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Article by DailyStocks_admin    (09-16-11 01:42 AM)

Description

HMS Holdings Corp. Director William F Miller III bought 10000 shares on 9-14-2011 at $ 25.45

BUSINESS OVERVIEW

General Overview

We provide a variety of cost containment services, including coordination of benefits and program integrity services, for government and private healthcare payors and sponsors. These services are designed to help our clients recover amounts due from liable third parties, save dollars, reduce fraud, waste and abuse and ensure regulatory compliance.

Our clients are state Medicaid agencies, Medicaid and Medicare managed care plans, government and private self-funded employers, Pharmacy Benefit Managers, or PBMs, child support agencies, the Veterans Health Administration, or VHA, the Centers for Medicare & Medicaid Services, or CMS, commercial plans, other healthcare payors and large business outsourcing and technology firms. We help these entities contain healthcare costs by ensuring that claims are paid correctly, through our program integrity services and by ensuring that claims are paid by the responsible party, through our coordination of benefits services.

In September 2010, we acquired privately-held Chapman Kelly, Inc. or Chapman Kelly. Based in Jeffersonville, Indiana, Chapman Kelly provides dependent eligibility audits to large, self-insured employers, as well as plan and claims audits to employers and managed care organizations. With our acquisition of Chapman Kelly we have developed a robust Employer Solutions product area that provides dependent eligibility audit services to employers of all sizes and also augments our claim audit offering for healthcare plans.

In June 2010, we acquired privately-held Allied Management Group — Special Investigation Unit, or AMG-SIU, a leading provider of fraud, waste and abuse prevention and detection solutions for healthcare payors. Based in Santa Ana, California, AMG-SIU provides audit and consulting services to both government and commercial healthcare payors and offers a proprietary forensic claim editing system to analyze claim data for patterns of fraud, waste and abuse. AMG-SIU employs an in-house special investigation unit to conduct preliminary research, investigations, medical record reviews and pharmacy reviews.

Our 2010 revenue increased to $302.9 million, $73.6 million, or 32%, over 2009 revenue, primarily as a result of the expansion of existing product offerings and acquisitions. In addition, we have leveraged our expertise to acquire new clients at the state, federal and employer levels and expand our current contracts to provide new services to current clients.

The Healthcare Environment

The largest government healthcare programs are Medicare, the healthcare program for aged and disabled citizens that is administered by CMS and Medicaid, the program that provides medical assistance to eligible low income persons, which is also regulated by CMS but administered by state Medicaid agencies. Medicare and Medicaid combined pay about one-third of the nation’s healthcare expenditures and serve over 100 million beneficiaries. Many of these beneficiaries are enrolled in managed care plans, which have the responsibility for both patient care and claim adjudication.

By law, the Medicaid program is intended to be the payor of last resort; that is, all other available third party resources must meet their legal obligation to pay claims before the Medicaid program pays for the care of an individual eligible for Medicaid. Under Title XIX of the Social Security Act, states are required to take all reasonable measures to ascertain the legal liability of “third parties” for healthcare services provided to Medicaid recipients. Since 1985, we have provided state Medicaid agencies with services to identify the other parties with liability for Medicaid claims and since 2005, we have provided these services to Medicaid managed care plans.

The Deficit Reduction Act, or the DRA, signed into law in February 2006, established a Medicaid Integrity Program to increase the government’s capacity to prevent, detect and address fraud and abuse in the Medicaid program. The DRA is the largest dedicated investment the federal government has made in ensuring the integrity of the Medicaid program. Additionally, the DRA added new entities, such as self-insured plans, PBMs and other “legally responsible” parties to the list of entities subject to the provisions of the Social Security Act. To date, at least 47 states and the District of Columbia have enacted legislation in order to comply with requirements of the DRA. These measures at both the federal and state level have strengthened our ability to identify and recover erroneous payments made by our clients.

The Patient Protection and Affordable Care Act, as amended or the ACA, was signed into law on March 23, 2010. The legislation touches almost every sector of the healthcare system and we believe provides us with a range of opportunities across products and markets. We are focused on four critical areas related to this legislation:


• Medicaid Expansion

• Health Insurance Exchanges

• Program Integrity, and

• Employer-Sponsored Health Coverage

Medicaid Expansion: States will have to expand their Medicaid programs significantly at a time when most states are facing severe budget shortfalls. According to CMS’s projections for national health expenditures for 2009-2019, which were updated in September 2010 and which we refer to as the CMS NHE Projections, the number of individuals enrolled in Medicaid and the Children’s Health Insurance Program, or CHIP, is expected to increase from 60.4 million in 2010 to 82.2 million in 2019, with expenditures expected to more than double over the same period from $427 billion to $896 billion. As a result, we anticipate a considerable increase in the need for our cost containment services.

Health Insurance Exchanges: The ACA calls for new pathways to coverage, including the creation of health insurance exchanges similar to the “Health Connector” program established in Massachusetts. CMS reports that 16 million people will receive health coverage through these newly created exchanges. The complex process of ensuring that all available benefits are coordinated at the time of enrollment is the target of our eligibility solutions. States will also be required to coordinate their exchanges with Medicaid agencies and will be charged with determining the appropriate level of federal subsidy for individuals. We believe that our experience with the Massachusetts Connector program and in administering health insurance premium payment programs for states will enable us to support states in developing premium assistance and coordination of benefits technology and processes across Medicaid and the exchange programs.

Program Integrity: The ACA contains a number of new provisions for combating fraud and abuse throughout the healthcare system, including in Medicaid and Medicare. These initiatives include (i) the expansion of CMS’s Recovery Audit Contractor program to include Medicaid, (ii) the establishment of a national healthcare fraud and abuse data collection program and (iii) increased scrutiny of providers and suppliers who want to participate in Medicare, Medicaid and other federally-funded programs. The ACA allows for significant increases in funding for these and other fraud, waste and abuse efforts. We will be building on our current partnerships with CMS, states and health plans to provide innovative ideas for increasing our support of their new program integrity initiatives.

Employer-Sponsored Health Coverage: The ACA largely preserves and builds upon the existing employer-sponsored health coverage model. Though not all employers will be required to provide healthcare coverage, large employers (those with 50 or more employees) will pay a penalty if they fail to do so. Employers will also be prohibited from imposing waiting periods for enrollment of more than 90 days and in certain cases, employers will have to automatically enroll employees into their benefit plans, while providing them with the ability to opt out. These new requirements for employers, coupled with the Medicaid expansion and implementation of state exchanges, will result in more overlapping coverage situations and an opportunity for our employer clients and Medicaid to collaborate. We expect that HMS Employer Solutions will be able to offer claim audit services to employers of all sizes, which will be necessary as these employers extend coverage to their employees.

Principal Products and Services

The demand for our services arises, in part, from the small but significant percentage of government funds spent in error, where another payor was actually responsible for the service, or a mistake was made in applying complex claim processing rules. According to the 2010 Agency Financial Report, the U.S. Department of Health and Human services estimates that improper payments in the Medicaid and Medicare programs totaled $70.4 billion in 2010. Our services focus on containing costs by reducing errors that result in these improper payments.

Our services draw upon proprietary information management and data mining techniques and include coordination of benefits, cost avoidance and program integrity. In 2010, we recovered more than $1.7 billion for our clients and provided data to our clients that assisted them in preventing billions of dollars more in erroneous payments.

We provide the following services:


• Coordination of benefits services, which route claims already paid by a government program to the liable third party, which then reimburses the government payor. The Medicaid and Medicare programs, including Medicaid and Medicare managed care organizations and VHA must all coordinate benefits with other payors to ensure that claims are paid by the entitlement program, group health plan or other party that actually bears responsibility for a particular incident of medical service. By properly coordinating benefits, these programs are able to recover dollars spent in error and avoid unnecessary future costs.

• Cost avoidance services, which provide validated insurance coverage information that is used by government payors to reject claims that are the responsibility of a third party, typically a group health plan sponsored by a beneficiary’s employer. Additionally, child support agencies use this information to identify children who have coverage from either the custodial or non-custodial parent, as well as to identify children without coverage. With validated insurance information, healthcare payors can avoid unnecessary future costs.


• Program integrity services, which are designed to ensure that medical services are utilized, billed and paid appropriately. We identify payment errors and then recover the erroneous payments, if appropriate. Our program integrity services include: data mining; credit balance reviews; clinical reviews; fraud, waste and abuse detection; compliance audits; and recoupment services.

To perform our services, we aggregate medical claims, medical records, health insurance and other beneficiary data from a variety of sources. The data is mined to identify instances of health insurance coverage, or claims that were paid in error for administrative or clinical reasons. We provide our clients with ways to recover funds or avoid future errors, including validating primary insurance coverage, generating electronic claims to liable third parties, documenting liens that attach to personal injury litigation and estates, providing overpayment edits to claims adjudication systems and enrolling children under the insurance of non-custodial and custodial parents, as appropriate.

Clients

The majority of our clients consist of state Medicaid agencies and managed care organizations and large business outsourcing and technology firms. From 2005 through 2010, we increased our penetration into the Medicaid managed care market, as states increased their use of contracted health plans. As of December 31, 2010, we served 41 state Medicaid agencies and 125 Medicaid health plans under 57 contracts.

In 2008, we were awarded a Medicaid Integrity Program, or MIP, Task Order in the CMS Dallas jurisdiction and in 2009, we were awarded a second MIP Task Order in the San Francisco jurisdiction. Under these task orders, we examine payments to providers made under the Social Security Act, with the objective of identifying potential overpayments made as a result of fraud, waste, or abuse. We are now the CMS Audit Medicaid Integrity Contractor, or Audit MIC, for 22 state and territory Medicaid programs.

By the end of 2010, we also provided coordination of benefits and third party insurance identification services to medical centers across all 21 Veterans Integrated Service Networks of VHA and to child support agencies in 14 states.

In most cases, clients pay us contingency fees calculated as a percentage of the amounts recovered, or fixed fees for cost avoidance data. Most of our contracts have terms of three to four years.

Our largest client in 2010 was the New York State Office of the Medicaid Inspector General. This client accounted for 6.7%, 7.8% and 7.9% of our total revenue for the years ended December 31, 2010, 2009 and 2008, respectively. The New York State Office of the Medicaid Inspector General became our client in September 2006, as part of our acquisition of the Benefits Solutions Practice Area, or BSPA, of Public Consulting Group, Inc., or PCG. We provide services to the New York State Office of the Medicaid Inspector General pursuant to a contract awarded in October 2001, which was subsequently re-procured and extended through January 6, 2015. Our second largest client in 2010 was the New Jersey Department of Human Services. This client accounted for 5.3%, 6.2% and 6.6% of our total revenue in the years ended December 31, 2010, 2009 and 2008, respectively. We provide services to this client pursuant to a three year contract awarded in January 2008, which has been renewed through December 2012. The loss of either one of these contracts would have a material adverse effect on our financial position, results of operations and cash flows.

The list of our ten largest clients changes periodically. For the years ended December 31, 2010, 2009 and 2008, our ten largest clients represented 36.4%, 39.5% and 43.5% of our revenue, respectively. Our agreements with these clients expire between 2011 and 2015. In many instances, we provide our services pursuant to agreements that may be renewed subject to a competitive re-procurement process. Several of our contracts, including those with our ten largest clients, may be terminated for convenience. We cannot assure you that our contracts, including those with our ten largest clients, will not be terminated for convenience or that any of these contracts will be renewed, and, if renewed, that the fee rates will be equal to those currently in effect.

Market Trends/Opportunities

Containing healthcare expenditures presents challenges for the government due to the number and variety of programs at the state and federal level, the government appropriations process and the rise in the cost of care and number of beneficiaries. Healthcare reform legislation adds increased pressure to states to cover more individuals even as most states are projecting significant budget deficits, making cost containment a high priority.

Government healthcare programs continue to grow. CMS has projected that Medicaid, CHIP and Medicare expenditures will increase to $1.8 trillion by 2019.

According to CMS’s NHE Projections, at the end of 2010, Medicare programs covered approximately 46.8 million people and spent approximately $535 billion. CMS projects that by the end of 2010, Medicaid/CHIP programs covered approximately 60.4 million people and spent approximately $427 billion. Altogether, it is projected that the government programs we serve covered more than 107 million people and have spent nearly $962 billion in 2010. We believe that enrollment in these programs will increase significantly under healthcare reform legislation.

In its financial report for 2010, the U.S. Department of Health and Human Services estimated that improper payments in Medicare and Medicaid will total approximately $70.4 billion for the 2010 fiscal year.

Coordinating benefits among these growing programs and ensuring that claims are paid appropriately, represents both an enormous challenge and opportunity for us.

Competition

We compete primarily with large business outsourcing and technology firms and with small regional firms specializing in one or more of our services, in addition to the states themselves, which may elect to perform coordination of benefits and cost avoidance functions in-house. Against these competitors, we typically succeed on the basis of our leadership position in the marketplace, staff expertise, extensive insurance eligibility database, proprietary systems and processes, existing relationships and effectiveness in cost recoveries and pricing.

Business Strategy

Over the course of 2011, we expect to grow our business through a number of strategic objectives or initiatives that may include:


• Drive organic growth. We will seek to tap demand for our services created by the steadily increasing expenditures of government-funded healthcare.

• Strengthen regulatory framework. On behalf of our clients, we will take advantage of congressional and state legislation reinforcing the ability of government agencies to implement more rigorous cost-containment programs.

• Expand scope. We will actively seek to expand our role with existing clients by extending our reach to new services and claim types and by providing earlier access to claim data.

• Improve the quality and effectiveness of our services. We will continue implementing new technology and processes to better engineer the services we provide to our clients, which we expect will enable us to increase cost recovery, cost-containment and client satisfaction.

• Add new clients. We will continue to market to additional healthcare payors and sponsors, including mid- to large employers, middle market Medicaid managed care plans, behavioral health programs and commercial plans.

• Expand program integrity footprint. We will continue to seek new program integrity business at the state and federal levels and in the employer and commercial markets.

• Add new services. Where opportunities exist, we will continue to add services closely related to cost containment through internal development and/or acquisition.

CEO BACKGROUND

William F. Miller III has served as one of our directors since October 2000. Mr. Miller is a partner of Highlander Partners, a private equity group in Dallas, Texas focused on investments in healthcare products, services and technology. From October 2000 to April 2005, Mr. Miller served as our Chief Executive Officer and from December 2000 to April 2006, Mr. Miller served as our Chairman. From 1983 to 1999, Mr. Miller served as President and Chief Operating Officer of EmCare Holdings, Inc., a national healthcare services firm focused on the provision of emergency physician medical services. From 1980 to 1983, Mr. Miller served as Administrator/Chief Operating Officer of Vail Mountain Medical. Mr. Miller also serves as a director of Lincare Holdings, Inc. and several private companies. From 1999 to 2009, Mr. Miller served as a director of AMN Healthcare Services, Inc.

Mr. Miller brings to the Board of Directors both a thorough understanding of our business and the healthcare industry and extensive experience in the financial markets. His significant operational experience, both at HMS and at EmCare Holdings, makes him well-positioned to provide the Company with insight on financial, operational and strategic issues and makes him a valuable member of our Audit, Compensation and Nominating Committees.

Ellen A. Rudnick has served as one of our directors since 1997. Since 1999, Ms. Rudnick has served as Executive Director and Clinical Professor of the Polsky Center for Entrepreneurship, University of Chicago Booth School of Business. From 1993 until 1999, Ms. Rudnick served as Chairman of Pacific Biometrics, Inc., a publicly held healthcare biodiagnostics company and its predecessor, Bioquant, which she co-founded. From 1990 to 1992, she served as President and Chief Executive Officer of Healthcare Knowledge Resources (HKR), a privately held healthcare information technology corporation and subsequently served as President of HCIA, Inc. (HCIA) following the acquisition of HKR by HCIA. From 1975 to 1990, Ms. Rudnick served in various positions at Baxter Health Care Corporation, including Corporate Vice President of Baxter Healthcare and President and Founder of Baxter Management Services Division. From 1992 to 2003, Ms. Rudnick served as Chairman of CEO Advisors, Inc., a privately held consulting firm. Ms. Rudnick also serves as a director of Patterson Companies, Inc. and First Midwest Bancorp, Inc.

Ms. Rudnick brings to the Board of Directors extensive business understanding and demonstrated management expertise, having served in key leadership positions at a number of healthcare companies. Ms. Rudnick has a comprehensive understanding of the operational, financial and strategic challenges facing companies and knows how to make businesses work effectively and efficiently. Her management experience has provided her with a thorough understanding of the financial and other issues facing large companies, making her particularly valuable as the Chairman of our Audit Committee and as a member of our Nominating and Compliance Committees.

Michael A. Stocker, M.D. has served as one of our directors since January 2007. Since September 2008, Dr. Stocker has served as Chairman of the Board of the New York City Health and Hospitals Corporation (HHC), the largest municipal hospital and health care system in the country. From January 2006 to April 2007, Dr. Stocker served as President and Chief Executive Officer of WellPoint, Inc.'s East Region. Dr. Stocker served as President and Chief Executive Officer of Empire Blue Cross Blue Shield from 1994 until its acquisition by Wellpoint, Inc. in December 2005. Dr. Stocker has also held executive level positions with both CIGNA and US Healthcare. Dr. Stocker serves as a director of Coventry Health Care, Inc. He also serves on the Boards of the Arthur Ashe Institute for Urban Health, New York Stem Cell Funding Committee, SeeChange Health and Triveris, Inc. (part of the Psilos Group).

Dr. Stocker brings a unique perspective to our Board of Directors given his background as a medical professional, his recognized expertise as a business leader, which is exemplified by his appointment as Chairman of HHC by New York's Mayor Bloomberg and his executive-level experience at some of the largest US health insurance companies. Dr. Stocker's background and experience make him well-positioned to serve as the Chairman of the Nominating Committee and as a member of the Compliance Committee.

Richard H. Stowe has served as one of our directors since 1989. Mr. Stowe is a general partner of Health Enterprise Partners LLP, a private equity firm. From 1999 to 2005, Mr. Stowe was a private investor, a senior advisor to the predecessor funds to Health Enterprise Partners and a senior advisor to Capital Counsel LLC, an asset management firm. From 1979 to 1998, Mr. Stowe was a general partner of Welsh, Carson, Anderson & Stowe. Prior to 1979, he was a Vice President in the venture capital and corporate finance groups of New Court Securities Corporation (now Rothschild, Inc.). Mr. Stowe is also a director of several private and not-for-profit companies and educational institutions. From 1998 to 2007, Mr. Stowe served as a director of MedQuist, Inc.

Mr. Stowe brings 40 years of financial, capital markets and investment experience to our Board of Directors. Mr. Stowe's background and experience make him well-positioned to serve as the Chairman of the Compensation Committee and as a member of the Audit and Nominating Committees.

MANAGEMENT DISCUSSION FROM LATEST 10K

Business Overview

Beginning in the first quarter of 2007, we were managed and operated as one business, with a single management team that reports to the chief executive officer. We do not operate separate lines of business with respect to any of our product lines.

We provide a variety of cost containment services, including coordination of benefits and program integrity services, for government and private healthcare payors and sponsors. These services are designed to help our clients recover amounts due from liable third parties, save dollars, reduce fraud, waste and abuse and ensure regulatory compliance.

Our clients are state Medicaid agencies, Medicaid and Medicare managed care plans, government and private self-funded employers, PBMs, child support agencies, VHA, CMS, commercial plans, other healthcare payors and large business outsourcing and technology firms. We help these entities contain healthcare costs by ensuring that claims are paid correctly, through our program integrity services and by ensuring that claims are paid by the responsible party, through our coordination of benefits services.

At December 31, 2010, our cash and cash equivalents and net working capital were $94.8 million and $147.5 million, respectively. In connection with our BSPA acquisition, we entered into a credit agreement with several banks and other financial institutions, with JPMorgan Chase Bank, N.A. as administrative agent, or the Credit Agreement. The Credit Agreement, which expires in September 2011, provided for a term loan of $40 million, or the Term Loan and revolving credit loans of up to $25 million, or the Revolving Loan. During the year ended December 31, 2009, we repaid in full the $17.3 million of debt outstanding under the Term Loan. Although to date we have not borrowed under the Revolving Loan, we continue to have an irrevocable standby Letter of Credit for $4.6 million against the Revolving Loan, as required by a contractual arrangement with a client. As a result of the Letter of Credit, the amount available under the Revolving Loan as of December 31, 2010 is $20.4 million. Although we expect that operating cash flows will continue to be a primary source of liquidity for our operating needs, we also have the remaining balance of the Revolving Loan available for future cash flow needs, if necessary.

Our revenue, most of which is derived from contingency fees, has increased at an average compounded rate of approximately 38.2% per year for the last five years. Our 2010 revenue increased to $302.9 million, $73.6 million over 2009 revenue. Our growth has been attributable to our expansion of existing product offerings and acquisitions, as well as the increase in Medicaid costs, which has historically averaged approximately 8% annually. In addition, state governments have increased their use of vendors for coordination of benefits and other cost containment functions and we have been able to increase our revenue through these initiatives. Leveraging our work on behalf of state Medicaid fee-for-service programs, we began to penetrate the Medicaid managed care market in 2005, into which more Medicaid lives are being shifted. In addition, to acting as a subcontractor for certain business outsourcing and technology firms, as of December 31, 2010, we served 41 state Medicaid agencies and 125 Medicaid health plans under 57 contracts.

To date, we have grown our business through the internal development of new services and through acquisitions of businesses whose core services strengthen our overall mission to help our clients control healthcare costs. In addition, we leverage our expertise to acquire new clients at the state, federal and employer levels and to expand our current contracts to provide new services to current clients.

With the exception of our acquisition of BSPA, to date we have used internally generated cash to fund our acquisitions.

Since 2006, we have acquired the following companies:


• Benefits Solutions Practice Area. In September 2006, we acquired the assets and liabilities of BSPA for $81.2 million in cash, 1,749,800 shares of our common stock, then valued at $24.4 million and a contingent cash payment of $15.0 million, which was paid to BSPA upon its achievement of certain revenue targets for the twelve months ended June 30, 2007. BSPA, which is based in Boston, Massachusetts, provides a variety of cost avoidance, insurance verification, recovery audit and related services to state Medicaid agencies, children and family services agencies and the U.S. Department of Veterans Affairs.

• Prudent Rx. In September 2008, we purchased the assets and liabilities of Prudent Rx for $4.5 million in cash. Prudent Rx is a pharmacy audit and cost containment company based in Culver City, California. With this acquisition, we further expanded our portfolio of program integrity service offerings for government healthcare programs and managed care organizations, particularly in the pharmacy arena. Prudent Rx’s key products and services include audit programs, program design and benefit management, as well as general and pharmacy systems consulting. The acquisition of Prudent Rx did not have a material effect on 2010, 2009 and 2008 revenue, earnings, earnings per share or liquidity.

• IntegriGuard. In September 2009, we acquired the assets and liabilities of IntegriGuard for $5.1 million. IntegriGuard, which operates as our wholly owned subsidiary, provides services for the prevention and detection of fraud, waste and abuse in the healthcare system and is based in Omaha, Nebraska. This acquisition expanded our portfolio of program integrity service offerings for government healthcare programs, particularly in the Medicare and Medicaid programs.

• Verify Solutions. In December 2009, we acquired the assets and liabilities of Verify Solutions for $8.1 million, with additional future payments of up to $5.5 million contingent upon future financial performance ($2.7 million and $2.8 million for the years ended December 31, 2010 and 2011, respectively). The additional future payments will be made and recorded as compensation expense in the year in which the milestones are expected to be achieved. No compensation expense was recorded in 2010 as the performance milestones were not achieved. Verify Solutions, specializes in dependent eligibility audit services for large, self-insured employers and is based in Alpharetta, Georgia. With this acquisition, we moved into the large and mid-market employer-based market.

• Allied Management Group — Special Investigation Unit. In June 2010, we purchased all of the issued and outstanding common stock of AMG-SIU for a purchase price valued at $15.1 million, consisting of a $13.0 million initial cash payment (subsequently reduced by a working capital reduction of $0.2 million), and future contingent payments estimated and recognized as of the acquisition date at $2.3 million. These payments are contingent upon AMG-SIU’s financial performance for each of the twelve month periods ending June 30, 2011 and June 30, 2012. The undiscounted contingent payments are currently estimated to be $3.4 million and relate to the 12 month period ending June 30, 2012. AMG-SIU, which is based in Santa Ana, California; specializes in fraud, waste and abuse prevention and detection solutions for healthcare payors, which further strengthens our ability to service this segment of the market. The acquisition of AMG-SIU did not have a material effect on our 2010 revenue, earnings, earnings per share or liquidity.

• Chapman Kelly. In August 2010, we acquired the assets and liabilities of Chapman Kelly for a $13.0 million cash payment. Chapman Kelly, which is based in Jeffersonville, Indiana, provides dependent eligibility audits to large, self-insured employers, as well as plan and claims audits to both employers and managed care organizations. The acquisition of Chapman Kelly did not have a material effect on our 2010 revenue, earnings, earnings per share or liquidity.

Operating Results

Revenue for the year ended December 31, 2010 was $302.9 million, an increase of $73.6 million, or 32.1%, from revenue of $229.2 million for the year ended December 31, 2009. This increase reflects the organic growth in existing client accounts of $42.6 million, together with changes in the yield and scope of those projects and differences in the timing of when client projects were completed in the current year compared to the prior year. Revenue generated by our 2009 acquisitions, IntegriGuard and Verify Solutions, was $24.9 million, an increase of $21.2 million compared to the prior year. Revenue generated by our 2010 acquisitions, AMG-SIU and Chapman Kelly, was $2.3 million. Revenue generated by approximately 19 new clients for whom there was no revenue in the prior year was $14.9 million. These increases were partially offset by a decrease of $7.4 million as a result of expired contracts.

Compensation expense as a percentage of revenue was 36.2% for the year ended December 31, 2010, compared to 33.7% for the prior year. Compensation expense was $109.6 million for 2010, an increase of $32.4 million, or 42.0%, from the prior year compensation expense of $77.2 million. This increase reflects $24.2 million in additional salary expense, $6.4 million in additional expense related to employee benefits and $1.8 million in additional variable compensation. For the year ended December 31, 2010, we averaged 1,409 employees, a 43.8% increase over the year ended December 31, 2009, during which we averaged 980 employees. This increase reflects the addition of new staff as a result of our acquisitions of AMG-SIU and Chapman Kelly during the second and third quarters of 2010, respectively and the addition of staff in the areas of client support, technical support and operations during 2010.

Data processing expense as a percentage of revenue was 6.0% for the year ended December 31, 2010, compared to 6.0% for the prior year. Data processing expense was $18.1 million for 2010, an increase of $4.4 million, or 31.9%, from the prior year data processing expense of $13.7 million. Revenue growth as well as acquisitions drove the need for increased capacity in our data processing environment. This increase reflects $2.7 million in additional software related costs, a $1.1 million increase for data communications and data costs due to the growth of our business, including the number of field offices and employees and a $0.6 million increase in hardware maintenance and related costs.

Occupancy expense as a percentage of revenue was 4.5% for the year ended December 31, 2010, compared to 4.7% for the prior year. Occupancy expense was $13.6 million for 2010, an increase of $2.8 million, or 25.4%, from the prior year occupancy expense of $10.9 million. Rent expense increased $1.3 million in connection with our acquisitions of IntegriGuard, Verify Solutions, AMG-SIU and Chapman Kelly. Other increases included a $0.8 million increase in depreciation of furniture and fixtures, leasehold improvements, office and telephone equipment, a $0.7 million increase in utilities and telephone expense and a $0.5 million increase in equipment expense, rental and maintenance, primarily for photocopy and mail machines. These increases were partially offset by a decrease of $0.6 million relating to the write off of accrued rent liabilities following our purchase of the office building in Irving, Texas. All other rental expenses increased by $0.1 million.

Direct project expense as a percentage of revenue was 11.7% for the year ended December 31, 2010, compared to 12.4% for the prior year. Direct project expense for 2010 was $35.4 million, an increase of $7.0 million, or 24.7%, from the prior year direct project expense of $28.4 million. This increase resulted primarily from a $2.6 million increase in subcontractor expenses primarily driven by new projects and revenue increases, a $1.4 million increase for temporary help, consultants and marketing partners, a $1.3 million increase for lockbox, postage and delivery expense. Direct project expense increased at a rate lower than revenue growth due to the composition of the revenue from our acquisitions which has a lower cost component.

Other operating expenses as a percentage of revenue were 5.6% for the year ended December 31, 2010, compared to 6.1% for the prior year. Other operating expenses for 2010 were $17.1 million, an increase of $3.1 million, or 22.0%, from the prior year expense of $14.0 million. This increase resulted from a $1.7 million increase in professional fees, including consulting, subcontractors and temporary help, a $0.7 million increase for supplies, printing, postage, delivery, a $0.4 million increase for travel expenses and $0.3 million in accretion expense related to the contingent payment for AMG-SIU.

Amortization of acquisition-related software and intangibles as a percentage of revenue was 2.1% for the year ended December 31, 2010, compared to 2.2% for the prior year. Amortization of acquisition-related software and intangibles expenses for 2010 were $6.2 million, an increase of $1.1 million, or 22.7%, compared to the prior year expense of $5.1 million. This expense consists primarily of amortization of client relationships, trade names and software. The increase in amortization of acquisition-related software and intangibles expense compared to last year is a result of our acquisitions of IntegriGuard, Verify Solutions, AMG-SIU and Chapman Kelly.

Selling, general and administrative expenses as a percentage of revenue were 11.9% for the year ended December 31, 2010, compared to 12.3% for the prior year. Selling, general and administrative expenses for 2010 were $36.1 million, an increase of $8.0 million, or 28.4%, compared to the prior year expense of $28.1 million. During the year ended December 31, 2010, we averaged 93 employees in the sales, general and administrative group, a 27.4% increase over our average of 73 employees in that group during the year ended December 31, 2009. Compensation increased by $4.7 million due to a $2.1 million increase due to headcount additions and annual salary increases, a $1.2 million increase due to fringe benefits, a $0.8 million increase in stock compensation expense and a $0.7 million increase for variable compensation. Other expenses increased by $3.1 million, of which $2.1 million related to an increase in professional fees, consisting of accounting fees, acquisition-related transaction fees, public company costs and consulting fees.

Operating income for the year ended December 31, 2010 was $67.0 million, or 22.1%, of revenue compared to $51.9 million, or 22.6%, of revenue for the prior year. This increase was primarily the result of increased revenue, which was partially offset by incremental operating costs incurred during the year ended December 31, 2010.

Interest expense was $0.1 million for the year ended December 31, 2010 compared to $1.1 million for the same period in 2009. For the year ended December 31, 2010, interest expense represents commitment fees for our Credit Agreement and issuance fees for our Letter of Credit. For the year ended December 31, 2009, interest expense was attributable to borrowings under the Term Loan, amortization of deferred financing costs, commitment fees for our Credit Agreement and issuance fees for our Letter of Credit. Interest income was $94,000 for the year ended December 31, 2010, compared to interest income of $226,000 for the year ended December 31, 2009, principally due to lower interest rates, which were partially offset by higher cash balances. Net other expenses included $69,000 related to the acquisition of the office building in Irving, Texas. We did not incur any real estate expense in the prior period.

Income tax expense of $26.6 million was recorded for the year ended December 31, 2010, an increase of $5.6 million compared to the same period in 2009. Our effective tax rate decreased to 39.9% in 2010 from 41.1% for the year ended December 31, 2009, primarily due to a change in state apportionments. The principal difference between the statutory tax rate and our effective tax rate is state taxes.

MANAGEMENT DISCUSSION FOR LATEST QUARTER

General Overview



We provide a variety of cost containment services, including coordination of benefits and program integrity services, for government and private healthcare payors and sponsors. These services are designed to help our clients recover amounts due from liable third parties, save dollars, reduce fraud, waste and abuse and ensure regulatory compliance.



Our clients are state Medicaid agencies, Medicaid and Medicare managed care plans, government and private self-funded employers, Pharmacy Benefit Managers, or PBMs, child support agencies, the Veterans Health Administration, or VHA, the Centers for Medicare & Medicaid Services, or CMS, commercial plans, other healthcare payors and large business outsourcing and technology firms. We help these entities contain healthcare costs by ensuring that claims are paid correctly, through our program integrity services and by ensuring that claims are paid by the responsible party, through our coordination of benefits services.



In September 2010, we acquired privately-held Chapman Kelly, Inc., or Chapman Kelly, based in Jeffersonville, Indiana. Chapman Kelly provides dependent eligibility audits to large, self-insured employers, as well as plan and claims audits to employers and managed care organizations. With our acquisition of Chapman Kelly we have developed a robust Employer Solutions product area that provides dependent eligibility audit services to employers of all sizes and also augments our claim audit offering for healthcare plans.



In June 2010, we acquire d privately-held Allied Management Group — Special Investigation Unit, or AMG-SIU, a leading provider of fraud, waste and abuse prevention and detection solutions for healthcare payors. Based in Santa Ana, California, AMG-SIU provides audit and consulting services to both government and commercial healthcare payors and offers a proprietary forensic claim editing system to analyze claim data for patterns of fraud, waste and abuse. AMG-SIU employs an in-house special investigation unit to conduct preliminary research, investigations, medical record reviews and pharmacy reviews.



At June 30, 2011, we had cash and cash equivalents of $117.7 million, and net working capital of $181.6 million. We have a credit agreement with several banks and other financial institutions with JPMorgan Chase Bank, N.A. (JPMCB), as administrative agent, which we refer to as the Credit Agreement. The Credit Agreement, which expires in September 2011, provided for a term loan of $40 million, which we refer to as the Term Loan, and revolving credit loans of up to $25 million, which we refer to as the Revolving Loan. The term loan was repaid in 2009. To date, we have not borrowed under the Revolving Loan. Although we expect that operating cash flows will continue to be a primary source of liquidity for our operating needs, we also have the Revolving Loan available for future cash flow needs, if necessary.



Our revenue, most of which is derived from contingency fees, has increased at an average compounded rate of approximately 38.2% per year for the last five years. Our growth has been attributable to our expansion of existing product offerings and acquisitions, as well as an overall increase in Medicaid costs, which has historically averaged approximately 8% annually. In addition, state governments have increased their use of vendors for the coordination of benefits and other cost containment functions, and we have been able to increase our revenue through these initiatives. Leveraging our work on behalf of state Medicaid fee-for-service programs, we have penetrated the Medicaid managed care market, into which more Medicaid lives are being shifted. In addition to acting as a subcontractor for certain business outsourcing and technology firms, as of June 30, 2011, we served the District of Columbia and 42 state Medicaid programs, and 129 Medicaid health plans under an aggregate of 60 contracts.

To date, we have grown our business through the internal development of new services and through acquisitions of businesses whose core services strengthen our overall mission to help our clients control healthcare costs. In addition, we leverage our expertise to acquire new clients at the state, federal and employer levels and to expand our current contracts to provide new services to current clients. We are continuously evaluating opportunities that will enable us to expand the breadth of the services we provide and will consider acquisition opportunities that enable us to continue to grow our business to address the increasing needs of the healthcare industry in the post-healthcare reform era.



In March 2010, the Patient Protection and Affordable Care Act, or the Affordable Care Act, was signed into law. According to Centers for Medicare & Medicaid Services, or CMS, under the Affordable Care Act, approximately an additional 18 million lives will be added to Medicaid by 2019. In addition, the Affordable Care Act includes a number of provisions for combating fraud and abuse throughout the healthcare system, allows for significant increases in funding for program integrity initiatives and provides for the creation of insurance exchanges. The Affordable Care Act largely preserves and builds upon the employer-sponsored health coverage model. However, under the Affordable Care Act, employers are faced with new compliance guidelines, coverage requirements and mandates that will challenge their systems and processes and will likely raise their healthcare costs. We plan to build on our existing partnerships with states, the federal government, and health plans to provide services that address the program integrity, fraud and abuse initiatives created by the Affordable Care Act and to assist these clients in meeting the requirements of the Affordable Care Act. In addition, we believe that we are well-positioned to work with employers to address the new requirements of the Affordable Care Act and plan to work with our clients to develop collaborations that support the overarching goal of controlling healthcare costs.

To date, we have grown our business through the internal development of new services and through acquisitions of businesses whose core services strengthen our overall mission to help our clients control healthcare costs. In addition, we leverage our expertise to acquire new clients at the state, federal and employer levels and to expand our current contracts to provide new services to current clients. We are continuously evaluating opportunities that will enable us to expand the breadth of the services we provide and will consider acquisition opportunities that enable us to continue to grow our business to address the increasing needs of the healthcare industry in the post-healthcare reform era.



In March 2010, the Patient Protection and Affordable Care Act, or the Affordable Care Act, was signed into law. According to Centers for Medicare & Medicaid Services, or CMS, under the Affordable Care Act, approximately an additional 18 million lives will be added to Medicaid by 2019. In addition, the Affordable Care Act includes a number of provisions for combating fraud and abuse throughout the healthcare system, allows for significant increases in funding for program integrity initiatives and provides for the creation of insurance exchanges. The Affordable Care Act largely preserves and builds upon the employer-sponsored health coverage model. However, under the Affordable Care Act, employers are faced with new compliance guidelines, coverage requirements and mandates that will challenge their systems and processes and will likely raise their healthcare costs. We plan to build on our existing partnerships with states, the federal government, and health plans to provide services that address the program integrity, fraud and abuse initiatives created by the Affordable Care Act and to assist these clients in meeting the requirements of the Affordable Care Act. In addition, we believe that we are well-positioned to work with employers to address the new requirements of the Affordable Care Act and plan to work with our clients to develop collaborations that support the overarching goal of controlling healthcare costs.

Data processing expense as a percentage of revenue was 6.3% for the three months ended June 30, 2011, compared to 6.1% for the three months ended June 30, 2010. Data processing expense was $5.7 million for the current quarter, an increase of $1.4 million, or 31.6%, over data processing expense of $4.3 million for the same quarter in the prior year. Revenue growth as well as acquisitions drove the need for increased capacity in our data processing environment. This increase reflects $0.7 million in additional software related costs, $0.6 million in additional hardware costs, and $0.1 million in additional data communications and data costs due to the growth of our business, including the number of field offices and employees.



Occupancy expense as a percentage of revenue was 4.2% for the three months ended June 30, 2011, compared to 4.0% for the three months ended June 30, 2010. Occupancy expense for the current quarter was $3.7 million, a $0.9 million, or 32.6%, increase compared to occupancy of expense of $2.8 million for the same quarter in the prior year. This increase reflects $0.6 million in additional rent and related expense, $0.2 million in additional depreciation of leasehold improvements, furniture and equipment, and $0.1 million in other occupancy related costs including common area maintenance charges, additional telephone and utilities expense.



Direct project expense as a percentage of revenue was 12.4% for the three months ended June 30, 2011, compared to 11.6% for the three months ended June 30, 2010. Direct project expense for the current quarter was $11.1 million, a $2.9 million, or 34.9%, increase, compared to direct project expense of $8.2 million for the same quarter in the prior year. This increase resulted from a $1.3 million increase for temporary help, consultants and marketing partners, a $1.0 million increase for subcontractor expenses primarily driven by new projects and revenue increases, a $0.3 million increase for lockbox, postage and delivery expense, a $0.2 million increase for project-specific software costs, and a $0.1 million increase for travel expenses.



Other operating costs as a percentage of revenue were 5.2% for the three months ended June 30, 2011 compared to 5.6% for the three months ended June 30, 2010. Other operating costs for the current quarter were $4.6 million, an increase of $0.7 million, or 16.5%, compared operating costs of $3.9 million for the same quarter in the prior year. This increase resulted from $0.3 million in additional accretion expense related to the future contingent payments that may be payable to the former owners of AMG-SIU and Prudent Rx, $0.2 million for supplies and related expenses, $0.1 million in professional services, consisting of temporary help and consulting services, and $0.1 million of employee relocation expenses.



Amortization of acquisition-related software and intangibles as a percentage of revenue was 1.8% for the three months ended June 30, 2011, compared to 2.0% for the three months ended June 30, 2010. Amortization of acquisition-related software and intangibles for the current quarter was $1.6 million, a $0.2 million, or 17.9%, increase compared to amortization of $1.4 million for the same quarter in the prior year. The increase resulted from the amortization of $0.4 million related to our acquisitions of AMG-SIU and Chapman Kelly for which there was no amortization expense in the prior year period, which was partially offset by a reduction of $0.2 million related to prior year acquisitions having been fully amortized.



Selling, general, and administrative expense as a percentage of revenue was 11.9% for the three months ended June 30, 2011 compared to 13.4% for the three months ended June 30, 2010. Selling, general, and administrative expense for the current quarter was $10.7 million, a $1.2 million, or 12.3%, increase compared to $9.5 million for the same quarter in the prior year. During the quarter ended June 30, 2011, we averaged 120 corporate employees, a 6.2% increase over our average of 113 corporate employees during the quarter ended June 30, 2010. Compensation expense increased by $0.3 million as a result of increased headcount and related fringe benefits expense. Other operating expenses increased by $0.5 million, of which $0.4 million related to non-recurring management and training events and $0.1 million related to employee relocation. Data processing expense increased by $0.4 million relating to expenses for hosting services and disaster recovery preparedness. Occupancy expenses were roughly equivalent in both periods.



Operating income for the three months ended June 30, 2011 was $20.5 million, an increase of $5.3 million, or 34.7%, compared to $15.2 million for the three months ended June 30, 2010. This increase was primarily the result of increased revenue, which was partially offset by incremental operating costs incurred during the quarter ended June 30, 2011.



Interest expense was $23,000 for the three months ended June 30, 2011 and 2010. Interest expense represents commitment fees for our Credit Agreement and issuance fees for our Letter of Credit. Interest income was $16,000 for the three months ended June 30, 2011, compared to interest income of $24,000 for the three months ended June 30, 2010. Net other income primarily relating to rental income from our office building in Irving, Texas was $277,000 for the quarter ended June 30, 2011. We purchased the office building in Irving, Texas in June 2010, as a result, we did not realize any rental income during the second quarter of 2010.



We recorded income tax expense of $8.3 million for the quarter ended June 30, 2011, compared to income tax expense of $6.1 million for the three months ended June 30, 2010, an increase of $2.2 million. Our effective tax rate increased to 40.1% for the quarter ended June 30, 2011 from 40.0% for the quarter ended June 30, 2010, primarily due to a change in state apportionments. The principal difference between the statutory rate and our effective rate is state taxes.

Revenue for the six months ended June 30, 2011 was $171.8 million, an increase of $36.1 million, or 26.6%, compared to revenue of $135.7 million in the same quarter for the prior year. Organic growth in existing client accounts, together with changes in the yield and scope of those projects, and differences in the timing of when client projects were completed in the current year compared to the prior year, provided $28.2 million of the increase in revenue. Revenue generated by our 2010 acquisitions, AMG-SIU and Chapman Kelly, was $5.1 million. Revenue generated by eleven new clients for whom there was no revenue in the same six month period of the prior year was $3.6 million. Expired contracts accounted for a decrease of $0.8 million.



Compensation expense as a percentage of revenue was 36.6% for the six months ended June 30, 2011, compared to 36.3% for the six months ended June 30, 2010. Compensation expense for the current quarter was $62.8 million, a $13.6 million, or 27.8%, increase over compensation expense of $49.2 million for the same quarter in the prior year. During the six months ended June 30, 2011, we averaged 1,621 employees, a 26.6% increase over our average of 1,280 employees during the six months ended June 30, 2010. This increase reflects the addition of new staff as a result of our acquisitions of AMG-SIU and Chapman Kelly during the second and third quarters of 2010, respectively, and the addition of staff in the areas of client support, technical support and operations.

Data processing expense as a percentage of revenue was 6.2% for the six months ended June 30, 2011, compared to 6.0% for the six months ended June 30, 2010. Data processing expense was $10.6 million for the six months ended June 30, 2011, an increase of $2.5 million, or 31.0%, over data processing expense of $8.1 million for the same period for the prior year. Revenue growth as well as acquisitions drove the need for increased capacity in our data processing environment. This increase reflects $1.3 million in additional software related costs, $1.0 million in additional hardware costs, and $0.2 million in additional data communications and data costs due to the growth of our business, including the number of field offices and employees.



Occupancy expense as a percentage of revenue was 4.4% for the six months ended June 30, 2011, compared to 4.5% for the six months ended June 30, 2010. Occupancy expense for the current period was $7.5 million, a $1.3 million, or 22.5%, increase compared to occupancy expense of $6.2 million for the same period in the prior year. This increase reflects $0.8 million in additional rent and related expense, $0.3 million in additional depreciation of leasehold improvements, furniture and equipment, and $0.2 million in other occupancy related costs including common area maintenance charges, telephone and utilities expense.



Direct project expense as a percentage of revenue was 12.0% for the six months ended June 30, 2011, compared to 11.6% for the six months ended June 30, 2010. Direct project expense for the current period was $20.7 million, a $4.9 million, or 30.9%, increase, compared to direct project expense of $15.8 million for the same period in the prior year. This increase resulted from a $2.3 million increase for temporary help, consultants and marketing partners, a $1.8 million increase for subcontractor expenses primarily driven by new projects and revenue increases, a $0.4 million increase for project-specific software costs, and a $0.4 million increase for lockbox, postage and delivery expense.



Other operating costs as a percentage of revenue were 5.1% for the six months ended June 30, 2011 compared to 5.3% for the six months ended June 30, 2010. Other operating costs for the current period were $8.8 million, an increase of $1.6 million, or 22.8%, compared to operating costs of $7.2 million for the same period in the prior year. This increase resulted from additional expenses of $0.6 million in professional services, consisting of temporary help and consulting services, $0.4 million in accretion expense related to the future contingent payment that may be payable to the former owners of AMG-SIU and Prudent Rx, $0.2 million of travel expenses related to business expansion, $0.2 million of employee relocation expenses, and $0.2 million for supplies, delivery and other office-related expenses.



Amortization of acquisition-related software and intangibles as a percentage of revenue was 2.0% for the six months ended June 30, 2011, compared to 2.1% for the six months ended June 30, 2010. Amortization of acquisition-related software and intangibles for the current period was $3.4 million, a $0.5 million, or 16.8%, increase compared to amortization of $2.9 million for the same period in the prior year. The increase resulted from $0.9 million related to our acquisitions of AMG-SIU and Chapman Kelly for which there was no amortization expense in the prior year period, partially offset by a reduction of $0.4 million related to prior year acquisitions having been fully amortized.



Selling, general, and administrative expense as a percentage of revenue was 12.4% for the six months ended June 30, 2011 compared to 13.6% for the six months ended June 30, 2010. Selling, general, and administrative expense for the current period was $21.4 million, a $2.9 million, or 15.6%, increase compared $18.5 million for the same period in the prior year. During the period ended June 30, 2011, we averaged 118 corporate employees, a 5.4% increase over our average of 112 corporate employees during the period ended June 30, 2010. Compensation expense increased by $0.6 million as a result of increased and related fringe benefits expense. Other operating expenses increased by $1.5 million related to professional fees, including consultants, legal fees and costs associated with annual audit expenses and SEC filings, and $0.9 million related to data processing expense for hosting services and disaster recovery preparedness. Occupancy expenses decreased by $0.1 million.



Operating income for the six months ended June 30, 2011 was $36.6 million, an increase of $8.7 million, or 31.1%, compared to $27.9 million for the six months ended June 30, 2010. This increase was primarily the result of increased revenue, which was partially offset by incremental operating costs incurred during the period ended June 30, 2011.



Interest expense was $46,000 for the six months ended June 30, 2011 and June 30, 2010. Interest expense represents commitment fees for our Credit Agreement and issuance fees for our Letter of Credit. Interest income was $36,000 for the six months ended June 30, 2011, compared to interest income of $41,000 for the six months ended June 30, 2010. Net other income primarily relating to rental income from our office building in Irving, Texas was $549,000 for the period ended June 30, 2011. We purchased the office building in Irving, Texas in June 2010, as a result, we did not realize any rental income during the second quarter of 2010.



We recorded income tax expense of $14.9 million for the six months ended June 30, 2011, compared to income tax expense of $11.2 million for the six months ended June 30, 2010, an increase of $3.7 million. Our effective tax rate decreased to 40.1% for the six months ended June 30, 2011 from 40.2% for the six months ended June 30, 2010, primarily due to a change in state apportionments. The principal difference between the statutory rate and our effective rate is state taxes.



Net income of $22.2 million in the current period represents an increase of $5.5 million, or 33.2%, compared to net income of $16.7 million in the same period for the prior year.



Contractual Obligations



There have been no material changes in our contractual obligations as presented in our Annual report on Form 10-K for the year ended December 31, 2010.



Off-Balance Sheet Arrangements



We do not have any off-balance sheet arrangements. See Footnote 5 of the Notes to Unaudited Consolidated Financial Statements in this Quarterly Report on Form 10-Q.



Liquidity and Capital Resources



Our principal source of funds has been from operations. We believe that our cash, cash equivalents, and future cash flows from operations will be adequate to fund our current operating requirements. At June 30, 2011, our cash and cash equivalents and net working capital were $117.7 million and $181.6 million, respectively. We expect that operating cash flows will continue to be a primary source of liquidity for our operating needs. There are currently no loans outstanding under the Revolving Loan.



Net cash provided by operating activities for the six months ended June 30, 2011 was $24.2 million, compared to $22.3 million for the same period in 2010. The increase in cash provided by operating activities primarily resulted from net income of $22.2 million and non-cash expenses of depreciation and amortization, stock-based compensation, deferred income taxes and accretion of contingent consideration. These sources of cash were partially offset by increases in accounts receivable, prepaid expenses and other assets, together with decreases in accounts payable, accrued expenses and other liabilities.

CONF CALL


Bill Lucia

Thank you Jennifer and good morning everyone. It's a pleasure to have you join our fourth quarter and full year 2009 earnings call. I'm Bill Lucia, CEO of HMS Holdings. I'll be hosting the call along with Walter Hosp, our CFO.

The slide presentation designed to compliment the conference may be found may be found at our website at hms.com. Please see the quarterly results page under Investors and click on the link to the webcast.

We will be making forward-looking statements in the course of this call, so please refer to the list of qualifiers included in this morning's press release and the Safe Harbor statement on slide #2 of the presentation.

HMS finished a solid 2009 with a very strong fourth quarter financial performance. For the quarter, revenue was $66.3 million, up 26.5% and EPS was $0.33 per share, up 26.9% from the prior year quarter.

To start off this morning, Walther will take you through our financial results. Then, I'll briefly provide an overview of 2009 and the quarter and discuss the healthcare environment. Then, we'll take your questions. Walter?

Walter Hosp

Thank you Bill and good morning everyone. I'll walk through our fourth quarter 2009 results first and then turn to the full year results.

As Bill mentioned, revenue resulted in a quarterly record of $66.3 million, an increase of $13.9 million or 26.5% from the $52.4 million reported for the same quarter of 2008. Our reported revenues require some drilldown to better understand strength of HMS's revenue growth.

The acquisition of IntegriGuard added $3.7 million in revenue for the 2009 fourth quarter. Adjusting for the IntegriGuard revenue, growth for the quarter was 20%.

From a product view, program integrity grew 87% in the quarter to $13 million. Product sales for all other lines of business were $53.3 million for the quarter, up 17.4% and demonstrating the high teens growth rate that we had expected.

Regarding expenses, total cost of services for the quarter were $42.2 million, an increase of $7.1 million or 20% compared to the $35.1 million in the same quarter last year. Compensation expense related to the cost of services of $22.7 million increased $6.1 million of 37% from the same quarter of the prior year.

The unusually high growth in this line item results partially from a $2.5 million increase from the IntegriGuard acquisition and from cost shifting from the direct project cost line as we continued to hire temporary workers into full time positions.

The average total company headcount, including SG&A headcount was 1237 employees, an increase of 324 employees of 35.5% above the average headcount for the fourth quarter of 2008. But, IntegriGuard accounted for 126 of the 324 increase in headcount.

Data processing expense of $3.6 million, increased $0.6 million or 21% from the prior year quarter. Spending in this line item is associated with hardware expense and depreciation, software costs and data communication costs and decreased as a percentage of revenues to 5.4%.

Occupancy cost, $3.1 million will increase $0.3 million or 11% from the prior year. This increase was entirely related to the acquisition of IntegriGuard. We expect this line to fluctuate in the future as we continue to optimize our space and the consolidation of functions into our Irving, Texas facility.

Direct project costs of $7.2 million decreased $1.5 million or 17% from the same quarter of the prior year. As mentioned, this decrease was primarily the result of bringing work in house for which we formerly utilized sub-contractors, consultants and job-specific temporary help. We expect additional cost shifting of this type into 2010.

Other operating costs of $4.2 million increased 1.4 million or 46% year-over-year with $0.4 million coming from IntegriGuard. Other increases related to professional fees, travel, postage and delivery charges.

Amortization of intangibles was $1.4 million for the quarter, up $0.2 million or 20.2% higher than the prior year quarter. Intangibles increased slightly from the acquisition of IntegriGuard.

SG&A expenses were $7.9 million for the quarter earning increase of $2 million or 35% from the comparable period last year. As a percent of revenue, SG&A expenses did increase to 11.9% from 11.2% in the prior year. This increase is attributable to higher companywide compensation expense related from stock, also professional fees and local taxes.

Average headcount in our SG&A group increased from 66 to 76 employees or 15% year-over-year. This resulted in operating income for the quarter of $16.2 million, an increase of $4.8 million or 42% versus Q4 ’08. Operating margin for the quarter increased to 24% versus 22% in 2008.

Net interest expense was $0.2 million for the quarter, the same amount as in the fourth quarter last year. This was a result of reduced interest income from cash balances due to lower interest rates and reduced interest expense from lower debt levels.

Income taxes were $6.6 million for the current quarter for an effective tax rate of 41.6%, compared to $4.2 million with an effective tax rate of 37.4% for the same quarter prior year.

Our higher effective tax rate in the quarter resulted from a one time increase in our state apportionments due to a high level of option exercises in higher tax rate states. We do expect a lower effective tax rate in subsequent quarters and we maintain the 40.5% effective rate estimate we have guided to for 2010.

Net income for the quarter was $9.3 million, an increase of $2.3 million or 32.1% from prior year. Fully diluted weighted average shares outstanding for the quarter were 28 million shares and fully diluted EPS was, as mentioned, $0.33 up 27% for the quarter compared to the 26% reported for the fourth quarter of 2008. The $0.33 equates to $0.40 in cash or adjusted EPS and both EPS figures meet the consensus forecast of the analysts that cover HMS.

Looking at the full year income statement, revenue for 2009 was $229.2 million, 24% above revenue of a $184.5 million for 2008. Adjusting for the acquisition of IntegriGuard, annual total revenue increased 24% for the year.

From a product view, program integrity grew to $32.4 million in 2009, up 78% for the year. Product sales for all other product lines were $196.8 million for the full year, up 18.4%, again, validating the high teens growth rate we had projected.

Total operating expenses for the year was a $177.4 million, a 20% increase over 2008. As a percent of revenue, total operating costs decreased year-over-year from 80.1% to 77.4% demonstrating the operating leverage in our business model.

Compensation expenses related to cost of services of $77.2 million were up 27% or $16.6 million over 2008, $2.5 million of which was from IntegriGuard. Total headcount including SG&A averaged 1,053 full-time employees, a 24.3% increase over full year 2008.

Data processing expenses were $13.7 million, up 25% versus the prior year. Most of this increase related to software with the balance related to depreciation and amortization and data communications.

Our occupancy costs increased only 7.9% or $0.8 million year-over-year, as we subleased some higher cost space and replaced it with additional low cost space in Texas. Direct project costs decreased 0.2% to $28.4 million for the year again, mainly due to the cost shifting into compensation expense and other operating costs as mentioned before.

Other operating costs were $14 million, up 29% versus prior year. Most of this increase came from increases in non-payroll, contract personnel and consultants, which has been decreased substantially in the second half of 2009.

SG&A expenses for year of $28.1 million was 27% higher than the prior year resulting in SG&A as a percentage of sales of 12.3%, slightly higher than the 12% last year. The main driver of this increase over last year was higher company-wide stock compensation expense, which is all within SG&A.

Operating income for the year was $51.9 million, an increase of $15.1 million or 41% which resulted in a full year operating margin of 22.6%, a 2.6 point increase compared to the 20% operating margin for 2008.

Net interest expense of approximately $0.9 million increased slightly compared to the $0.8 million last year. Having fully paid off our term loan in the fourth quarter, we fully advertise our deferred financing costs at the same time.

Additionally, savings related to lower interest expense were offset by lower interest earnings on our cash balances.

Our full year tax expense of $21 million resulted in a 41.1% effective tax rate for the year and was slightly above our guidance rate of 41%. As mentioned, we continue to expect an effective rate of 40.5% for 2010 guidance.

Net income was $30 million for 2009, up 41% for the year. Fully diluted outstanding shares were $27.6 million for 2009 and fully diluted EPS for the year was $1.09 versus $0.80 in 2008, an increase of 36%.

Cash or adjusted EPS for the year was $1.33. The $1.9 GAAP and the $1.33 cash EPS were both $0.01 above the consensus forecast of security analysts.

We now turn to the balance sheet and look at our general financial condition at December 31, 2009. Our cash and cash equivalents were $64.9 million having decreased from $69.5 million at the end of Q3 '09. Cash decreased $4.7 million due to debt payments and acquisitions, which I will discuss later but remain at a very healthy level.

As at the close of business yesterday, we had over $73 million of cash on hand and this cash continues to be invested in federally insured money market accounts.

Accounts receivable of $64.8 million grew 43% from year-end 2008. Due to a higher level of business activity the number of day sales outstanding at year-end increased to 87 days, compared to 84 days at the end of September 2009.

On the liability side, accounts payable, accrued expenses and other liabilities were $26.5 million, an increase of 16%, again related to the level of business activity. We fully repaid all our $17.3 million in outstanding debt by October 2009 and so had no debt outstanding as of 12/31/09.

There still have been no borrowings under our $25 million revolving credit facility. For 2009, we anticipate that existing cash balances and funds generated by operations, will be sufficient for all of our cash needs.

Looking at the statement of cash flows for the year-ended 2009, cash provided by operations increased to $32.8 million, an increase of 6% compared to $30.8 million in the same period of the prior year.

Cash from operations did not grow as rapidly as revenues or profits due primarily from higher working capital requirement and accounts payable, accounts receivables and prepaid expenses. We expect strong cash flow in Q1 2010 as we work down these working capital items.

Cash used in investing activities was $23.2 million. Purchases of property, equipment and software development were $10.7 million. During the year we acquired Verify Solutions, which utilized $7.5 million and IntegriGuard, which utilized $5 million.

Cash provided from financing activities of $6 million consisted of $10.1 million received from stock option exercises and $13.2 million for the tax benefit from the exercised stock options. This was partially offset by the $17.3 million in principal payments on the term loans.

We expect that given our outstanding pool of unexercised stock options, our cash taxes will continue to benefit substantially from disqualifying dispositions into 2010. However, we also expect to pay increasing amounts of cash taxes in 2010. We are currently estimating cash taxes at $10 million for the year.

Now, onto guidance. As we are only in the first quarter of this year, which due to our seasonality is our weakest quarter, we are not at this time changing our 2010 guidance. We are however reaffirming it. Guidance for 2010 remains at $280.5 million for revenue and $1.34 for GAAP EPS or a $1.59 for cash or adjusted EPS.

Bill will comment more about the strength we are seeing in our business, as we work our way through Q1. Or if we have any material developments in the quarter we will revise our 2010 guidance accordingly.

That concludes our review of the financial results and the financial position of the company.

Bill?

William Lucia

Thanks Walter. I’d now like to spend a few minutes highlighting some of our key strategic successes from 2009, which combined served as an excellent platform for 2010 and why we are very optimistic about the continued high levels of growth for HMS.

In our state government market, we won competitive procurements in five states, two of which Mississippi and Minnesota were new to us. Many of these contracts include a broad range of services. We should note however with the scope of procurements expanding, we're finding that the line between our coordination of benefits and program integrity services is blearing.

As we announced this quarter, HMS has entered into a subcontract with ACS State Healthcare LLC to provide cost avoidance and retrospective recoveries for the state of Florida's agency for healthcare administration. We believe that this subcontract underscores the value that HMS brings to Medicaid programs across the nation.

Now in our MCO business, we added 4.4 million Medicaid managed care lives to our portfolio in 2009 ending the year with a total of 16.6 million lives under contract, 89% of which are implemented and now generating revenue.

In 2009 our managed care business extended beyond just Medicaid to now include Medicare advantage, commercial and behavioral health lives. At the Federal level, we were awarded a second Medicaid Integrity Program task order by CMS comprising 11 states and territories.

With this award, HMS became the next contractor for 22 states and territories and a key contractor to the Federal government for identifying potential over payments resulting from fraud, waste, and abuse in the Medicaid program.

We also expanded our program integrity footprint by securing a number of key contracts in both the state and managed care market.

On the state side, we secured a behavioral health audit contract in Virginia, utilization review services for the state of Massachusetts and real time pharmacy audit services in Indiana, just to mention a few. We also sold program integrity services to large managed care organizations including Centene, Molina Healthcare, and Coventry Healthcare. From 2008 to 2009, as Walter mentioned, our revenues from program integrity grew 78%.

And finally as a result of our M&A activity in 2009, we entered two new strategic markets. First with the acquisition of IntegriGuard, we became a key player in fraud, waste, and abuse service for the Medicare program. As a CMS contractor, IntegriGuard is recognized as having the expertise and capabilities to perform program integrity work to protect the Medicare trust fund under the Medicare integrity program. Their potential impact can be significant.

As an example, IntegriGuard worked behind the scenes for more than 6 years, providing thousands of hours of audit, investigation, medical review and data analysis services to the Office of Inspector General. Their efforts provided the U.S. Attorney's Office, the OIG, and the FBI with information that helped to resolve a law enforcement investigation that led to a $60 million Medicare settlement.

We’re confident that these fraud analysis and investigative services can also be applied to our Medicaid and managed care markets over the years to come.

And in late December, we completed the acquisition of Verify Solutions. HMS through Verify now offers a proven dependant eligible audit product for self-insured employers. This audit services assures that our clients are paying healthcare costs only for those employees who are truly eligible.

And as recently reported by Price Water House Coopers’ Health Research Institute, employers are increasingly hiring experts to audit their benefit plans. According to PWC, 3% to 8% of people fail to produce dependent verification. And at $1900 average annual cost per dependent, savings can range in the millions of dollars for employers.

Based on Verify's experience we believe these rates are actually conservative. Demand for these audits is expected to continue to increase in 2010. We have also begun to cross-sell these services into our large government and managed care markets. And we believe that the large self-insured employer will ultimately benefit from our broad range of program integrity services.

Now lets touch briefly on healthcare reform. Given the recent events, the outcome of healthcare reform remains unclear. The Senate and House must reach agreement on a final bill. The two major parties appear to be far apart idealogically, so this debate will be complex and political.

However, national healthcare spending is estimated to have grown 5.7% and reached $2.5 trillion in 2009. CMS reports that national health spending is expected to grow at an average annual rate of 6.1% to $4.5 trillion by 2019.

Medicaid spending in particular will grow significantly. Federal and State Medicaid spending combined is projected to have grown 9.9% in 2009, the fastest rate of growth since 2002.

And regardless of what reform ends up looking like, medicaid is already conservatively projected by CMS to continue to grow an average 7.5% for the years 2013 through 2019, more than doubling in size. And, new claims for unemployment climbed unexpectedly last week, while people filing continuing claims did not drop. Many economists believe that unemployment will continue to rise this year.

Unemployment is the largest driver of future medicaid growth and the conservative estimates we see from CMS may not be factoring in the continued high unemployment and under-employment.

This comes at a time when individual buyers of health insurance are seeing record increases in premium rates. Insurers state that older and sicker individuals are keeping their insurance, while the younger and healthier drop coverage.

Reform proposals in Congress are aimed at addressing this issue, mandating that most individuals buy coverage, but are also assisted by premium subsidies to acquire more competitive and comprehensive coverage. You might ask as we do, how is this going to be financed? Well for medicaid CMS's fiscal year 2011 budget proposal includes $25.5 billion in medicaid assistance for states.

This expands on the Federal stimulus that already granted states $87 billion. It’s clearly an indication that the federal government will continue to support states as they deal with their expanding medicaid roles in this economic environment.

Given this rate of growth, the Federal Government must focus on cost containment and in CMS's 2011 budget is $1.7 billion to fight fraud, including $561 million in discretionary funding for Health Care Fraud and Abuse Control and $52 million in discretionary funding for the Office of the Inspector General.

Healthcare fraud has become a high profile issue and we expect to see increased interest in our program integrity offering as a result. In summary, our company has become larger and more diverse with an ever expanding range of services offered to more classes of healthcare payers.

We continue to seek bolt-on acquisitions that we can leverage across our growing client base. The programs we serve continue to grow and continue to need our services. All of these factors are very positive for HMS and our shareholders as we proceed into 2010 and beyond. We look forward to building on our strong performance in 2009.

This concludes our formal discussion about the business and we will now be happy to take your questions.

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