Richard Zubek – Investor Relations Lisa Im – Chief Executive Officer Hakan Orvell – Chief Financial Officer.

Edward Caso - Wells Fargo Anj Singh - Credit Suisse Michael Tarkan - Compass Point S.K. Prasad Borra - Goldman Sachs Toby Wan - Obsidian Research.

Greetings, and welcome to the Performant Financial third quarter 2014 earnings call. [Operator instructions.] I would now like to turn the conference over to your host, Mr. Richard Zubek with investor relations. Thank you, you may begin. .

Thank you, operator. Good afternoon, everyone. By now, you should have received a copy of the earnings release for the company's third quarter 2014 results. If you have not, a copy is available on our website, www.performantcorp.com. Today's speakers are Lisa Im, chief executive officer and Hakan Orvell, chief financial officer.

Before we begin, I would like to remind you that some of the comments made on today's call including our financial guidance are forward-looking statements. These statements are subject to the risks and uncertainties as described in the company's filings with the SEC. Actual results may differ materially from those described during the call.

In addition, all forward-looking statements are made as of today and the company does not undertake to update any forward-looking statements based on new circumstances or revised expectations.

Also, non-GAAP financial measures discussed during this call are reconciled to the most directly comparable GAAP measures in the table attached to our press release. I would now like to turn the call over to Lisa Im.

Lisa?.

Thank you, Rich. Good afternoon everyone, and thank you for joining us for our earnings call. During the third quarter, we reported overall revenues and adjusted EBITDA of $39.6 million and $5.8 million, respectively.

These results were softer than we had anticipated as new documentation requirements in our student lending market pushed out revenues that we expected to recognize in the quarter.

As we look specifically at our key markets during the third quarter, total student lending accounted for revenues of $28.1 million, which is down approximately 29.9% sequentially and down 35.3% from the 2013 period.

During the third quarter of 2014, we received total loan placements of $1.7 billion compared to the $2.2 billion we received in the prior year period and the $1.9 billion we received during the second quarter of 2014. On a year to date basis, placements are even with prior year levels.

As we discussed last quarter, part of the decrease in student lending revenues was anticipated due to lower rehabilitation revenues from our guarantee agency clients following changes to the fees those clients receive upon rehabilitations that became effective on July 1, 2014.

This accounted for about $5 million of the revenue decrease during the third quarter. Also impacting the quarter was the effect of new documentation requirements that were imposed by some of our guarantee agency clients as they implemented income based repayment, or IBR.

As you know, IBR has increased the pool of student loans that can be successfully rehabilitated, but with that has come additional requirements to establish borrower eligibility for IBR.

These new requirements were retroactively implemented, which required additional time and interaction with borrowers, which delayed some loans from qualifying for rehabilitation in Q3. We will continue to adjust our process to meet the new requirements through Q4 and expect that this will impact Q4 at a lesser level.

We are still awaiting word about the award of the new contracts by the Department of Education. The current contract has been extended to April of 2015 and we believe the new contract will become effective at that time.

Revenues in our healthcare business during the quarter were $5.2 million, lower than what we reported during the third quarter last year, but expected due to the transition and wind down of the original CMS contract. Net claim recovery during the third quarter was $46.1 million.

As we discussed in August, CMS allowed the recovery auditors to restart some reviews during the quarter, including a limited number of automated and complex reviews of certain specific types of claims.

The limited restart is currently scheduled to continue until year end, but is not expected to significantly impact our fourth quarter revenues due to the timing of the restart. Since our last earnings call, there have been a couple of developments as it relates to the CMS recovery audit contract awards. In mid-August, the U.S.

Federal Court of Claims found in favor of CMS and denied a suit against changes to the payment terms in the new contracts, but in early September, the court granted a stay to allow an appeal to the federal circuit, effectively halting the award process.

From the court documents, we understand that the appeal is proceeding on an expedited basis, but we don’t know when this will be resolved or when the new contracts will be awarded. Another development related to the CMS contract involves CMS’s efforts to resolve a backlog of appeals by providers.

In September, CMS announced an offer to settle provider appeals of part A and part B issues at the ALJ level for $0.68 on the dollar. Keep in mind that appeals at the ALJ include all program integrity contractors for Medicare/Medicaid state agency appeals for dual-eligible beneficiaries.

Moreover, there has been a significant increase due to the sheer number of beneficiaries who utilize services covered by Medicare, according to the Office of Medicare Hearings and Appeals.

The implications of this settlement offer related to claims that have already been paid to recovery auditors are unclear at this time, and would depend on a variety of factors, including the number of providers that accept the settlement offer, how appeals are validated for the recovery audit program, and the time required to work through this backlog, so at this time, it is premature to speculate on how this may impact and potentially relieve our appeal reserve.

Overall, as a reminder, we have reserved for claims that may be overturned on appeal, and we believe that our current reserve balance is a fair estimate of the amount that we expect to be required to be returned. With that, I’d like to turn the call over to Hakan to walk you through the financials.

Hakan?.

Thank you, Lisa, and good afternoon everyone. Today, we’re reporting results for the third quarter with revenues of approximately $39.6 million, net loss of $479,000, or a loss of $0.01 per share, and adjusted EBITDA of $5.7 million. Student lending revenue totaled $28.1 million, a decline of $15.3 million compared to the third quarter of last year.

However, approximately half of this decline is the result of timing delays associated with additional documentation required to authenticate the status of individuals that utilize the rehabilitation process to remedy their defaulted student loans.

Third quarter 2014 placements were $1.68 billion, which is down from $2.14 billion we received in the third quarter of 2013, and a slight decrease from the $1.86 billion in placements we received in the second quarter of 2014. Revenues as a percentage of placement volume in the third quarter were 1.7% compared to 2% in the prior year period.

Our healthcare revenues in the quarter were $5.2 million compared to $28.3 million in the third quarter of last year. The decrease in healthcare revenues was primarily due to the contract wind down of the CMS [RAC] contract in advance of a new contract ramp up.

While our net claim recovery volume decreased to $46.1 million, our claim recovery fee rate remained flat at 11.3%. Revenues from other markets in the third quarter were $6.4 million compared to $5.1 million in the prior year period, primarily as a result of favorable activities with some of our larger clients in this category.

Moving to our expenses, salaries and benefits expenses in the third quarter were $22.2 million, a decrease of 11.5% compared to $25.1 million in the prior year period. Other operating expense for the quarter was $15.7 million, a decrease of $7.9 million primarily due to the wind down of the CMS RAC contract.

For the third quarter of 2014, our reported net loss was $479,000, or a loss of $0.01 per share, compared to net income of $15.5 million or $0.31 per diluted share in the prior year period. Adjusted net income in the third quarter was $743,000 or $0.01 per diluted share, compared to $16.6 million or $0.34 per diluted share in the prior year period.

Fully diluted weighted average outstanding shares were 49 million shares in the third quarter of 2014. Our adjusted EBITDA in the third quarter was $5.7 million compared to $31.7 million in the same period last year.

Our effective tax rate in the third quarter of 2014 was 26.8% and cash flows from operating activities in the third quarter of 2014 were $25.9 million. However, our effective annual tax rate for 2014 is expected to be 42.7%. Turning to the balance sheet, as of September 30, 2014, we had cash and cash equivalents of $85 million.

Our total outstanding debt as of June 30, 2014 was $114.3 million. The sequential decrease in outstanding debt reflects continued payments on our long term debt.

In light of the prolonged, unexpected delays for the CMS contract award and other transitions and timing issues, we have proactively amended some of the terms in our credit agreement to address this situation. This amendment is expected to provide us with room to maneuver the company through the much delayed RAC contract process.

Let me now turn the call back to Lisa for some concluding remarks..

Thanks, Hakan. Before I get to our outlook for the year, I want to discuss recent developments on our Department of Education contract and our commercial healthcare opportunities.

With respect to the Department of Education contract, upon rehabilitation of a loan we previously received a success fee based on a percentage of the loan balance after nine consecutive payments had been made by the borrower.

However, the Department of Education recently advised us of a revised pricing structure that goes into effect on April 22, 2015, where we would receive a fixed fee amount of $1,710 for a successful rehabilitation.

To put this fixed fee into context, hypothetically, based on completed loan rehabilitations thus far in 2014, the new fixed rehabilitation fee implies a decrease in Department of Education revenues of approximately 13% in a scenario where everything else remains the same.

But clearly, with the smaller scope of the Medicare recovery audit extension, the guaranteed agency fee reduction and this Department of Education fee change scheduled for April of 2015, everything can’t stay the same, and we have the challenge of changing how we perform our work to maximize productivity.

As a response, across every part of our operation, we will reduce organizational expenses as well as streamline and enhance productivity by aggressively engaging technology, workflow, and analytics.

When we evaluate our commercial healthcare business, we feel very strongly about our market position and the future potential of this business as we are seeing a significant positive shift in momentum going into 2015.

We are ramping services for commercial clients with our current offerings, and as our contracts with these clients mature, we believe there are tremendous growth opportunities as these clients have an aggregate membership in excess of 80 million insured lives.

In parallel, we continue to invest in our sales organization and growth strategy to accelerate penetration within mid-tier health plans nationally. While we are intensely focused on increasing product penetration with our national payer accounts, the implementation process for some of our contracts has not been as timely as we would have liked.

As a result, we now expect 2014 commercial healthcare revenues will be below the lower end of our original range of $5 million to $15 million. However, as these contracts come online and ramp, it is our expectation that we will recognize significant revenue from the commercial healthcare sector in 2015.

Finally, regarding our outlook, we are reducing our view of the fourth quarter somewhat due to our expectations that some student loan revenues will be pushed into 2015, due to the documentation requirements that I discussed and the slower than expected ramp on the commercial healthcare contract side.

We now expect 2014 full year revenue to be in the range of $195 million and $200 million, with adjusted EBITDA to be between $44 million and $48 million. With that, I’d like to open the call up for questions. .

[Operator instructions.] Our first question is coming from the line of Edward Caso with Wells Fargo. .

My first question is just on the RAC. Maybe a clarifier.

Is the partial restart running all the way through when the new award starts, or does that just run through the end of the year?.

At this time, the extension runs through the end of the year. The last communication that we received from CMS, we believe that they would like to keep the program consistent without any additional pauses.

That comes from earlier in the summer, when they actually implemented this current work period in which, again, the scope was smaller, but the intent was to restart the audit and recovery of Medicare dollars. So we believe that CMS believes in the program, and we believe it is their intent and their objective to keep the program going. .

And just sort of a follow up on the RAC, earlier this week it looked like CMS put out an update that said the RAC region three and DME contracts are going to be moving forward, I think it said by the end of the year, but the other regions, the protests aren’t expected to be resolved until late summer 2015.

Is that consistent with what you’re hearing, or is there any color that you can add to that?.

Well, we read the same posting. I think the only thing that we might add is just, I think as we read it, we actually thought they felt the awards might be made by late summer, in the hopes that, again, the resolution of the lawsuit in the appeals court will actually be resolved early in 2015. So we read the same thing you did.

I don’t think there’s any more color that we can add, other than our takeaway was we thought the awards might be made by late summer..

Our next question is coming from the line of Anj Singh with Credit Suisse. .

I guess first off, on the limited activity that you’re able to start on the current contract, do you have an estimate of what the contribution that could be for next year? Or is that still unknown at this point?.

We are actively working based on the scope that we have on this extension. Most of that revenue, as we stated, will be recognized at the beginning of next year. So as we look at this particular window that we have, we believe that that revenue could be in the range of $3 million to $5 million.

And again, we’ll see, as Lisa mentioned, what further extensions, and what further potential scope increases could be implemented as we enter into next year..

And then on the issues regarding the new documents, should we view these as deferred revenues. It sounds like they’re deferred revenues, but unclear as to when they might come in.

When should this issue resolve and I guess when should those deferred revenues perhaps start being recognized?.

Yes, I think it’s correct to characterize it as deferred revenue. We are working through this very actively as far as meeting and fulfilling the needs associated with this new program that went into effect in July. So we saw some of this being resolved in the latter part of Q3, and we’re actively working on it as we speak right now.

So it’s hard to accurately determine exactly when all this will flow through. It’s deferred, it’s not lost revenue, and we anticipate to recognizable that revenue over Q4 and into Q1 as well..

Do you have an estimate of what the size of that revenue push out was?.

As we stated in our remarks, as we compare to last year, and you compare quarter over quarter, about half of the decrease in revenue this quarter relates to, again, the delays in revenue recognition. .

As we think about your expenses, can you discuss what has been the biggest area of the expenses that you've taken out in the other operating expenses? And as we look forward, where do you see more opportunity to rationalize expenses?.

As you can see in our press release, our expenses this quarter is down pretty materially versus not only last year but also versus Q2. So we had taken appropriate measures, as we are going through this transition, to adjust our overall expense level. And you see salaries and benefit expense is down about $3 million this quarter versus last year.

Other operating expenses lower by $8 million.

And again, to give you a bit of perspective on some of those other operating expenses, what falls into that category is subcontractor fees, so as we look at and the RAC program in particular, as you get this wind down that we’re seeing right now in this quarter, based on the lower revenue, there is, again, no expense or much lower level of expense, for subcontractors that we have used under that program.

And then you have other volume related expenses as well that are lower just based on the lower revenue that we have seen this quarter..

Our next question is coming from the line of Michael Tarkan with Compass Point. .

Just first on the student lending side, I appreciate the color around the new fixed payment, but I guess you had mentioned that all things equal, it’s a cut of around 13% based on what you’ve done year to date. But isn’t it fair to say that the dynamics of the underlying business would change, and sort of the incentive structure.

With that change to a fixed payment, couldn’t that completely alter the way you actually conduct the business and go after different types of loans?.

That’s a fair statement, and that is certainly a part of our strategy overview. So as I mentioned in the call, we are certainly looking at streamlining, we’re looking at increasing productivity, we’re clearly looking at the types of borrowers who fit the profile. So we are addressing this in a very proactive and aggressive way.

That would certainly be one of those considerations..

So if you are paid a fixed amount, just asking it a different way, per recovery, would you consider rehabilitating maybe lower balance loans, which may be easier to recover as opposed to some of the higher balance longer tailed defaults?.

I think the way we actually rehabilitate borrowers now, just based on the policy directive for income based repayments or the pay as you earn, the borrowers who are eligible for rehabilitation, regardless of loan balance, but more so dependent on their monthly income, is really the target.

So we wouldn’t necessarily target lower balance loans versus higher balance loans. We would target the portfolio in terms of borrowers who would qualify for rehabilitation who are very interested in resolving those obligations and really kind of taking the direction of client and maximizing our productivity under those rules. .

I guess directionally, I’m not asking for you to provide some guidance here around the segment related revenue, but just directionally, it sounds like you have some deferred revenue that’s going to move from 2014 into 2015, and this is all on the education side.

I’m just wondering, should we still expect revenue growth in that segment even though this changing compensation structure is going to take place?.

Not to provide guidance on a segment basis.

Again, we clearly mentioned the move toward productivity, and while this is a unique situation from the pricing perspective, as you know, our productivity can be leveraged through technology and analytics, which we really think differentiates the work that we do for our clients, as well as our ability to move the operational needle.

So as we look at what’s happening in the industry, clearly no one likes to see increases in defaults, but unfortunately that is still the case in student loans, as well as in the guarantee agency channel of federally guaranteed student loans.

I think we mentioned earlier in the call that we would expect to see some level of consolidation of smaller guarantee agencies into larger ones, and that we do service and have the privilege of serving clients, six of the eight largest agencies..

I guess shifting gears onto healthcare, of the $5.2 million worth of healthcare revenue this quarter, can you let us know sort of how much came from the commercial side and how much came from the RAC business?.

We don’t have it broken out, but what I can say is, as we look at the commercial healthcare, it’s ramping up, so we have seen a steady increase in that revenue on a quarter over quarter. And then again, as we look at the RAC wind down there’s been an offset there.

So overall, we’re encouraged by, again, the quarterly trends that we’re seeing in the commercial healthcare side..

I guess sticking on that side, one of your competitors came out this week and said that they think they can run the RAC business at a breakeven perspective from an EBITDA perspective by shifting some costs out.

Do you think you can do the same thing for 2015?.

Yes, Mike, we do see that as well, that we have those abilities to, again, generate that program at a positive EBITDA..

With the DME contract potentially coming out by year-end, how confident are you in your ability to potentially win that contract?.

We’re hopeful. Obviously, we believe we submitted a good response. We think our results are very strong in the program. In the last report to Congress that DMS published, we had the highest accuracy of the recovery auditors. On a provider basis, our results are very competitive with the best.

Again, the limitations we had of hospitals that we could audit and were not periodic interim payment providers. We also believe in strong customer service to providers, so our customer service, as self-reported by hospitals, is the highest.

And so when we look at our results, we really work hard to archive the objectives of the program and help strike the balance that we believe DMS is trying to strike between providers and program integrity. So we think our response is very strong. Again, we’re hopeful, we’d be very fortunate to get that award.

So how confident are we? I think we’re as confident as we can be, but again, there were clearly other submissions to the RFQ, so we’ll have to wait and see. .

Our next question is coming from the line of S.K. Prasad Borra from Goldman Sachs. .

Firstly, with regards to potential for cost reductions, obviously you’re achieving some cost savings already, but if you see on a going forward basis.

Can you give us clarification around what is headcount related and what is non headcount related cost savings that can be realized?.

This is an area that we are looking at very carefully as we look at these contract transitions, and again, as we look at how this RAC contract will evolve on the limited basis or also if we’re awarded one of these contracts.

But as you look at it, as I stated earlier, we saw a reduction, as you can see here, in salaries and benefit expense, in Q3, of $3 million. We are, again, as we sit right now in Q4, we’re looking at costs overall, as far as making potentially some further adjustments.

Similarly on the other operating expenses as well, which is down $8 million this quarter. So it’s an area that we think very close to, and as we look at getting into our next earnings call, we give guidance, we’ll have a better perspective there based on also the status of the RAC contract, and how that’s evolving. .

And probably more from a balance sheet perspective, what’s the latest capital allocation?.

As we look at our cash position, it’s strong at $85 million. We recently amended the terms of our credit amendment. That did not involve any paydown of debt. And again, our focus right now is to keep that cash on our balance sheet at this point. .

Our next question is coming from the line of Toby Wan of Obsidian Research. .

In terms of the commercial healthcare business, can you guys quantify maybe in terms of the number of covered lives or the number of lives that your commercial partners have, and that you all are doing business for, or on behalf of? Is that maybe a way to think about it, we can kind of quantify that component of the business?.

We’ve signed master servicing agreements, and more importantly, over the last quarter, we’ve seen a lot of traction in the statement of work and contracts that we signed under those. When we look at our body of insurers in aggregate, their membership exceeds 80 million insured lives.

We’re just now getting legs under these contracts and putting them in production. As I mentioned, we had some delays that we didn’t quite anticipate, and examples of these would be things like, we finally got quite a bit of data that we were expecting a few months ago. And it just takes time sometimes to implement these.

So we feel confident that as we’re working through and starting the work that we have, that we are contracted to perform, we’re starting to see some good legs under these contracts. .

And then I guess maybe drilling down a little bit deeper, are they true commercial lives, or are they Medicare Advantage, managed Medicaid? Is there a way to stratify that way, if at all possible?.

They are true commercial lives..

And then Hakan, on the balance sheet, a couple of quick items. Big jump on a sequential basis in prepaid items.

Can you provide any color there? And then also, on the net payable to client of about $14 million, kind of the source of that?.

As I look at the net payable to client, what that reflects is timing differences between cash we have received from invoicing and appeals related refunds that are processed through the same monthly invoices.

And as you look at it at the end of September, we have collected pretty much all of the outstanding receivables, but there’s a bit of a backlog on chargebacks that are to be refunded. So in the past, we have been presenting the net of outstanding AR, along with the refunds payable as a single amount in AR.

But this quarter, the refunds payable grew, and the AR diminished, so we have a net payable. And as we look at this net payable, we expect that this is going to be paid down in the upcoming months.

And similarly, as you look at the prepaid expenses, in the prepaid expenses that includes some appeals related receivables of approximately $5 million, and that relates to subcontractors that we use on the RAC contract.

So we have booked this receivable from the subs in conjunction with the estimated liability for appeals And if you look at it historically, this appeals related receivables was netted in the larger payable [unintelligible] orders that they have performed on our behalf.

And this quarter this payable to sub has been greatly reduced, so the appeals related receivables is presented with prepaid expenses. Again, it’s just a reallocation on the balance sheet as we look at these activities related to, again, the recovery work that we’re doing on the healthcare side. .

And then the changes to your credit agreements, can maybe we expand on those a bit in terms of [unintelligible]? Is it you paying a higher rate, or you have a little more onerous terms?.

What we did is we proactively approached our vendors to amend some of the terms, and these are primarily as it relates to our covenants, to loosen some of our covenants in the existing credit amendment as we are maneuvering through this delayed RAC process. So it’s really a loosening of the covenants that we did.

And again, as I mentioned earlier, with that no paydown of our debt. And again, this is just in order to give us a little more breathing room as we maneuver through this transition. .

Is there an associated higher cost associated with that, I would assume?.

Not really. You will see in our filing. You will have the full details in our upcoming 10-Q. But as we look at it in total, the key focus here is to loosen the covenants. .

With regards to the headcount on the RAC related activities, have you fully rationalized that given the current level of activity and the protracted delays and the new contract coming to the floor? And are there further rationalizations that can be made on that end?.

We’ve significantly reduced headcount on that contract as the work has diminished, to the levels where they are currently, and we have a small portion of our workforce remaining.

So as we look forward, and I think I mentioned, even though this current extension goes through the end of the year, earlier statements that CMS has made publicly lead us to believe, again, that they very much support the program.

We are optimistic that they may continue to extend the contract as it is, and hopefully if they expand the scope, that would be even better. But we, at this point, anticipate some level of continuity and so we expect to keep our current headcount on the recovery audit contract.

And clearly, once the awards are out, and we have certainty of startup, then we will need to reallocate some healthcare talent back to the recovery audit program, as well as hiring..

And then along those same sort of lines, with regard to the recovery audit contract, given the election’s results on Tuesday, and the change in the makeup of the Senate, any thoughts, speculative or not, with regards to kind of how the changed landscape in Washington is going to impact their thoughts on recovery audit contracting activity and CMS’s involvement in all those sorts of things? I know it’s mandated by the ACA, but the political parties certainly have different appetites for what they’re willing to allow and not allow..

Interestingly, what we’ve observed is that this program is really bipartisan. And by that, I mean we have strong supporters, both on the Democrat and the Republican side, as well as opposition both in the Democrat and Republican side.

It tends almost not to be a partisan issue, but more of an issue that comes from rural versus more well developed areas and communities. More of the pressure politically has come from folks on Capitol Hill who are dealing with smaller hospitals or maybe singular hospitals in a rural area. So that’s really more the divide that we have seen.

So we don’t anticipate that the elections will have actually much in the way of influence on the way the program is viewed. .

Ladies and gentlemen, at this time, we have concluded our question and answer session. I would like to turn the floor back over to our management team for any closing remarks..

We want to thank you for the time that you’ve spent with us today, and while our results in the third quarter were softer than we expected, and we have some challenges, we are aggressively and proactively addressing those challenges and really working our technology and analytics in order to maximize our productivity and our returns in the organization as well as to our shareholders.

So again, we really appreciate the time that you spent with us. Thank you..