HMS HOLDINGS CORP – 10-Q – Management’s Discussion and Analysis of Financial Condition and Results of Operations

We begin Management's Discussion and Analysis of Financial Condition and Results of Operations with a discussion of the critical accounting policies that we believe are important to understanding the assumptions and judgments incorporated in our reported financial results. We then present a business overview followed by a discussion of our results of operations. Lastly, we provide an analysis of our liquidity and capital resources, including discussions of our cash flows, sources of capital and financial commitments.

You should read the following discussion of our financial condition and results of operations in conjunction with the unaudited consolidated financial statements and the notes thereto included elsewhere in this Quarterly Report on Form 10-Q and with our audited consolidated financial statements included in our Annual Report on Form 10-K for the year ended December 31, 2012, as filed with the Securities and Exchange Commission. In addition to historical condensed consolidated financial information, the following discussion contains forward-looking statements that reflect our plans, estimates, and beliefs. Our actual results could differ materially from those discussed in the forward-looking statements. Factors that could cause or contribute to these differences include those discussed below, in Part I, Item 1A "Risk Factors" of the Annual Report and elsewhere in this Quarterly Report on Form 10-Q, particularly in Part II, Item 1A. "Risk Factors."

Critical Accounting Policies

Since the date of our Annual Report on Form 10-K for the year ended December 31, 2012, there have been no material changes to our critical accounting policies.

   General Overview   

We provide cost containment services to government and private healthcare payers and sponsors. Our program integrity services ensure that healthcare claims are paid correctly, and our coordination of benefits services ensure that they are paid by the responsible party. Together, these services help clients recover amounts from liable third parties; prevent future improper payments; reduce fraud, waste and abuse; and ensure regulatory compliance.

Our clients are the Centers for Medicare & Medicaid Services (CMS); state Medicaid agencies; commercial health plans, including Medicaid managed care, Medicare Advantage, and group health lines of business; government and private employers; Pharmacy Benefit Managers (PBMs); child support agencies; the Veterans Health Administration (VHA); and other healthcare payers and sponsors.

Since our inception, we have grown both organically and through targeted acquisitions. In 1985 we began providing coordination of benefits services to state Medicaid agencies. We expanded into the Medicaid managed care market, providing similar coordination of benefits services when Medicaid began to migrate members to managed care. We launched our program integrity services in 2007 and have since acquired several businesses to expand our service offerings. In 2009, we entered the Medicare market with our acquisition of IntegriGuard, LLC, or IntegriGuard, now doing business as HMS Federal, which provides fraud, waste and abuse analytical services to the Medicare program. In 2009 and 2010, we entered the employer market, working with large self-funded employers through our acquisitions of Verify Solutions, Inc. and Chapman Kelly, Inc. In 2011, we extended our reach in the federal, state and commercial markets with our acquisition of HealthDataInsights, Inc., or HDI. HDI provides improper payment identification services for government and commercial health plans, and is the Medicare Recovery Audit Contractor (RAC) in CMS Region D, covering 17 states and three U.S. territories. In December 2012, we acquired the assets and liabilities of MedRecovery Management, LLC, or MRM, which provides Workers' Compensation recovery services for commercial health plans, for an aggregate purchase price of $11.8 million, consisting of a $10.8 million initial cash payment and $1.0 million in future contingent payments that are based on the achievement of certain performance milestones. We recognized $11.2 million of goodwill in connection with our acquisition of MRM. During 2013, we expect to reallocate the intangible assets from goodwill upon the completion of our assessment of the fair value of the assets acquired.

In connection with our acquisition of HDI, we entered into a five-year, revolving and term secured credit agreement, which we refer to as the 2011 Credit Agreement, with certain financial institutions and Citibank, N.A. as Administrative Agent. On May 3, 2013, we amended and restated the 2011 Credit Agreement and entered into a $500 million five-year, amended and restated revolving credit agreement, which we refer to as the 2013 Credit Agreement. See, "Subsequent Events" for further information on the 2013 Credit Agreement.

At March 31, 2013, our cash and cash equivalents and net working capital were $139.2 million and $219.6 million, respectively. To date, we have grown our business through the internal development of new products and services, the extension of our products and services into new markets and through acquisitions of businesses whose core services strengthen our overall mission to help our clients control healthcare costs. In addition, we leverage our expertise to acquire new clients at the state, federal and employer levels and to expand our current contracts to provide new services to current clients. Our growth to date has also been

                                           17  --------------------------------------------------------------------------------

Table of Contents

driven by an overall increase in Medicaid expenditures and state governments' increased use of vendors for the coordination of benefits and other cost containment functions. We are continuously evaluating opportunities that will enable us to expand the breadth of the services we provide and will consider acquisition opportunities that enable us to continue to grow our business to address the increasing needs of the healthcare industry.

As of March 31, 2013, we served CMS, the VHA, 46 state Medicaid agencies and the District of Columbia. We also provided services to approximately 100 commercial clients and supported their multiple lines of business, including Medicaid managed care, Medicare Advantage, and group health plans. We also act as a subcontractor for certain business outsourcing and technology firms.

In September 2012, our wholly owned subsidiary, IntegriGuard, which is doing business as HMS Federal, was awarded a contract by CMS to perform the Coordination of Benefits and Medicare Secondary Payer Business Program Operations. A bid protest was filed with the Government Accountability Office (GAO) with respect to this contract and we received a stop work order from CMS, pending resolution of the protest. CMS then determined to undertake a procurement corrective action with respect to this contract award and we currently expect CMS's decision with respect to this award by the end of the second quarter of 2013. The procurement corrective action could result in CMS lifting the stop work order and affirming the award to HMS Federal, making a new award decision or taking some other action. If CMS lifts the stop work order and affirms the award to HMS Federal, a new bid protest could be filed with the GAO, which could result in CMS imposing a new stop work order on HMS Federal pending the GAO's decision on that new bid protest. The GAO is entitled to take up to 100 days to review any bid protest and issue its decision. As a result, even if CMS affirms the award to HMS Federal during the second quarter of 2013 or later, if a new bid protest is filed, we may not have resolution on this contract award until the third quarter of 2013, or later.

In February 2013, CMS issued a Request for Quote (RFQ) for the new Medicare recovery audit contract. Our current Medicare RAC contract, pursuant to which HDI serves as the Medicare RAC for Region D, expires in February 2014 and is one of our largest contracts. In April 2013, HDI submitted its response to the RFQ and also filed a bid protest with the GAO, which was subsequently dismissed based on CMS's decision to take voluntary corrective action to resolve the issues raised in the protest in an amendment to the RFQ. The amended RFQ and any award made thereunder may be protested, which could extend the time frame for implementing the new Medicare RAC contracts. In addition, CMS has established a transition plan pursuant to which incumbent contractors are permitted to request medical records only through May 2013. While this transition plan is subject to change, as currently proposed by CMS it may significantly reduce our expected revenues from this contract for the remainder of the contract term.

    Healthcare Environment    

In March 2010, the Patient Protection and Affordable Care Act, as amended, or the ACA, was signed into law and in June 2012, the U.S. Supreme Court upheld the constitutionality of the ACA, ruling that the federal government could not condition continued receipt of a State's existing Medicaid funding on its agreement to implement the Medicaid expansion. As a result, states choosing not to expand their Medicaid programs will forgo only the federal matching funds associated with such expanded coverage. As a result of the ACA, states face increasing pressure to cover more individuals even as many of them are projecting significant budget deficits.

It is expected that enrollment in government healthcare programs will continue to grow, particularly under the ACA. However, healthcare spending on Medicare and Medicaid has been reported to be growing more slowly than predicted, with the most recent report from the Congressional Budget Office, or the CBO, showing federal spending for the two programs was 5% lower than it estimated in March 2010. As a result, the CBO has lowered its seven-year spending projections for these programs by approximately 15% for each program and made changes to Medicaid spending outlays for the next 10 years, citing lower expected costs per person through Medicaid expansion. The CBO also expects Medicaid enrollment by 2014 will not be as high as previously thought because it is expected that more people will gain health coverage through other sources.

The ACA also includes a number of provisions for combating fraud, waste and abuse, and we believe that the strong bipartisan support for containing healthcare costs through the measures identified in the ACA, provides us with platform for continued growth across products and markets. We plan to develop and build on existing partnerships with our state, federal and commercial clients and our other partners to provide services that address these provisions and assist these clients with their cost containment objectives.

In addition to the information provided below, you should refer to the items disclosed as our Critical Accounting Policies in Part II, Item 7. "Management's Discussion and Analysis of Financial Condition and Results of Operations" of our Annual Report.

                                           18  --------------------------------------------------------------------------------

   Table of Contents    SUMMARY OF OPERATING RESULTS   

Three Months Ended March 31, 2013 Compared to Three Months Ended March 31, 2012

    The following table sets forth, for the periods indicated, certain items in our unaudited consolidated statements of comprehensive income expressed as a percentage of revenue:                                                     Three months ended                                                       March 31,                                                   2013         2012 Revenue                                            100.0 %      100.0 % Cost of service Compensation                                        37.7 %       36.6 % Data processing                                      7.8 %        6.4 % Occupancy                                            4.0 %        3.8 % Direct project costs                                11.4 %       12.0 % Other operating costs                                5.7 %        4.8 % Amortization of intangibles                          6.8 %        7.6 % Total cost of services                              73.4 %       71.2 % Selling, general, and administrative expenses       13.5 %       13.9 % Total operating expenses                            86.9 %       85.1 % Operating income                                    13.1 %       14.9 % Interest expense                                    (3.2 )%      (3.9 )% Other income, net                                    0.0 %        0.1 % Interest income                                      0.0 %        0.0 % Income before income taxes                           9.9 %       11.1 % Income taxes                                        (3.9 )%      (4.5 )% Net income                                           6.0 %        6.6 %    

Revenue for the three months ended March 31, 2013 was $116.6 million, an increase of $9.3 million, or 8.7%, compared to revenue of $107.3 million in the same quarter for the prior year. Fluctuations in existing client accounts, together with changes in the yield and scope of those projects, and differences in the timing of when client projects were completed in the current year compared to the prior year, provided a $11.2 million increase in revenue. Revenue generated by new clients for whom there was no revenue in the prior year provided $1.1 million of the increase. These increases were offset by contract expirations in the amount of $3.0 million.

Compensation expense as a percentage of revenue was 37.7% for the three months ended March 31, 2013, compared to 36.6% for the three months ended March 31, 2012. Compensation expense for the current quarter was $44.0 million, a $4.7 million, or 12.0%, increase over compensation expense of $39.3 million for the same quarter in the prior year. During the quarter ended March 31, 2013, we averaged 2,441 employees, a 16.1% increase over our average of 2,102 employees during the quarter ended March 31, 2012. This increase reflects the addition of staff in the areas of client support, technical support and operations.

Data processing expense as a percentage of revenue was 7.8% for the three months ended March 31, 2013, compared to 6.4% for the three months ended March 31, 2012. Data processing expense was $9.1 million for the current quarter, an increase of $2.2 million, or 32.0%, over data processing expense of $6.9 million for the same quarter in the prior year. This increase reflects $1.1 million in additional hardware and hosting costs, $1.0 million in additional software related costs, and $0.1 million in additional data communications costs due to the growth of our business, including an increase in transaction volume.

Occupancy expense as a percentage of revenue was 4.0% for the three months ended March 31, 2013, compared to 3.8% for the three months ended March 31, 2012. Occupancy expense for the current quarter was $4.6 million, a $0.5 million, or 12.2%, increase compared to occupancy expense of $4.1 million for the same quarter in the prior year. This increase reflects $0.4 million in additional rent and $0.1 million in additional utilities and maintenance expenses.

                                       19  --------------------------------------------------------------------------------

Table of Contents

Direct project expense as a percentage of revenue was 11.4% for the three months ended March 31, 2013, compared to 12.0% for the three months ended March 31, 2012. Direct project expense for the current quarter was $13.3 million, a $0.5 million, or 3.3%, increase compared to direct project expense of $12.8 million for the same quarter in the prior year. This resulted from a $0.6 million increase in data costs and chart fees, which was partially offset by a $0.1 million decrease in printing expenses.

Other operating costs as a percentage of revenue were 5.7% for the three months ended March 31, 2013 compared to 4.8% for the three months ended March 31, 2012. Other operating costs for the current quarter were $6.6 million, an increase of $1.5 million, or 29.5%, compared to other operating costs of $5.1 million for the same quarter in the prior year. This increase primarily resulted from a $0.6 million increase in professional fees, a $0.4 million increase in office expenses, comprised of postage, delivery and supplies, a $0.4 million increase in travel expenses and a $0.1 million increase in recruiting costs.

Amortization of acquisition-related software and intangibles as a percentage of revenue was 6.8% for the three months ended March 31, 2013, compared to 7.6% for the three months ended March 31, 2012. Amortization of acquisition-related software and intangibles for the current quarter was $7.9 million, compared to amortization expense of $8.1 million for the same quarter in the prior year. As a result of certain intangibles being fully amortized, there was a $0.2 million decrease in amortization expense during the period.

Selling, general, and administrative expense as a percentage of revenue was 13.5% for the three months ended March 31, 2013 compared to 13.9% for the three months ended March 31, 2012. Selling, general, and administrative expense for the current quarter was $15.8 million, a $0.9 million, or 6.3%, increase compared to $14.9 million for the same quarter in the prior year. During the quarter ended March 31, 2013, we averaged 214 corporate employees, a 10.9% increase over our average of 193 corporate employees during the quarter ended March 31, 2012. Compensation expense increased by $0.3 million due to the increase in headcount, partially offset by decreases in stock compensation expense and variable compensation. Other costs increased by $0.5 million primarily due to a $0.7 million increase in legal fees partially offset by a reduction of $0.2 million in training and employee relocation costs. Occupancy costs increased by $0.1 million.

Operating income for the three months ended March 31, 2013 was $15.3 million, a decrease of $0.7 million, or 4.8%, compared to $16.0 million for the three months ended March 31, 2012.

Interest expense was $3.7 million for the three months ended March 31, 2013 and $4.2 million for the three months ended March 31, 2012. The decrease of $0.5 million compared to the prior year period primarily represents a reduction of $0.4 million in interest expense on our Term Loan and a reduction of $0.1 million in related amortization of deferred financing costs. Interest income was $1,000 for the three months ended March 31, 2013, compared to interest income of $2,000 for the three months ended March 31, 2012. Net other income decreased to $23,000 for the quarter ended March 31, 2013 from $110,000 in the prior year period, primarily as a result of a reduction in rental income as tenant leases associated with our Irving, Texas building expired and were not renewed.

We recorded income tax expense of $4.6 million for the quarter ended March 31, 2013, compared to income tax expense of $4.9 million for the three months ended March 31, 2012, a decrease of $0.3 million. Our effective tax rate decreased to 39.7% for the quarter ended March 31, 2013 from 41.1% for the quarter ended March 31, 2012, primarily due to a change in state apportionments and permanent differences. The principal differences between the statutory rate and our effective rate are state taxes and permanent differences.

We reported net income of $7.0 million for the three months ended March 31, 2013 versus $6.9 million for the three months ended March 31, 2012.

                                       20  --------------------------------------------------------------------------------

   Table of Contents    Contractual Obligations   

There have been no material changes in our contractual obligations as presented in our Annual report on Form 10-K for the year ended December 31, 2012.

Off-Balance Sheet Arrangements

Other than our Letter of Credit, we do not have any off-balance sheet arrangements.