Robert Frist - President, Chief Executive Officer Gerard Hayden - Senior Vice President, Chief Financial Officer Mollie Condra - Vice President, Investor Relations and Communications.

Charlie Eidson - Craig Hallum Richard Close - Canaccord Genuity Ryan Daniels - William Blair Nicholas Jansen - Raymond James Matthew Gillmor - Robert Baird Peter Levine - Needham & Co. Frank Sparacino - First Analysis.

Good day ladies and gentlemen and welcome to the HealthStream third quarter 2016 earnings conference call. At this time, all participants are in a listen-only mode. Later we will conduct a question and answer session and instructions will be given at that time.

Should anyone require operator assistance, you may press star and then zero on your touchtone telephone. As a reminder, today’s teleconference is being recorded. I’d now like to turn the conference over to your host for today, Ms. Mollie Condra, Vice President, Investor Relations and Communications. Ma’am, you may begin..

Thank you, and good morning. Thank you for joining us today to discuss our third quarter 2016 results. Also on the conference call with me are Robert A. Frist Jr., CEO and Chairman of HealthStream, and 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. With that, we’ll begin. I’ll turn the call over to Bobby Frist..

Good morning, thank you, Mollie. Welcome to our new Chicago office. Morrisey is our acquisition this quarter, they’re probably a little busy today celebrating, but welcome all of our new Morrisey employees up in Chicago.

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

So first, let’s take a look at kind of overall, revenues for the quarter came within our guidance range and operating income fell short of our expectations. Our workforce development segment saw strong revenue growth. It was led by outperformance in our resuscitation portfolio, and that has a comparatively lower gross margin on the whole.

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

Then finally, strong sales continued in our provider solutions segment, but revenue trailed expectations due to a growing implementation backlog, which is really an execution issue that we’re working through. So now with those three kind of generalizations or characterizations, let’s go into each segment in more detail.

Within the workforce development segment, our resuscitation portfolio, and I’ll remind you that it’s led by our Heart Code product, continues to perform above our expectations.

Together, this portfolio includes our NRP solution, our Heart Saver solution, our Heart Code products, and a relative newcomer product which is called RQI, and we’re going to need to talk a little bit about RQI to understand what’s happening with the resuscitation portfolio.

These products are focused on teaching resuscitation skills to healthcare professionals, and they are offered through our partnerships with American Heart Association, Laerdal Medical, and the American Association of Pediatrics, and continued outperformance by this portfolio of products will likely continue to pressure the company’s gross margin into the next several quarters, or maybe for a long while as it has a lower overall gross margin profile, so it’s something you have to remember, these products are outperforming to expectations, which if you can back up from it enough is a good thing.

But they do carry lower gross margins, and you probably saw a little bit of gross margin pressure compared to expectations, and that’s due to just this continuing shift.

As we noted in prior calls, in Q1 and Q2 it was our highest performing product, and in Q3 it continued to be a high performing product, and now it’s compounding a bit on its impact on gross margin. Now turning our attention to patient experience, this business segment increased by 2% for Q3 compared to last year.

That was definitely lower than expected, and that has prompted us to lower our revenue guidance for the patient experience business segment for the full year.

We have decided to lower that expectation to zero to 1% growth, so essentially flat, and obviously 60 days ago we had different expectations of that, growing upwards of 6%, and so that is a change in the last 60 days that we’re going to need to talk about. I’ll give you a little color on that here.

During the quarter, we experienced a greater than expected shift from phone-based surveys to online surveys, which does have for us a dampening effect on revenue, and so a little more on that.

Two of our top five customers made meaningful progress collecting the necessary contact information, like emails and cell phones or texts so they could text, and that supports their move to online surveying for non-CMS mandated patient experience programs.

So for example, on the quarter our largest account was able to transition their CG caps program from phone-based data collection to our online surveying platform, and so these online surveys are contracted at a lower price point, but--so the short run impact is lower revenues from that particular survey set. However, it will deliver a lower cost.

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

So finally, we do have to talk a bit about provider solutions. I think we’ve made some really, really good acquisitions in the HealthLine acquisition, as far back as the Sy.Med acquisition, and the Morrisey acquisition.

All are very profitable, high recurring revenue businesses with long histories, and we acquired them at fair and reasonable prices and they continue to perform. Now, two of those businesses had a culture of slow growth and high margins, and we’ve turned those businesses over to a high growth oriented team, and they are beginning to deliver.

They have increased the sales organization from three to five sales people up to 20, and the new business is pouring in.

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

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

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

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

So until we improve the execution on implementations for provider solutions, we’ll not be in a position to recognize revenues from these new accounts. Again, our teams are working diligently, they have a thoughtful plan, and we are having to do a little bit of hiring and also reengineering to do this really well now.

We do have good experience overall at HealthStream at figuring these kind of challenges out and executing on them, so I’m confident we’ll work it through. But for now, we are below expectations on revenue recognition and we’re--we’ve also parlayed that into lower expectations for the next couple of quarters.

That’s pressured again our revised guidance, which we have now provided.

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

So for real reasons, we’ve had to lower expectations, and again relative to our size, fairly--a pretty good move on our declined expectations on operating income because of those two business segments. Again, remember this underlying pressure in the primary segment, which is the outperformance of a lower gross margin business as well.

We’re kind of three quarters into that trend, and that will persist on a go-forward basis if we continue to see that product do really well.

So I think that’s my color on these three segments, some of the challenges we faced in the last, say, 90 days, and how some of these--some trends are positive and have long run, positive implications; others have several quarters of now business execution issues we have to work through.

We want you to know management is fully aware of those and well underway in getting them back where they need to be. Let’s turn it over to Gerry for a dive through the P&L, operating income, cash flow, balance sheet, and then we’ll come back and I’ll continue with my characterization of what we’re doing about some of these situations..

Well, thank you, Bobby, and good morning everyone. I’ll provide some additional information about our financial results, including certain items that impacted the quarter. We’ll also provide background information on the impact of the Morrisey Associates acquisition, which closed earlier in August of this quarter.

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

During the quarter, the Morrisey Associates acquisition that we closed in August contributed $841,000 of revenue net of deferred revenue write-downs. The operating loss related to Morrisey Associates was approximately $1.8 million, including $805,000 in closing costs.

Now [indiscernible] the income statement, revenues, gross margin, operating expenses and operating income..

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

workforce 5% to 6%; patient experience 0% to 1%; provider solutions 80% to 82%. In the workforce segment, [indiscernible] revenues from ICD-10 readiness will be $1 million in the fourth quarter and $8.4 million for the full year of 2016.

This represents an approximate $18 million to $19 million decline from 2015 when ICD-10 readiness revenues were $26.8 million. We anticipate our full-year 2016 operating income will decrease 45% to 55% over 2015.

We expect that our capital expenditures will be between $14 million and $15 million, and once again our effective tax rate will be between 39% and 41% for the full year of 2016.

As many of you already know, we held our client summit in October and [indiscernible] impact is estimated at approximately $750,000, which will be recorded largely in the fourth quarter of 2016, being the current quarter.

This guide includes the anticipated impact of Performance Management Systems, Nursing Registry Consulting Corporation, and Morrisey Associates acquisitions but does not include the impact of any other acquisitions that we may complete during the remainder of 2016. Thanks for your time. I’ll turn the call back to Bobby..

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

First, our clinical courseware products were a large contributor to revenue growth in the third quarter. Clinical products include content from medical association partners, different clinical skills and procedures products, and of course CE Center we’ve talked about quite a lot.

Our association content continues to expand and so do the ways we make them available to our customers. The revenue growth from clinical courseware products was up 32% year-over-year, so this is an area of good core growth in the workforce segment.

Also, just a brief update, our compliance product suite is also in the workforce segment, and we announced the launch of Knowledge Q last year.

It’s an exciting new mobile-enabled solution for hospitals to manage and achieve compliance for regulatory training, and it’s our second product, I’ll remind you, that follows the one we built with Precyse, called DNA, that includes our new control center application.

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

So it’s fun to watch that product begin to materialize into business, which it did in fact do in the last few quarters. We believe that the information and the network effect of having a data-driven product is powerful and has the potential over time to have a positive impact on our business.

During the second quarter, we signed over 74 contracts for Knowledge Q, and I’ll remind you that this Knowledge Q product is an upgrade product from our current core regulatory courseware library, so we’re going from having a courseware library to an application data-driven product, and over 74 customers signed contracts for this new product in the quarter, which is an upgrade.

We get a-it does cannibalize a bit the old courseware sale, but it adds value and we get a little higher price point, and overall the margin on that product is very high, so it was really exciting to see the Knowledge Q product really start to take off in the last, say, 90 days, with 74 upgrade contracts signed during the third quarter.

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

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

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

So as Gerry mentioned, this year we expect ICD-10 readiness revenues in totality to contribute about $8.4 million, and that’s about $4 million of margin, so that’s a decrease of $18.4 million in revenues and $9.2 million in margin from the prior year.

That’s important because as we think forward, we need to think about next year, and unfortunately the ICD-10 readiness story isn’t quite over.

So we expect, for example, the ICD-10 readiness product will generate less than $1 million in revenue next year, which given our $8.4 million this year would represent yet another decline next year of $7.4 million and a decline of $3.7 million of margin.

So again, it’s significantly smaller than the decline from ’15 to ’16, but I just want everyone to make sure they’re thinking about as we enter ’17 that there’s another $7 million decline that we’ve got to climb out of and overcome with other growth products, some of which I’ve already mentioned.

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

We announced in August that we acquired Morrisey Associates, which expanded our provider solutions segment and brought in market-leading products on credentialing and privileging. It’s a new area of focus and strength for the business.

Coupled with our acquisition of HealthLine, we believe we’re very well positioned to build off the synergies in this business in the future, but this business as we mentioned is having the challenge we talked about, about the implementation backlog.

So completing these three acquisitions, we still continue to maintain an active M&A pipeline, although for the next 60 days I’d say we’re pretty focused on the execution of some of the challenges I outlined a little bit earlier. So as I conclude, I’d like to remind us of all the moving parts.

I saw that one of the analysts talked about the amount of movement going on inside of our business, and it is true - this is a period of great movement and it’s hard to see all the moving parts, so let’s kind of refresh on what some of those moving parts are.

First is the retirement of the ICD-10 readiness products and their impact, which we discussed.

Second, these acquisitions we’re doing, there’s a little bit of work-through on them but we’re very confident in them, and they do come with this accounting convention of deferred revenue write-down, and that accounting treatment will persist for the next several quarters, particularly as we just completed the Morrisey acquisition.

We want to make sure that everyone is thoughtful to that deferred revenue write-down, kind of an accounting convention. Third, our PX business is obviously struggling to expectations, and it’s not really helping matters that our new higher margin products also have lower price points, which challenges the top line growth rate into the future.

You know, it’s not just the mix of lower price point that affected the third quarter. It is also in fact lower than expected sales and the timing of those sales in some cases, and so we--you know, we have a good fight going on there.

We’re bringing in business a little late to expectations, and so we have had to revise the guidance down for that segment disappointingly to really a flat business this year, and that’s having its impact, and also with that price point pressure and the trend again towards higher margins over time but lower revenue growth, that will have a dilutive effect to our overall growth rate into next year.

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

So just because we’re a little behind on revenue recognition in provider solutions, we’re not going to trim our expense run rate, and again you can see that in our lower operating income guidance expectations. I think these will prove wise investments over time.

They are clearly providing short run disappointment as we revise our operating income guidance expectations for the quarter, but we’re going to continue to do what’s right for the long term of the business, which is to get these businesses and products and exciting new data-driven products into the market.

So we just want to remind everybody that these--some of these pressures continue on into next year, and as Gerry mentioned, we modeled our third quarter--tried to model out the noise.

Organic growth rate is about 14.7%, and some of these pressures are taking root and will continue to affect us into the coming quarters and years, and so we want to just reiterate that when we factor out the deferred revenue write-down and some of the other issues we talked about, kind of the core growth rate we’re looking at in the third quarter is 14.7%.

So we’ll wrap up. I do want to wrap up by mentioning that we had an incredibly successful customer summit. Over 800 customers came to Nashville.

We actually co-hosted two events at one, our normal summit and an echo user group, which had about 170 attendees, was co-located in downtown Nashville, across the street actually, with our typical customer summit. We had over 46 speakers present 75 breakout sessions, three keynotes, 800 customers.

We conducted research and development on exciting new products, and launched a few new products as well, an incredibly successful but busy week, and I want to congratulate all of our employees who worked on pulling off that summit.

It was really a great testament to our culture, our customers that came to see our exciting business and our development teams that are focused on new products research while all those customers were in town. It was really, really a great, great week last week.

Then finally, I can’t go without mentioning as we welcome our new Morrissey employees, that the Cubs won the World Series and they’re probably not listening in on this call right now, but we’ll welcome them later when they settle down a bit and come to the reality with the celebration they’re having. I’d like to turn it over.

We’ve got a lot of questions. We have some challenges to talk through, so let’s get right to the questions. .

[Operator instructions] Our first question comes from the line of Matt Hewitt of Craig Hallum. Your line is open. Please go ahead..

Hi, this is actually Charlie Eidson on for Matt. Thanks for taking our questions. .

Sure..

First question I had was kind of related to the survey trends, what you’re seeing. You mentioned that a couple of your larger customers switched to online-based surveys from phones, given that they had more data.

Is this something you see as a trend long term, or could we expect to maybe move back to phone-based? What are you seeing as the preferred method long-term for customers?.

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

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

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

It will take time, it will take multiple quarters to see those improved margins come into play while simultaneously it will pressure the top line overall growth rate the more we have success in that migration.

So I would call it a trend that will carry forward for a while now and maybe indefinitely, and it is a desired outcome but it may rethink--it may have us rethink and have us focus more on margin for that business than top line revenue growth for that business as we think forward to the next year..

Okay, that makes sense. Thank you.

Then I guess related to your investments in the future and your product development and what you’re seeing and how your newer products might be higher margin but lower revenue, and from a product mix perspective that’s then kind of an issue, with your products in the pipeline, what are you seeing as far as margins? Should we expect margins to rebound going forward, or I guess just some thoughts on that would be good..

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

All of those products are doing very well, and in an absolute sense they’re all growing and contributing more absolute dollars to EBITDA, but at a--they do carry a lower gross margin than most all of the products that HealthStream carries. They do carry a lower gross margin than almost all, within workforce and across the company.

So we have seen--we reported in Q1 that we saw incredible sales results on those products. We reiterated in Q2 that we saw strength in those products yet again, and that persisted in Q3.

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

That said, we noted in our patient experience business a shift to higher margin products, albeit with lower price points, and so all of these things will push and pull on our gross margins, and as you can see the effect in Q3, we had a dip in the gross margin, a pretty good basis point dip in the gross margin in Q3 that will probably persist in Q4, and then when we give guidance for next year in February, we’ll have a lot more clarity about the mixture of the relative movement of all of these parts for next year when we give more clarity for next year, usually around February of next year..

Okay, that’s extremely helpful. Thank you..

Thank you. Our next question comes from the line of Richard Close of Canaccord Genuity. Your line is open. Please go ahead..

Great, thank you. Gerry, I was wondering if you could go over the operating income guide in a little bit more detail for us.

How much is maybe related to the revenue adjustments, I guess on the provider solutions, patient experience, and then maybe the expense lines for the operating income guide?.

Well--.

Yes, we’re here. Gerry’s a little further away from the microphone, so let me kind of reiterate a couple of things.

Most of the change in guidance is tied to the two business segments, as you noted, I saw in your pre-note, Richard, of the patient experience business and the provider solutions business, both which underperformed on the top line roughly about a million each to our internal thinking.

So if you play that all the way down through margins and operating income, those two are really the drivers where we missed the top lines of those businesses to our expectations and they played out all the way down through the bottom line.

So it really is kind of a flow-through issue on lower than expected either material--the materialization of revenues from provider solutions, where we have that big backlog that’s growing, and the way that played out in our revenue expectations.

Then on patient experience, it’s probably a little more on the sales side and then a little bit on the revenue mix side as we talked about move to lower price points that caused that revenue to be lower than expected.

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

Yes, Richard, it’s actually the Morrisey effect for the fourth quarter as well. That gets added to that guidance range for the fourth quarter. .

Okay. I guess I’m just trying to understand a little bit, because Morrisey was done in mid-August, and then it’s a pretty big change, so I’m just trying to--.

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

Then secondarily, I would attribute it to some of these mix issues, say for example in workforce, relative to our expectations the mix continues to shift to a lower gross margin product, so when you’re modeling, you need to think about resuscitation products delivering a lower gross margin than the blend of our company, and so that gross margin line you might see more impact, a cumulative effect of three quarters of outperformance for resuscitation products is now compounding into a lower gross margin, and so that would be the third element.

Again, that’s not a change in the last 60 days, but it did--it does continue to compound as we had another third quarter of incredible results with that product. That’s kind of a third dimension to this.

If I had to list them, it would be the backlog, $5 million backlog in provider solutions not turning to revenue, a shortfall in sales in patient experience, and then a slight shift in the mix there that we talked about, lower price point, and then third I would say the compounding effect of continuing outperformance of resuscitation at a lower gross margin than most everything we carry in the company.

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

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

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

Okay.

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

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

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

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

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

So once they get enough data, they move their CG-CAHP surveying. We both allow them to and encourage them to. So again, hard to model. Not a surprise, meaning we were marketing it as an opportunity, but the timing of which in both those large customer cases occurred in the last 60 to 90 days, and it was their decision to make that shift.

It’s a logical and desired decision, though..

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

Yes, so they did jump a little bit. Our goal is to have those get back to a more normalized range, which is roughly 57 to 60 days or so by calendar year-end. One piece of that is also we picked up the balances from the Morrisey Associates acquisition without all the revenues, so that does have a minor effect on the calculation.

But the economic substance is that we are a little bit higher and we do have plans to get those back down by calendar year-end..

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

No, because that would be--that wouldn’t be billed until we do begin the [indiscernible] actual access to the software. So that’s more of a business issue than an accounting and finance issue at this point..

Yes, you know--and I’m not a big fan about talking about macro situations; however--so for example, our sales pipelines were good in Q3 in spite of what we’re hearing about macro conditions in healthcare.

But I would say that if I were to say where there might be some macro things for us to watch, it might be getting stretched a bit on receivables and payables for hospitals being stretched. So I think we’ll put our [indiscernible] in place to have better collections.

We have better technologies now, we’ve built faster with our new Netsuite products, and so we are making improvements simultaneously.

But I would say if there was anywhere that I would say there might be a macro thing for us to watch while we’re trying to improve that, as Gerry mentioned, it would be in this area where hospitals may try to stretch a bit their payables.

I haven’t seen any material changes in default rates or anything like that, that concerns me, but I would say that it is logical right now, given the overall environment, that hospitals may try to stretch their payments a bit with their vendors..

Okay, thank you..

Thank you. Our next question comes from the line of Ryan Daniels. Your line is open, please go ahead..

Hey guys, thanks for taking the questions and all the detail so far. Gerry, maybe a quick follow-up for you just on the contracted subscribers. I know that was down a bit sequentially. Assuming that was due to ICD-10 only rolling off, so I’m hoping we can get the current number of ICD-10 only that are on the system..

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

Okay, that’s helpful.

Then going back to the provider services, I know a lot of color on that, but can you talk a little bit more about the solution to the implementation jam? Is it really more on the technology side where you want to invest, is it more on implementation teams and staff, is it on training there, number one? Then number two, are you actively slowing the sales down such that you’re not kind of continuing to add to that backlog and then having to go back to customers and say, well, we can’t get you up and running when promised and risk alienating them?.

Ryan, it’s Bobby. I would comment on that a little bit. So it is a little bit of needing to add some operations personnel to work through the backlog. It’s also just getting better organized. These were low growth cultures when we acquired the companies, and they’re having to be oriented to having new scale on the pipelines coming at them.

So we probably underestimated and need to add some people and some expertise to help with that process, and so we’re doing that now.

To your question on the sales front, I would say that--one thing I know that leadership has done is ask the sales organization to be more involved in the handover process with the people that they’ve sold to, that are in the backlog.

So I would say we will see a little slowing of sales as the sales team now is part of what we’re calling the surge effort - you know, talking to, communicating with and working with the customers that were sold to make sure they understand that we’re working through these and working to get to them as fast as we can.

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

But I would say we have asked our sales organization, that group which has gone from about five to 20 people or more, to slow down a bit and be part of the thoughtful plan we’re calling the surge, to talk to, communicate with, stay in touch with all the customers in the backlog.

By its nature, by asking them to spend time a little bit there, they probably will see a little slowing and I would say that’s a little bit of a desired outcome right now, because we need to get operations in parallel and in capabilities to sales team..

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

I’m curious what portion of revenue there is sold to customers that is above and beyond the mandate, meaning with the mandate they have to do phone or mail, but for the above and beyond they can do the transition to e-surveying.

So is that still a significant portion of your revenue, number one, that could be cannibalized? Then number two, how much up-selling opportunity do you also have as you expand e-surveying into customers who don’t go above and beyond the mandate? Thanks..

Yes, so a derivative of that question is kind of expectations as we think forward. I would say that management’s attention has turned to fixing the margins and profitability of that business, and these are more profitable products.

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

So if you went to any of our big health system customers and said, you’re doing your CG-CAHPS with phone, you could switch it to e-surveying, they have a process to undergo to get ready for that, like collecting emails or collecting cell phone numbers.

But I think they view it as an opportunity to cut their costs, collect more data, maybe even move more to a census-based approach where we get more data for them, and overall they spend a little less money and then our margins would boost. So I think that those are some of the trends we’d see as we think forward.

You’re going to see management focus a little more on getting all these customers to use these new modalities. You’ll see a little more focus instead of on top line growth and repair there, on margin expansion. It will take us several quarters to see that, though, because the rate of shift is such that it will take time to materialize.

So second half of next year, we should be seeing important margin expansion in that business, which I’m excited about.

I know it’s hard to say because this is going to--this strategy dilutes our growth rate overall as you think about next year, but it just is time for that business to be profitable and get the data people want at the scale they want it, and these new modalities allow for that, for them to get more data, get the data they want, get it faster, and it makes us more competitive frankly in our service offerings.

So these are all desired outcomes, but they will pressure that top line growth. So I’d say almost all customers have some business that we should be moving to this new modality. .

Okay, makes sense, and very helpful. Thank you..

Thank you. Our next question comes from the line of Nicholas Jansen of Raymond James. Your line is open, please go ahead..

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

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

Yes, so one of the things to note about it is our new products that we’ve been building now.

We kind of owned another problem that we’re almost through now related to the patient experience business, and that is we acquired a consultancy a few years back that was--had a lot of intellectual property, like they were really good at advising how to improve the patient experience.

Now, our vision for that acquisition wasn’t to be necessarily a growing consulting business, it was to build curriculum, online intervention tools from what they knew that would improve the patient experience outcomes, the actual CAHPS results.

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

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

The data is one part of the story, but intervening with the workforce, developing them to get a better outcome was another part, and again it took us way too long to build those kinds of tools, but the good news is that we’ve launched them and we actually saw our first sales on that product coming in this quarter, and a good pipeline on them.

So another thing for that business that could drive margin expansion next year is that the educationally related products that are core to our business, that relate to patient experience are now in the market and we have good hope for them as well. So I hope that gives you a little color.

We think it is aligned with our core because it is a problem in healthcare that is rooted in the workforce, meaning there’s really no way to get better CAHPS scores without better trained and better developed and better selected people, and so it’s consistent with our business model to have the data about the outcome, which is the CAHPS data, and then have the intervention tools that are online, like what we mentioned with Develop Rx in the market.

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

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

Yes, so the HealthLine piece is pretty much going to be fully absorbed by the end of the year. If you go to the back of the press release, there’s a table that shows the quarter and year-to-date impacts of the deferred revenue write-downs. I suggest picking up the same relative proportions of deferred revenue you see on HealthLine for Morrisey.

That would be a good approximation. History will be a good guide to the future. .

Okay, I’ll leave it at that. Thanks..

Thank you. Our next question comes from the line of Matthew Gillmor of Robert Baird. Your line is open. Please go ahead..

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

Can you maybe describe the competitive environment both in the credentialing and the privileging side, and then also give us some sense for how your platforms are differentiated?.

Sure. So we’re really excited about that business, and for lots of reasons. One, the two businesses we acquired have been around for a long time, they have very sticky software applications.

They’re really often considered a source of truth on data about some of the most important people in healthcare, the doctors that generate a lot of the revenue, and so we’re excited to be in the business of managing the data about those people, the doctors.

Increasingly actually the prescribing nurses are being added to the credentialing process, so if you think overall, having this software in place, and about half of U.S.

hospitals through the acquisition of Morrisey and HealthLine gives us really a market leading position to manage data and know a lot about the people of healthcare, the workforce here, the providers and the prescribing nurses. So we like overall the strategic position that we’re in, and then from a potential standpoint, it’s really fascinating.

Some of our advantages, I’ll articulate one, you may remember, and if you look back at our history we acquired a company called Sy.Med, and they had a credentialing and privileging type of solution and what’s called provider enrollment solution that they sold to physician practices.

So they’re in hundreds, I think over 800 or more physician practices, and with their solution which does a little bit of credentialing, a little bit of privileging but a whole lot of what’s called provider enrollment, which uses the data about physicians to get them enrolled and kind of revenue ready, if you will.

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

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

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

When we acquired Morrisey Associates in Chicago, we inherited a privileging library, which is a form of content that goes into a credentialing system or a privileging system.

So while we’re a market leader in the software to manage credentialing and privileging, we now have what we think is the premier library of information, the privileging library from the acquisition of Morrisey which can be cross-sold to all the customers at HealthLine.

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

Also, the thing I love about this model is that data about physicians is very important, and we’re in a great position there.

Privileging is a form of content that’s sold to the people that own the software, so it’s just like our learning platform creates consumption of courseware, the privileging and credentialing software creates consumption of a privileging library. So we like the fact that they are kind of additional products to cross-sell and up-sell into that market.

Then overall, the landscape, it’s not a huge, huge market. There’s a handful of other consolidators we compete with that we feel well positioned to compete with in this marketplace of credentialing and privileging.

One of those companies was a company called CACTUS, that was kind of also in the market along with HealthLine and Morrisey that’s been recently acquired by a private equity group and rebranded, and so they would be one of the primary competitors you could take a look at as well.

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

Great, thanks very much..

Thank you. Our next question comes from the line of Scott Berg of Needham & Company. Your line is open, please go ahead..

Great, morning. This is actually Peter Levine in for Scott. I was wondering if you could break down the dynamics of what drove your ARPU number up sequentially.

I mean, I guess expectations on ARPU, taking into consideration the ICD-10 runoff would have had that number kind of slightly under pressure for the remainder of the year, so question is did the Morrisey acquisition impact that, and if so, can you give us a sense of what that organic number would have looked like?.

Yes, so there’s no impact from acquisitions on the ARIS because the Morrisey Associates numbers are in the provider solutions segment, and the ARIS is only the workforce segment. I think the themes to look at on the ARIS for this quarter, one is the revenue for that, subscription-based revenue, that portfolio was up about 5%.

As you look at the subscriber count, it’s roughly flat, so therefore you get [indiscernible] to the increase.

Does that help answer your question?.

Yes, great. Thanks.

Then I guess most of my questions have been answered, so if you look into ’17 next year, any changes that you see in terms of spending patterns across all your product lines that could change the make-up of [indiscernible]?.

Yes, let me take that one. So as most of our analysts who have been with us for a long time know, we provide detailed guidance about ’17 when we get more clarity, and we’re just not through our processes yet of getting a board-approved budget.

We came out of our retreat with a lot of great ideas, and throughout December we’ll get a board-approved budget and then in February we’ll provide detailed guidance about all the decisions we make, and also obviously we’ll know more about the fourth quarter played out.

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

I’ve seen a lot of models that keep talking about 20% organic growth rates, and I just think--again, we don’t have enough clarity to provide a full advanced look at next year, and we look forward to when we have clarity on the fourth quarter and when we have the results and decisions we’ve made about investing by finishing our budget process--we haven’t finished our board approval process for our budget, so our expense categories, we haven’t decided yet exactly fully how to ramp up each of those areas, like sales and marketing and tech.

We will continue to invest in those areas, though, commensurate as we’ve done in past years.

But I would say that some of these trends we’ve noted have continued pressure on kind of top line, core growth, for example the shift in patient experience business is one that we need to--you need to be thinking forward about next year if we’re successful in these migrations to more online surveying.

That growth rate, which we’ve now moved to nearly flat with more of a focus on margins, will continue to be dilutive to our overall growth rate at its core, and so just a bit of thinking forward about that overall core growth rate, it will continue to pressure.

Then on the margin side, about all we can provide right now because it’s all we know, is that this resuscitation portfolio is also providing great financial opportunity, but it’s pressuring gross margins. We don’t see any letting up in that product right now.

I hope and expect it will have another good fourth quarter, and that sets up a little bit of margin pressure for next year as well. So I think that--again, I know it’s a tough position to be in, but we don’t have all the data to give the guidance about next year. We need to wait until February.

We’ll make a lot of actual decisions that impact that final decision on overall investment rates, as you asked. But I do think we have enough signs now about some of the items we’ve clearly listed out today to think about that growth rate, and there will be some pressure on that core growth rate next year..

Great, thanks for the insight..

Thank you. Our next question comes from the line of Frank Sparacino of First Analysis. Your line is open, please go ahead..

Hi guys, we can talk offline for the sake of time, so I’ll drop out. Thanks..

Thank you. Our next question comes from the line of Richard Close of Canaccord Genuity. Your line is open, please go ahead..

Yes, just a quick couple questions here. With respect to PE and the margin improvement, understand it’s in the back half of next year.

What do you see as the long term margins in that business once the shift occurs from phone and paper to the online format?.

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

Okay. .

Did you have another question?.

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

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

Everybody on the HealthStream team is working really hard and set a great trajectory of new product introductions and exciting new offerings to take to customers, so we look forward to continuing our reporting. Probably the next time we get together, we’ll be talking about our guidance for ’17 in great detail.

We’ll have a lot more clarity on that, so we look forward to our next earnings conference call with all of you. Thank you, and we’ll talk to you soon..

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