• COB – this business benefited from a Federal mandate passed in 2005 and implemented over the last several years for health insurance companies to provide their Medicaid claims data to the states, who consequently then provided it to HMSY for analysis
  • HMSY was the leader in the space for ingesting and analyzing all this unstructured data at the time, hence they basically controlled this market (as of 12/31/14, they were serving 46 states)
  • However, increasingly states are cutting HMS out as their IT providers are giving them these same capabilities through easy-to-use software as part of their MMIS (Medicaid Management Information System) update
  • Additionally growth has dried up in this segment as they have nearly fully-penetrated their market opportunity
• Medicare RAC – this business was acquired at the end of 2011 and provided significant growth in 2012, however the gov’t is making significant changes to the program that has hurt near-term results and likely long-term profitability
  • While auditing claims made to Medicare is an important function, the payment structure for the auditors completely misaligned incentives and caused a significant backlog of audit appeal hearings that currently are and will be plaguing providers for years
    • RACs were paid up-front on denial of claims, which incentivized them to deny as many claims as possible…estimates suggest that ~40% of denials are challenged and the providers win ~70% of those challenges = <75% accuracy on denial of Medicare payments
  • The government shut down the ability for the RACs to audit new claims in June 2014, which caused revenue to decline 80% last year
  • CMS is also putting measures into place that they believe will help improve the auditing and reversal process that will ultimately hurt the long-term economics of the business
    • For example, payments to RAC providers may be extended from 120 days after completion of the audit to 420 days, which is after any audit appeal hearing could take place

• State COB (~50% of revenues) - 40% of this segment's revenues are up for re-bid in 2015 and HMSY faces significant price-down risk due to precedent transactions, technology obsolescence risk, worsening mix and increased competition
• Commercial (~40% of revenues) - this segment is projected to growth 20% in 2015, which is an acceleration from 2014.  It is split into two subsegments:
  • Commercial COB (~20% of revenues) - This segment grew ~30% in 2014 and needs to accelerate to +40% in 2015 to hit numbers
  • Commercial Payment Integrity (~20% of revenues) - This segment was flat in 2014 and was inexplicably declining in H214 and likely needs to start growing again in 2015
• Medicare RAC (~5% of revenues) - This business declined 80% in 2014 due to regulatory shutdown.  New contracts may be awarded at some point over the next few years, but it is my belief that this segment might very well be more of a drain than a boon relative to the 15-20c of EPS that it previously generated.
• Other (~5% of revenues) - mostly irrelevant, fledgling businesses

Short Thesis:

• HMSY’s State COB business is in trouble and is the main aspect of the short
  • HMSY’s COB business is effectively a people-heavy outsourcing business that is beginning to be replaced by software solutions that are much cheaper and easy-to-use
    • Example in MI: http://www.kunzleigh.com/current/ted/
    • Systems integrators for states are using these types of solutions as bait to win businesses with states
  • Even excluding technological obsolescence, their COB business already appears to be saturated so growth is limited by spend on Medicaid anyway
    • YoY growth rates for revs ex. RAC (COB+some other, faster growing stuff) from 2010-2014 = 32%, 17%, 9%, -1%, 10%
      • 2014 growth rate benefited from a sizable influx of medicaid members due to the implementation of the ACA...this is unlikely to repeat to this magnitude
        • Initial lives added in 2014 resulted in "look-back revenue," where HMSY looks at multiple years of payment history by Medicaid for an individual and then works to recover incorrect payments...this can account for up to 50% of expected revenue for a given patient
    • Mgt blamed the slowing through 2013 on weak Medicaid spending, but spending on a state and local level (vs. Federal) has actually grown significantly in recent years and the aggregate growth rates (state+local+federal) was not drastically different
      • I instead believe that HMSY effectively reached saturation as the main provider of COB midway through 2012, at which point the number of revenue generation opportunities flat-lined (number of claims by Medicaid patients that actually had primary coverage elsewhere…”matches”)
  • Competition is picking up as execs from a former acquisition by HMSY left to go back to their former employer (PCG) after their non-compete expired and started stealing business
    • PCG (Public Consulting Group) then won the Louisiana TPL (3rd Party Liability...or COB) contract from HMSY by undercutting their price by up to 40%
      • This was <1% of revenues (<$5M) according to management
    • HMSY is responding by suing PCG for misappropriating trade secrets, a lawsuit for which they've already spent $7M and will continue to spend quite a bit per quarter going forward
      • Given the amount they are spending relative to the value of the competitive loss, there is certainly something more troubling going on here
      • I believe this is a last ditch effort to protect their space before 40% of their revenues go up for rebid this year with the possibility of competitive losses and/or price-downs in the 20-40% range (or more in NJ/NY)
  • As mentioned, 40% of their state revenue is up for renegotiation by Q116 (20% of total revenues)
    
    • This includes NY and NJ, which combine for ~10% of revs...each is estimated to pay 4-5x as much as other states per “match” due to an antiquated contract structure
    • New Jersey recently completed an audit of this program and it came back unfavorable, calling certain payments to TPL providers "unreasonable"
      • http://www.njleg.state.nj.us/legislativepub/Auditor/544112.pdf
        
    • There is precedent for re-pricing/contract losses in Louisiana, Michigan and Kentucky
  • Mix shift from State managed Medicaid programs to Managed Care Organizations managing Medicaid is very negative for HMSY
    • Average MCO buys
  • • Assuming this guidance is right, what's troubling is the likely exit trajectory of growth for the segment projected below...it might be declining by YE
    • However, if I'm right and their renegotiations are worse in pricing and/or scope, the revenue decline could be more precipitous (see below)
    • Management is guiding toward flat YoY growth in State COB, which assumes similar pricing and scope in each state that is being renegotiated

    Q1 2014 Q2 2014 Q3 2014 Q4 2014 Q1 2015 Q2 2015 Q3 2015 Q4 2015 YoY Growth                     COB State Revs - Guide -1.0% 3.6% 20.8% 12.7% 10.0% 5.0% -5.0% -10.0%   COB State Revs -  Bad case -1.0% 3.6% 20.8% 12.7% 10.0% 4.0% -9.0% -20.0%

    • Is management just being conservative in their projection?
      • Potentially, but they made it a point to suggest that much of the growth that impacted State COB in 2014 would be shifting to MCOs in 2015, which will be a drag on growth, particularly given the difficult comps created through 2014

• Commercial
  • As mentioned above, Commercial COB guidance assumes an acceleration throughout 2015, which given this company's history of missing guidance and the transactional/lumpy nature of their revenues (= lack of visibility), it's hard for me to put a lot of trust in what they're saying
  •  History of Misses:

    Quarter   Rev Guide   What happened? FQ1 2011   370     FQ2 2011   372     FQ3 2011   363   Guide-down FQ4 2011   520     FQ1 2012   500-515   Miss & Guide-down FQ2 2012   500-515   Miss FQ3 2012   480-490   Miss & Guide-down FQ3 2012P   600-620   Miss FQ3 2012   570-600   Miss & Guide-down FQ4 2012   570-600   Miss FQ1 2013   495-525   Miss & Guide-down FQ2 2013   495-525   Slight beat FQ3 2013   495-510   Slight beat & Guide-down FQ4 2013   +10-11%   Massive Miss FQ1 2014   +10-11%   Massive Miss FQ2 2014   +10-11%   Beat FQ3 2014   +10-11%   Beat FQ4 2014   +10-11%   Rev/EPS Miss

    • Current expected revenue trends for Commercial:

      Q1 2014 Q2 2014 Q3 2014 Q4 2014 Q1 2015 Q2 2015 Q3 2015 Q4 2015 YoY Growth                   COB Commercial Revs -10.3% 24.0% 53.5% 67.2% 62.2% 41.4% 25.4% 32.0% PI Commercial Revs 25.5% 4.5% -11.8% -9.4% -8.2% -2.0% 12.2% 7.6% Total Commercial Revs 8.2% 13.6% 18.0% 18.1% 20.0% 20.0% 20.0% 20.0%

    • Additionally, Commercial was supposed to grow 25-30% in 2014...it grew on 15%...still a good number, but a sizable disappointment relative to expectations

• Medicare RAC is currently generating negligible revenue and profit and is viewed by analysts as a sizable source of upside optionality, however I believe this opportunity is overstated and risks still exist 
  • The RAC audit process was stopped in the middle of last year as the backlog of 480K+ audit appeals would take nearly eight years to work through (three years at an accelerated rate)
    • Given the backlog, it is conceivable that CMS may not restart the audit program until we are substantially through the current backlog of appeals (2016-2017)
    • CMS also implemented the two-midnight rule, which is intended to prevent denials of short stay claims (a popular claim denial by the RACs)
  • Additionally, HMSY may be under-reserved for liabilities related to audit appeals
    • HMSY must pay revenues back for those audits that are ultimately over-turned
    • In FY13, 54% of audits were appealed and in 2014, CMS offered a blanket 68% reimbursement rate for certain types of appeals
    • HMSY has reserved ~18% of RAC revenue, however this math suggests that they may be under-reserved by upwards of 19%, or 2/3 of potential operating income generated by the Medicare RAC
  • Eventually the new contracts will be re-awarded though, and work and revenues will start again, and while we don't know much about the new contracts, the initial view of them by the RACs (particularly CGI Group) doesn't seem great
    • We do know that the likely payment terms have gone from 120 days to 420 days, so it’s not out of the question that HMSY may need to raise capital in order to fund their receivables, should they win back their region
    • HMSY already protested this announced change and the protest was rejected last year
    • CGI Group (the same company that botched Healthcare.gov) has been suing CMS and appealing and continuing to drag this process out b/c they view the new contracts as uneconomical
  • So thinking about the new contract, I think it will be:
    • Less profitable - 30-40% of initial revenues seem to be at risk (~40-50% of denials appealed, 60-70% win-rate), yet the company will need the same number of employees to ingest the same number of claims
    • Less cash flow generative - 120 days -> 420 days
  • Scenarios:
    • Scenario 1 (not very likely): The new Medicare RAC program is similar to the old program and HMSY is able to maintain similar profitability/cash flow dynamics
      • I estimate the old program generated probably 15-20c of EPS upside, assuming same $100M revenue run-rate
    • Scenario 2 (most likely): HMSY maintains its current domain over one region with drastically worse payment terms and possibly worse pricing…goodwill write-down possible
      • Depending on revenue recognition, 5-10c EPS upside and terrible cash flow dynamics, assuming same $100M revenue run-rate
    • Scenario 3 (not very likely): HMSY wins a 2nd region…this is unlikely, but would be an upside scenario
      • Depending on revenue recognition, 10-20c EPS upside and terrible cash flow dynamics, assuming same $100M revenue run-rate
    • Scenario 4 (not very likely): HMSY winds up with zero regions…goodwill write-down very likely
      • No upside

• Other
  • Margins may surprise to the downside this year
    • The company is dealing with a lawsuit against PCG that they spent $5M last Q, and this will be an ongoing expense, though they didn't quantify it
    • They also admitted that they will be continuing to invest in the business throughout 2015
  • Recent executive turnover
    • CFO announced he was leaving in June 2014 two weeks after the company announced poor FY13 earnings
      • I will admit, the new CFO seems to be a real guy
    • CMO resigned effective 3/14
    • COO left in 12/12
  • Over time, management has tended to obfuscate growth rates of their segments by not disclosing consistent metrics across quarters, though this has improved a bit recently
    • B/S has been deteriorating (DSOs ballooning) and will likely continue to deteriorate as payment terms on the Medicare RAC worsen and audit appeals occur 
    • The company just wrote down $5M in receivables in Q414 and has had a history of lawsuits brought against them by former customers claiming over-charging

• The company is sandbagging on the opportunity for growth related to the increase in Medicaid lives in 2015
  • Medicare RAC surprises to the upside
  • The ACA creates an entirely new audit/payment integrity program that is not currently envisioned
  • Some of this is predicated on government decision-making and news flow, which has historically been difficult to predict

• Risk = 25x Street Non-GAAP 2016 EPS of 88c (assumes RAC returns), discounted one year = $20 (20% downside)
• Reward = 20x Base Non-GAAP 2015 EPS of 55c (50c base business + 5c of discounted RAC EPS) = $11 (40% upside)