1, but all the technology you mentioned is wave 2. And then AI, machine learning is wave 3. And so we've really set up the market to be receptive to that. Now -- and we plan, as we mentioned, to continue to carry those really strong products into the market. In general, there hasn't proven to be much of additional marketplace for other providers in that solution. And so we have started that dialogue with some of our bigger health system customers about just receptivity to trying other approaches, other models, maybe other brands. And one of our largest said something I really like hearing because again there's no promise. These are strong brands. We'll be an underdog by a long shot. It's going to be a -- no doubt, a challenge to introduce additional. And we plan to introduce multiple new models of getting certificates in this area, models and partners, but it will certainly be a challenge because there is one established brand. We've just spent 7 years telling the market that it's the best and the strongest, but in January of '19, we're going to begin to show new things, different ways and new partners. That discussion with one of our largest customers and clients was really encouraging because -- this is the quote: We care about the competency, not the card. And everyone refers to the card as the AHA card. And so I think it'll be incumbent on HealthStream and our new partners to prove that we develop the competency and reduce the risks and improve the outcomes. And if we do those things, I think the market will be receptive to alternative solutions. Now that's my job to say that. I do believe it. I think our new partners believe it. I've heard it directly from the mouth of one of our largest health system customers, but there's -- no one doubt the power of incumbency and the brand that exists. And again, we're proud of that brand. We've enjoyed carrying it to market, and it's definitely made an impact in resuscitation outcomes. We're just now required by the relationship change to bring alternatives to market. And I have increasing confidence we're going to have a good suite of solutions. The other thing to remember is we've told all our new partners that we plan to bring choice and selection to the series. There's not just one way to do things. I believe there's never just one way to do something. And here we're going to bring alternative ways and alternative models, new credentials to the market; be compliant with international guidelines at the same time. So there's a standards body that's international not beholden to one vendor. And I think, if we do all of those things right, we've got a really good shot. And all of our partners go in knowing that our goal is to lower the costs. So in an environment we just talked about, it's really important to have a focus on costs. And so every partner we've signed, the 2 we've signed to date understand that it is our job to bring lower price points in this area to the market. And I think -- given the sensitivities we see today and what we've just talked about on cost pressures, I think that will resonate as well with the financial officers of all these institutions. Particularly, the quote holds true, that we care about the competency, not the card.

And our next question comes from the line of Matt Hewitt of Craig-Hallum Capital.

First question. Last quarter, you had mentioned that you have been challenged on ramping up your sales hiring. You, I think, at the time were roughly 15 salespeople short of your goal. I'm curious, any progress on that front?

We continue to do mostly organic hiring. I mean the way to really change that number is to hire recruiters, as you know. And that drives cost, so we've taken a different approach in the last, say, 12 months of really reducing our reliance on recruiting. That has created a slowdown in backfilling, and so we have not -- we've chipped away at it here and there and made some progress, but we're being more cognizant of our operating leverage and margins. And frankly, I think we'd probably get a better outcome when we select people carefully by hand instead of being brought in by recruiters. So I think the quality maybe is going to go up, but it is taking us longer to fill the spots. And so we have not really completely plugged that backfill hole. Now as we enter the very end of the year, I do like to try to get new sales positions in place before our sales planning sessions, which are usually end of January, early February. And so we -- our goal would be to try to find a way to catch those up and keep accelerating between now and February.

Okay, great. And then a question about the large OB risk sale in the quarter. It's a multiyear contract. How will that layer on? Is that a simple flip of the switch and that the entire system will have access? Or will that be a steady rollout across that large customer?

It should be a fairly quick implementation, and they would have universal access to it across the system. It does not require a hospital-to-hospital implementation. And so it should be fairly linear once turned on. And now the contract is signed, pretty quickly it should begin revenue recognition and product adoption utilization. So yes, I don't see any issues. That should be a pretty quick power of integration to turn that product on and make it broadly available. And again, these health systems are very familiar to using our platform, so the integration value is very high then. They -- if they buy from us, they get the power of quick adoption, which I think is valuable to them and valuable to us and our shareholders.

Okay, one last one for me. Historically, you've been a good partner with your customers. And I think, back in times when there has been natural disasters and you've worked with the hospitals to help them either push off HCAHPS or other surveys or help them get back up and running as quickly and as efficiently as possible, given what happened here in the third quarter in Texas and in Florida, was there any impact? Was it a similar situation where you were working with your customers to maybe help them navigate some of the challenges that they were facing because of those weather-related storms? Or any color along the hurricane line would be helpful.

Sure, sure. I mean certainly a lot of our customers were directly affected by these hurricanes and the natural disasters that occurred. And certainly many senior executives, including myself, sent corresponsive communication out of understanding; of sympathy; and offers to help; and at least in one business unit, offers to make financial -- to help financially. And so we do -- that's a common part of our DNA in HealthStream is to reach out and see what we can do. We actually also let some of our employees have days off to travel down to the disaster areas and work in their -- in those neighborhoods, not directly to our customers but in -- some traveled to Texas and spend over a week down there trying to help out. So we tried to be part of solution there. What's fascinating is our sentiment is so broadly adopted now that, when something like that happens, you can see the usage patterns shift by region and state. It's almost like a visual map. You can see the hospitals go offline. And consumption drops off, of course, but you can watch the area of the disaster and impact as we look at utilization on our live network. And we're so broadly distributed coast to coast that it's almost like a weather map. You can almost look at our hospitals coming offline and then back online, and our job is to help them get back online as soon as we can. So we certainly want to be a part of the solution. And I'm proud that some of our employees are taking the time to do the things that they did.

And our next question comes from the line of Richard Close of Canaccord Genuity.

Question on the bad debt, just to follow-up on Ryan's question. On the bad debt, do you see it in any specific product area? Is it more in workforce? Or does it fall into the other buckets of revenue engagement or provider services?

Richard, it's Gerry. There's no one particular pocket and no one particular area or segment. It's been kind of generically spread across the board in terms of hospital location, hospital size, so there's no one particular identifying characteristic.

Okay. With the nurse ready product and OB risk, maybe KnowledgeQ, can you talk to us a little bit about the addressable market for those new products within your base? I assume they're sizable, or you wouldn't be bringing these to market, but any type of magnitude you can share with us in terms of that addressable market size?

Yes. That's a plan over time, but let me give you some characterizations. KnowledgeQ, think of KnowledgeQ as a third-generation compliance product. So if you think back over our history, we introduced basic Joint Commission training requirements and OSHA safety requirements and had a library. And then we updated it to include testing services and evaluations, and now we have data and benchmarking and analytics bundled in, with content. And we've enhanced the content to be mobile and responsive. And so that product is now kind of sold separately, not bundled in with the learning platform. And -- but it does -- there's some value ascribed to the prior-generation products. So that product, I believe, is something that we could potentially sell to everyone. It does have a lower price point and -- but it is broad adoption, so -- and it's high margin because we own all of the elements of it. We own platform delivery content, data and benchmarking, all of the components of KnowledgeQ. So it's a high-margin product. You've mentioned the nurse residency. That's an interesting one. It's actually a low-volume product. So if you take a hospital runs -- a good-size hospital runs 3 or 4 cohorts or maybe 2 or 3 cohorts of new nurses a year. They kind of have classes they bring in essentially over the course of the year. And the classes are fairly small, 20 to 30 people maybe at a medium-size hospital, so think of it as 40 to 60 new nurses coming in. Remember these are recent nurse grads. This is not just new nurse hires. This program is targeted for new graduates. They just graduated and are coming to the workforce the first time. We give them a prospective 1-year program. Now what's exciting about this product even though it's low volume, say a class of 20, it's a much higher price point than we've ever experienced, in almost any of our products in fact, because it bundles almost everything we have into a 1-year program. You get access to our checklist, to our learning system, our competency management system on a per-person basis. You get curriculum from up to 4 different vendors. And so the price point is -- we haven't put this out there yet, but it's over -- it's in the hundreds and hundreds of dollars, just shy of $1,000 actually, per person per year. And so it's a really high-price-point but low-volume product. There's about 170,000 new nurse graduates each year coming into the marketplace. You can think of this product as targeting that audience as they join the workforce in the hospital. So low volume, high price point, good margins and again includes a mix of products from other partners. And so the margins aren't as high as KnowledgeQ, but I believe it's safe to say the margins are higher than our current average margin or somewhere in there because you include a mix of content from multiple partners and platform into the residency program. Again, that's the program that was -- recently helped a hospital earn accreditation for their residency program, which is really exciting from a marketing standpoint. So I hope that helps. One is a high volume, low price point. We think it applies to every hospital, actually every employee in every hospital. And in long, we have a version for long-term care and post acute settings as well. And then -- that's KnowledgeQ. And then nurse residency is very targeted. There's about 170,000 nurse grads a year coming into the marketplace and -- but a much higher price point.

I guess one of my final questions here would be, Gerry, you talked about average-revenue implemented subscriber metric. And you're thinking about doing away with that. I'd -- if you could just go over the puts and takes on that.

Yes. So I think the most important consideration I think I mentioned in my remarks was it only covered 1/3 of the business, the workforce development segment. It does not include any contribution from patient experience or provider. So that's one consideration. The second is, as you saw it last year with the ICD-10-only subscribers, the fluctuations of it in the subscriber count kind of skews on the results. And the third thing is I think, as product lines change and morph, the combination of things can be much more important than a kind of distinct calculation by segment. So do I get a comprehensive, meaningful, incredible overall metric? ARIS is not it. I think we can all agree to that. So it's more a question of what we replace it with too as much as taking it away.

And we're interested in analyst feedback on this. We have over a -- over the last couple of years, we've brought this up. And we just never quite, [I guess], retired because we wanted -- idea was we'd have a good replacement metric like revenue per facility. Or we would do a proxy on, say, Provider Solutions and divide that into the number of employees and add that into ARIS so you'd get a sense for how much revenue per account or per facility or find a way to attribute [the] per subscriber in the other 2 business segments. We haven't yet figured that out, but I think the other segments are growing in importance. They have slightly different dimensions to their revenue. And that metric doesn't encapsulate those units, so we think we would like to just maybe rely more on GAAP reporting at the holistic level instead of metrics that reflect individual segments, but we're not completely sure of that. But we're also giving a heads-up that we may retire that metric in February of next year. Maybe we'll replace it with one.

Maybe, if you do decide to change and provide facilities or different metrics, will you provide us some historical data points in order to see what the trends are?

Yes, we would surely provide some kind -- if we had a new metric, we'd have to. It'll be more of a proxy metric. So take Provider Solutions for example. They sell to large health systems and get business there. And generally, it will be proportional to say that the revenue they generate from that account could be divided by the number of employees in the account, but it's really sold based on the number of providers that are credentialed or the scope of work. And so it'd be more of a proxy if that were added into ARIS in that way to try to kind of derive, like, how much revenue do we get at that health system per employee. And same difficulty with the patient experience surveys. The volume of surveys we do for a hospital is probably derived by the size of the hospital; number of patients they have, which is also derived from an approximation of number of employees, but if you took the revenue from patient experience at a given hospital, divided by the number of employees, it will just be a proxy, kind of a directional indicator of revenue per employee based on the scale metrics I said. So we try to put all that together into one metric. And we're just not quite comfortable releasing it because of the way it's -- they're more derivative. So we're working on it. We're -- maybe in sessions you can give us other ideas on things you'd like to see us measure. We'll take that into advice, but we do know that the ARIS metric is just almost too hard to interpret. We've pointed out how it can be anomalous at times, where you add 0.5 million subscribers at a very low price point. It's dilutive to the margin. Or you can lose a very big customer that is below the price point, and ARIS could go up, but you just lost a customer. So we struggle to do the puts and takes on it, and for that reason, we're thinking about retiring it.

And the next question comes from the line of Nicholas Jansen of Raymond James.

I just want to drill a little bit deeper into kind of organic growth. I think you mentioned 1 or 2 kind of onetimers in the quarter, so I'm just trying to get a better sense of the total magnitude of that revenue benefit. And then secondarily, as you strip out Morrisey, ICD-10, some of the deferred revenue puts and takes, your organic growth, at least under my math, is kind of in that 6%-or-so range in the quarter. And just wanted to get your thoughts on, given the pressures in patient experience that you've talked about, given the transition to SaaS on the subscription side for the Provider Solutions business, how do we think about that evolving as we true-up our models for '18. Can this be a double-digit business again?

Thanks, yes. So there's no doubt we've identified some intentional transformations in our business that will challenge -- if people are only focused on top line growth, it will challenge their -- maybe their interest because the story, as we mentioned, with OB risk is transformational, kind of the way Netflix got into content a little bit. You see us doing that. So a prior product was driven by a partnership with a lower margin. We move to one that's codeveloped and co-owned, and it's higher margin. And so in that case, there's a focus on margins and having a good replacement product. We also mentioned the 2 dynamics that made top line growth more challenging, but they're very healthy dynamics here focused on free cash flow and EBITDA. And ultimately I think that's how businesses should be valued. And so I think it's fair to say that we're going to have pressures on growing the top line in the coming months and even years as we finish these transformations, but there's no argument that -- by anyone I've ever heard that moving to SaaS is a bad idea, from installed revenues that have point-in-time recognition. There's no argument that in moving our patient experience business moving to more e-surveys, even though the price points can be drastically lower, the resultant gross and net cash flows can be higher from an e-survey from than a phone survey. And so just imagine that business as you continue to transform like $1 of revenue and sell it at a lower price point but the margins really expand pretty dramatically. So I think just, if you're an analyst on HealthStream watching free cash flow, watching EBITDA, watching operating leverage, as we think about the next several years, it's going to be pretty important. And it -- because these transformations are intentional and focused on delivering better free cash flows over time, I think that we may have to change some of our focus as we pull through those transformations from top line growth to bottom line growth.

That's very helpful. And then we think about this cash flow transformation. Certainly, you already have a pristine balance sheet. How do we think about your M&A pipeline, your desire to spend money on that effort as you go through this transformation? Because certainly I would assume any sort of acquisition would perhaps be dilutive to the margin in the short term. So I just wanted to get your thoughts on M&A.

Yes, sure. Before I do that, I want to add one more big transformation that's a known now. We mentioned the dropoff in the contract with Laerdal or the dropoff of access. That product will be ending at the end of next year. And so that will have a known and almost like ICD-10 quantifiable decline in revenues, as we're no longer able to sell that product and we start selling the new product. Now the good news on that one is the new product, we believe, that's right now, based on contracts, will have more than double the current margins, so we only have to sell half as much to make the same amount of money. But the revenue declines from that product is going to be challenging in the coming years, beginning in 2019, not 2020. So I've seen some analysts model some declines in the revenue in 2020, but if you think of it, we can only sell the product through December of next year. And so if an account comes up for renewal in February of '19. We will not have the right to renew that account. We will have the option to sell them something new at what is lower price point to them and double the margin to us, but we will not have the right to renew them if they want that existing product. So I do think that's a third element that will pressure top line growth in the coming years, beginning as early as '19. That said, you talk about our capital position. It's really strong. I mean, if you look at free cash flows in the quarter, I think that it was -- our year-to-date is about $35 million. It's up from $15 million in the prior year 9 months. And so deploying capital into inorganic strategies will have to be part of our story. We've got a talented team here that knows how to do and integrate and acquire businesses. And so we expect and you would expect us to deploy our current balance of $123 million, use some of our line of credit and our free cash flow in the coming years to have an inorganic component to our story. And of course, the challenge to that is you never want to do a dumb deal just to chase the top line. And we will try to be as careful as we've always been, but we are cognizant of the need to deploy the capital, the $123 million in cash. We think we can probably have access to a greater line of credit in the coming years as well because of our cash flow improvements. And so inorganic growth will be a part of our story. I know that's a bit uncomfortable because it's really hard to model, like we can't -- and it's hard to model even to our board because we can't just promise deals. You have to do good deals, but it will be a part of our story going forward. And we're [cognizant] of that, and we're working it -- we're working to develop that pipeline.

And the next question comes from the line of Matthew Gillmor of Robert Baird.

I just had one, which is I just wanted to get an update on your content partners and your -- sort of an overall strategy, so can you maybe update us or remind us on how much of your revenue is derived from self-developed content versus third-party partners and where you see that going over time. And then outside of Laerdal, are there other key renewals with your content partners over the next sort of 12 months that we should be monitoring?

The -- so I'll take the last question, first. Well, there are no other content partners that we depend on at the scale of a Laerdal, AHA. It's kind of the last piece of our model that we need to migrate to either multiple partners or different partners. And so in the prior years, we announced a transformation in clinical skills, for example. We used to be we just have 1 of the top 3 providers of clinical skills in the world actually. There's 3 very large multibillion-dollar corporations that provide clinical skills training in nursing. And up until about, I guess, 2 years ago or 18 months ago, we only represented 1 of the 3. And now I'm proud to say that we represent 2 of the 3. So we brought variety and choice. And those partners have created some competition, and it's been favorable to our customers. They get better price points and more choice and selection. So I would have said that the second area of dependence would have been in clinical skills, and we actually moved away from dependence on one partner in clinical skills about over a year ago. So that's exciting. Now the investment in our own content will be very targeted, kind of the way Netflix moved into building some of their own content, but I'll say a couple things: Third-party content from credible organizations is really important to our model. It's what provides choice and selection and breadth and shows our expertise and domain expertise in health care. So maintaining a partnership in over 70 partners and growing. It's always grown more than it shrank. We've lost -- I can think of 3 that we've lost in the last 5 years, but we add several more than that each year, so the partner network is growing. The breadth of that network -- even for niche products that may only do 200,000 a year, having that product in our catalog and have it easily integrated is an important part of our value proposition. So the breadth of our partnerships is very important. Now where it makes sense to introduce a house brand is a decision that we make. We've made that in a couple of areas. OB risk is the first area that's kind of publicly known shifts. So a very small percentage of our partners or content is owned by HealthStream, but KnowledgeQ that I mentioned earlier, a key and top grower with high margins, is also owned and developed by HealthStream. So a little like Netflix moving to content development, we're stepping -- step functioning into it. And the 2 key products today that are house owned are KnowledgeQ and OB risk. And there are some more already in development. In fact, I think we just announced the ED risk program, emergency department risk program; and it's going into the marketplace. And so you see these supplemental programs that have some house-owned dimension to them coming to market, but I don't want to deal with something -- we're not going to move all the way to house-owned content. It's the power of your -- of association brands. We've just signed some new associations to bring their branded, gold-standard content to market. It's critical to have the top 10 nursing associations involved in our network of 4.6 million health care workers, and so that mix is important.

Our next question comes from the line of Scott Berg of Needham.

Just 2 quick ones for me. First of all, Gerry, I'm not sure how far along you are in your assessment of implementing ASC 606 next year, but can you maybe give us some highlights on what you think that impact to your model will be next year?

So we'll pick up here on the process, and I can discuss the second part of your question. We've gotten through what I'll call the accounting -- research accounting policy portion of the projects, completed that. We're now in the phase of implementation, how we change our internal workflows, how we revet our contracts to comply with the new standard. In terms of, I guess, some general themes we've come across, and we can go from there, but I think what you'll find on the revenue recognition side, I think, will be very similar to how they are today. The one change -- and well, this [is really] quantified in the footnotes in future periods, but the one change, and maybe not just HealthStream but other companies you follow, the commissions accounting will most likely be very, very different. And what I mean by that is the new standard requires companies to capitalize commissions that amortize, not only the contract life, over the customer life. So if you think about HealthStream as one example: We've had very high renewal rates. Our customer life exceeds our contract period, and so you can expect a longer amortization period. We've kind of worked that out with the actuaries and all kind of -- or with experts right now, but I think I'd single that as a -- the more notable change you'll see in the impact on the new standard on HealthStream.

And Gerry, just go ahead to the mix of the model. I'll -- the costs that we're estimating for the fourth quarter and maybe the full year on implementing these new standards.

Yes. So the 9 months to date to September, we've incurred about $400,000 or so of expense for the compliance efforts. I think my text mentioned $600,000. We expect in the fourth quarter to wrap up work with E&Y, our auditors; plus our own internal execution of new workflows and platforms and so on.

So those costs are in G&A.

Through G&A.

Yes. So just kind of a bummer, right when we're getting good operating leverage on G&A. We have increased bad debt expense and government regs compliance in accounting that pressure that cost area. So that's unfortunate, but it is what it is. And we plan to -- obviously, just hearing reports recently, we're on schedule for compliance with those requirements; and expect to deliver compliance with them, beginning on January 1.

Helpful. Last quick one for me, Bobby, is the Laerdal products have sold well for you guys over the last couple years. And with this change that's coming in 14 months, I wanted to see what you're hearing from existing customers, maybe impact to sales cycles right now and maybe expectations over the next 14 months. Are you expecting to maybe see sales of those products flow to new customers as they wait for your new products? Or do you think that they kind of continue on the same trajectory as they have been?

Yes, that's a big thing we're trying to figure out. We look at -- remember I mentioned the changeover from 1 clinical partner to 2 others. And we have actually flip-flopped from 1 to 2 others. And our observation when we did that flip-flop was that, as we ended our ability to sell those products, the sales of the product was essentially the same as the prior year, which had really grown. And so it flattened out there, but it stayed strong. In other words, we didn't experience a dropoff. In fact, we did see some customers try to secure the rights to that product beyond the end of our relationship. And so at the very end there's a little surge in buying -- or an increase in buying, I should say. So we're trying to figure that out. I think customers -- it's a really good product, as I mentioned. I think our customers really value integration. And I think they will probably likely want to secure the product for as long as they can to be fully integrated, and so my thinking is -- now as we enter these next 14 months is that hospitals will contract for a little longer than an average period. Like, their average period is about 18 months, maybe a little longer than that, and what we're thinking is they'll probably -- some clients will want to secure essentially the -- what is now a 3-way partnership. They want to secure a working version of that out till 2020, but it is going to be hard to predict. And so right now the way we're modeling is essentially we'll probably sell about the same amount in this coming year, in the next 12 months, beginning in January, as we're going to sell in this year maybe with a little uptick at the last, to deliver modeling; and so not a decline, mostly flat but flat on a really good year here in '17. So we kind of expect to repeat that in '18. And then it's going to be difficult in '19 because we cannot sell, market or distribute a competing product until January 1, '19. So we can't even begin selling the replacement products until January 1, '19. And so it's going to be a hard backfill for us, but to answer your specific question, I do think that customers will want to secure it because they do value the integrated products. We've seen that over and over again when products come out of our network, that our customers are willing to shift. As we mentioned, clinical skills, a really good shift going on right now to our 2 integrated partners from the prior partner. And so we're -- again, we're modeling it relatively flat, but it's a strong year in '17, so I expect a strong year in '18.

Our next question is from the line of Vincent Colicchio of Barrington Research.

Yes, most of mine were asked, Bobby. Just one for me. In Provider Solutions, are you seeing the level of cross-selling activity that you expected?

In provide -- not yet. I would say we've seen that business get cleaned up. We have exciting announcements to -- and remember we -- it's the merger of 3 businesses. And I think we've done a really fine job of merging the 3 businesses, but there's more news to come on that front, including launching new products in January. It's the new technologies launching in January that will be more leverageable; that will receive data from other parts of our ecosystem, other products that we have and back and forth. So I think we'll see more cross-selling. Now if you mean are accounts buying into both product sets, that -- I would say we're seeing some of that. We are leveraging the relationships to try to have more wins against competitors, but the actual technical integration which will get us a selling advantage, I think, begins really in January, in first quarter of this next year. So we do see lots of accounts that have shared products. I think they value buying multiple products from one vendor, and so that has been helpful, but it's -- when we get technological integration actually is currently scheduled for Q1 next year, that we can really have product leverage in the sales process.

Our next question is from the line of Frank Sparacino of First Analyst (sic) [First Analysis].

Bobby, just maybe quickly: There hasn't been any talk around the post acute space, so anything noteworthy?

Yes, yes. So we've got a strong sales team there. And we're -- it's a steady contributor to our subscriber growth, so we just kind of fold it in. We have a great penetration in the acute care market. So some of our growth has been consistently coming from the post acute space, both within health systems that have post-acute operations and outside the market, and so I will just call it a steady contributor to our story. It's helping us maintain subscriber growth by adding. It is definitely a little harder to sell into that space because it's more fragmented at scale, so we're kind of learning new models of selling but pleased with the progress. And just I'd say steady contributor to our story. We have -- many of our products can be sold into both channels, the acute and post acute. We've adapted several, as I mentioned, KnowledgeQ to having a library for post -- on post acute. And so I will just report it as steady as she goes and part now of our growth opportunity. We've articulated our target audience is about 8 million people, and today, we're 4.6 million. And so adding to that market opportunity along gives us the chance to keep growing subscriber count.

We do have a follow-up question from the line of Richard Close of Canaccord Genuity.

Just really quickly, can you update us on the last 12 months revenue for Laerdal? I think, when you made the announcement originally back in the spring of -- trailing 12 months was $39.7 million. Is there any update there?

Yes, we'll look at that, but we probably don't plan to update on a line-by-line basis every quarter. But we'll consider that. It was a little over -- all the products from Laerdal were a little north of $40 million, maybe around $41 million, based on that relationship. That's the totality of revenues at that point. That was just a few months ago, so I don't suspect it's changed very much on a trailing 12-month basis.

Thank you. And at this time, I'm showing no further questions. I'd like to turn the call back over to Mr. Robert Frist, CEO, for his closing remarks.

Thank you for participating in this Third Quarter Call. We look forward to reporting in February our year-end results.

Thank you much. Bye-bye.

Ladies and gentlemen, thank you for your participation in today's conference. This does conclude the program. You may now disconnect. Everybody, have a great day.