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Edited Transcript of PFMT earnings conference call or presentation 1-Mar-17 10:00pm GMT

Thomson Reuters StreetEvents

Q4 2016 Performant Financial Corp Earnings Call

Livermore Mar 2, 2017 (Thomson StreetEvents) -- Edited Transcript of Performant Financial Corp earnings conference call or presentation Wednesday, March 1, 2017 at 10:00:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Richard Zubek

Performant Financial Corporation - IR

* Lisa Im

Performant Financial Corporation - CEO

* Hakan Orvell

Performant Financial Corporation - CFO

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Conference Call Participants

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* Michael Tarkan

Compass Point Research & Trading - Analyst

* Brian Hogan

William Blair & Company - Analyst

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Presentation

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Operator [1]

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Greeting and welcome to Performant Financial Corporation's fourth-quarter and full-year 2016 earnings conference call. At this time all participants are in a listen only mode.

(Operator Instructions)

I would now like to turn the conference over to Mr. Richard Zubek, Investor Relations for Performant. Thank you, Mr. Zubek, you may now begin.

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Richard Zubek, Performant Financial Corporation - IR [2]

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Thank you operator, good afternoon everyone. By now you should have received a copy of the earnings release for the Company's fourth-quarter and full-year 2016 results. If you have not a copy is available on our website, 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 risks and uncertainties including those 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?

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Lisa Im, Performant Financial Corporation - CEO [3]

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Thank you Rich, good afternoon, everyone, and thank you for joining us for our earnings call. Today I will give you a quick overview of our 2016 operational results then after Hakan provides a detailed financial update I will talk about how we are building the business, the implementation of IRS and CMS contracts, and status with the Department of Education contract. I will also provide our guidance and thoughts on 2017.

Full-year 2016 revenues and EBITDA were $141.4 million and $25.9 million, respectively. Revenue decline of $18 million versus prior year is entirely due to the wind down of the old Department of Education and CMS region A recovery audit contracts. Operating expenses without the customer relationship impairment were down $18.6 million or, 12.2% from prior year.

As we look specifically at our full-year key markets, total student lending accounted for revenues of $109.6 million which is down from last year by $9.8 million. Growth of $6.1 million, or 7.5% up, from other clients partially offset the Department of Education runoff decline of $15.9 million. Healthcare revenues of $11.4 million is down versus prior year by $8.5 million to the prior recovery audit contract end.

Revenue from other operations were $20.4 million, slightly up $300,000 from prior year. With that I would like to turn the call over to Hakan to walk you through the financials. Hakan?

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Hakan Orvell, Performant Financial Corporation - CFO [4]

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Thank you Lisa, and good afternoon everyone. Today we are reporting results for the fourth quarter with revenues of $33.8 million, net loss of $12.3 million or $0.24 per share, and adjusted EBITDA of $4.9 million.

Beginning with our student lending business revenues totaled $27.4 million, a decrease of $5.5 million compared to the fourth quarter of last year. During the quarter the Department of Education accounted for $3.7 million of revenues while guaranty agencies generated $23.7 million. These amounts represent a decline of $5.9 million and an increase of $0.5 million respectively when compared to the fourth quarter 2015. The decrease in student lending revenues is a reflection of Performant not receiving any new student loan placements from the Department of Education since April 2015.

Furthermore because we were not included in the December Department of Education contract award, from an accounting perspective it was appropriate to assess $15.4 million Department of Education customer relationship intangible asset for impairment. While we believe there are strong grounds for a protest, given the uncertainty around the outcome of the protest we were not able to conclude that the Department of Education customer relationship met the definition of an asset with probable future economic benefit.

Based on this conclusion, a non-cash expense of $15.4 million taken in Q4 2016 to write off the Department of Education customer relationship intangible asset. With respect to our guaranty agency results, we benefited primarily from strong placement volumes that were received at the end of last year. Student loan placements from guaranty agencies during the fourth quarter of 2016 totaled $0.6 billion, down from $0.9 billion in the fourth quarter of 2015.

Our healthcare revenues in the fourth quarter were $2.3 million compared to $4.3 million in the fourth quarter of last year. Revenues from our work for the Centers for Medicare and Medicaid was $0.6 million, down from $2.8 million in the prior-year period and our commercial healthcare business generated revenues of $1.8 million, an increase from the fourth quarter of 2015. Although we anticipate being able to begin auditing providers in region one and five under the CMS Medicare fee-for-service recovery audit program contracts in the second quarter 2017, we do not anticipate our results to have a meaningful impact on our 2017 financial results. Our other markets generated revenues of $4.1 million in the fourth quarter compared to $3.9 million in the prior-year period.

Moving to our expenses, salaries and benefit expense in the fourth quarter was $18.8 million, a decrease of 8.3% compared to $20.5 million in the prior-year period. Other operating expense for the quarter was $14.6 million, a decrease of 7.7% compared to the fourth quarter of 2015, primarily due to reduced volume related costs and other completed cost reduction initiatives.

For the fourth quarter of 2016 our reported net loss was $12.3 million or $0.24 per diluted share compared to net income of $2.2 million or $0.04 per diluted share in the prior-year period. Adjusted net loss in the fourth quarter was $1.5 million or $0.03 per diluted share compared to adjusted net income of $4 million or $0.08 per diluted share in the prior-year period. Fully diluted weighted average outstanding shares were 50.2 million shares in the fourth quarter of 2016.

Our adjusted EBITDA in the fourth quarter was $4.9 million compared to $9.8 million in the same period last year. Adjusted EBITDA margin was 14.6%. Our effective income tax rate increased to 28% for the year ended December 31, 2016 from 17% for the year prior.

The increase in the effective tax rate is primarily due to the increase in the 2016 net loss as the net loss in 2015 was closer to breakeven and the impact of permanent differences in state taxes was therefore reduced on a percentage basis by the larger loss in 2016, offset by the recorded valuation allowance in 2016. Cash flows from operating activities for FY16 were $17.8 million.

Turning to our balance sheet as of December 31, 2016 we had cash and cash equivalents of $33 million and our total outstanding debt was $55.2 million reflecting our continued focus on paying down our long-term debt. Lastly, as we mentioned last quarter we entered into an amendment of our credit agreement adjusting several our covenants through the fourth quarter 2017. This amendment is expected to provide us with additional flexibility to operate our business uninterrupted during FY17.

Additionally we have started the process of assessing our options as it relates to refinancing of our debt that becomes due in March 2018. As part of this process we have proactively solicited proposals from a number of financial advisors and investment bankers and have been looking to pursue the best available options for Performant. Now I will turn the call back to Lisa for some concluding remarks.

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Lisa Im, Performant Financial Corporation - CEO [5]

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Thanks, Hakan. In our last earnings call we announced a contract award for one of four positions on the IRS recovery contract. This program is a 10-year $2.4 billion pay for in the December 2015 highway transportation bill.

The target timeline for implementation remains Q2. Thus far the IRS' internal implementation team has been very focused on assessing and auditing companies for operational preparedness. We believe the thoroughness will add to a strong foundation in creating a very successful program.

Because this operation is one of building repayment plans for taxpayers who owe back taxes we believe it may take 18 to 24 months to see a solid run rate. Therefore we do not anticipate material impact in 2017. We are honored to be one of the initial vendors and believe that this contract could be very successful with great long-term potential.

We also received two new recovery audit contract awards for region one and region five from CMS. Region one was reconstructed to include 11 states in the Northeast and Midwest. You may recall that CMS equalized regions proportionately for the new contract. Some states dropped out and others were added. All in, we believe this is a positive. Region five is the national durable medical equipment and home health and hospice contract.

We have been working with the CMS operational team with the goal of beginning to implement the new contracts in April. However, due to the timing of revenue recognition we do not expect these contracts to have material impacts during 2017 but believe they remain strong future opportunities as CMS continues in their efforts to correct improper payments. Given CMS's reported error rates of 11% for total gross errors and 46.3% error rate on durable medical equipment, we are cautiously optimistic that CMS will continue to thoughtfully increase audit scope and volume limits in the recovery audit program.

With regard to the Department of Education contract, in January we protested the departments contract award decision. Although I cannot specifically comment on the details of our protest, we do know that the process is moving forward. While we cannot speculate on the outcome the current target timeline for GAO's ruling is mid-April. Regardless, we do believe we have strong grounds for protesting the award and will continue in that effort. As a reminder even if we were to receive an award early this year it would not have material impact until next year.

With these factors we believe 2017 will be a year in which we continue to execute against our growth strategies in other markets in healthcare. While we have not spent much time talking about our other markets we have been growing this revenue stream which includes specialty customer care contracts. These are contracts that require concierge level expertise and care and given our high level of regulatory compliance and trained workforce we are seeing some early success in expanding into this market. The current forecast is built on a handful of contracts already implemented which drives our growth of that business to be in the $25 million to $28 million revenue range for 2017, which represents growth of approximately 30% versus prior year.

You may recall that we restructured our commercial healthcare operation in 2016 which started to show improving results in Q4 of 2016. With contracts and products implemented, our audit and data mining run rate revenues are starting to trend upward during Q4 2016 and heading into 2017. Additionally with the startup of the two CMS recovery audit contracts, which will start to show some revenue in late Q2, we estimate healthcare revenue to be in the $15 million to $20 million range 2017, representing sustainable revenue growth of over 50% versus prior year.

During 2017 we will continue to focus on providing the best service possible to our clients and competitively differentiate ourselves through regulatory compliance and customer care. We are seeing growth and expansion in other markets in healthcare. That said, given the IRS and CMS contract timeline during 2017 we do not expect those to have meaningful revenue contribution in this startup year.

All of those factors combined, we expect revenue and EBITDA to decline versus prior year as the old Department of Education business runs off, and with currently known factors our 2017 revenue and EBITDA guidance is in the range of $125 million to $145 million and $10 million to $13 million, respectively. With that we would like to open up the call for questions.

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Questions and Answers

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Operator [1]

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Thank you.

(Operator Instructions)

Our first question is from Michael Tarkan of Compass Point. Please go ahead.

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Michael Tarkan, Compass Point Research & Trading - Analyst [2]

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Thanks for taking my questions. A few you on the education side.

As it relates to the ED contract, can you walk us through how the GAO process works? Do you get a chance to meet with the GAO or do they decide based on your written protest and their decision you are expecting by April?

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Lisa Im, Performant Financial Corporation - CEO [3]

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The GAO process is back and forth so there is some dialogue but largely through our counsel. At this point we have had a couple of different communications with the GAO through our counsel and the GAO as I mentioned in the call, the target date is mid-April. The process continues but we don't have direct interface with the GAO.

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Michael Tarkan, Compass Point Research & Trading - Analyst [4]

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That's helpful. I guess as a contingency if the GAO was to deny the protest, how are you thinking about other opportunities to serve as a subcontractor on the education contract for some of those that did win the contract? Is that possible?

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Lisa Im, Performant Financial Corporation - CEO [5]

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It is definitely possible and to be perfectly honest we are already starting that up with some of the folks that we already know so we are looking at all of the ways we can participate in the contract. There are different paths. One of them is certainly subcontracting. We are already down that path.

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Hakan Orvell, Performant Financial Corporation - CFO [6]

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As we look at that part of the process, the small business set-aside contract was awarded before the unrestricted category so [this will result] in getting large placements and we are again working with a few of those smaller businesses on the ED portfolio.

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Michael Tarkan, Compass Point Research & Trading - Analyst [7]

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Okay. I guess shifting gears a little bit but staying on education.

On the guaranty agency business, I know you have a long relationship with Great Lakes. I know that a big GA was just consolidated underneath Great Lakes and I'm just wondering how you think about opportunities to expand that relationship potentially winning that contract going forward?

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Lisa Im, Performant Financial Corporation - CEO [8]

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We think there will be a process. As you may know, in the market there are not that many organizations who do full portfolio management or master servicing agreements. We believe Great Lakes historically has always been a very fair and very conscientious not-for-profit organization. We believe there probably will be some sort of a process.

To date we've had a very long-term relationship with Great Lakes and our service to them has been an ongoing dialogue of achieving not only their results but over achieving their results. Continuing to improve our customer service to them. So we believe there will be an opportunity to at least be a player in the ring. I think there's probably more to come on that as the year passes.

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Michael Tarkan, Compass Point Research & Trading - Analyst [9]

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Okay, thanks. Hakan or Lisa, from a modeling perspective what are you guys assuming for CapEx for 2017?

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Hakan Orvell, Performant Financial Corporation - CFO [10]

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We expect CapEx to be pretty consistent with the CapEx we've had in 2016, so you are looking at approximately $8 million.

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Michael Tarkan, Compass Point Research & Trading - Analyst [11]

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Lastly for me, big picture here, you have three valuable contracts in hand but they are not going to be a material contributor to revenue in 2017 and you will have to build expenses. You have a stable guaranty agency collections business with upside.

At what point does it make sense for you guys to start thinking about strategic alternatives for somebody who maybe is a little better capitalized that would see value in those contracts where you wouldn't have to be standalone independent entity? Thanks.

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Lisa Im, Performant Financial Corporation - CEO [12]

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As a board we regularly have dialogue around the right capital structure for the Company and alternatives. I will tell you that as a board we are conscientious of the Company's outlook, about the long-term prospects and about strategic alternatives. That is an ongoing dialogue at the board level and has been, so we will continue to discuss that.

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Michael Tarkan, Compass Point Research & Trading - Analyst [13]

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Okay thank you.

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Operator [14]

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Thank you. The next question is from Brian Hogan of William Blair. Please go ahead.

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Brian Hogan, William Blair & Company - Analyst [15]

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Good afternoon.

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Lisa Im, Performant Financial Corporation - CEO [16]

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Hi Brian.

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Brian Hogan, William Blair & Company - Analyst [17]

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My questions center around -- initially around the revenue growth cadence by quarter. Obviously the first quarter would be a little soft because you don't have any of those contracts ramped up yet. Exiting 2017 what do you think the revenue cadence will be so it will be back end loaded?

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Hakan Orvell, Performant Financial Corporation - CFO [18]

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It will be better than next, Brian. First of all we do have a ramp on the healthcare part of our business and in other. We do still have some benefit from the Department of Education contract in particular in Q1, so that will act as a bit of an offset. As we look at it, it is back loaded but not significantly so.

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Lisa Im, Performant Financial Corporation - CEO [19]

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To our earlier comment, the CMS contract and the IRS contract will not be at their full ramp by fourth quarter so they will still be in a very soft start up phase of those contracts even at the end of 2017.

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Brian Hogan, William Blair & Company - Analyst [20]

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Have you sized up what the actual run rates fully ramped would be?

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Lisa Im, Performant Financial Corporation - CEO [21]

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It is hard for us to say, as I mentioned the DME error rate nationally is 46.3%. Almost all of that is improper payments versus undocumented or missing documentation. We are working with CMS to get a sense of exactly how they are going to approach that contract relative to document limits or audit scope.

We think, clearly, that error rate needs to come down and we think that's a contract that has a separate kind of view and revenue potential than the regional complex audit scope contracts. On the IRS contract there is a deliberate and very careful start.

That said, the last number that we have in 2011 there were $160 billion of unpaid back taxes. I'm speculating here but I'm guessing that number probably has not come down. We are not saying we are going to have access to all of that but we believe the IRS will very carefully start the contract and the longer-term run rate will depend on how well the contract is going.

As I mentioned earlier this is actually a pay for, so there is a need to drive $2.4 billion in a period of 10 years to pay for the project that we are included in the highway transportation bill. If you take that number and, say, back into it a 10-year timeframe that number has to be achieved. At this point I can't tell you in 2018 or 2019 this will be the run rate but I can tell you this program we believe the IRS is starting again.

These federal programs have to be done well. They have to start well. They have to have the level of compliance that can stand up to any criticism. That said it's a big pay for, we do anticipate that at some point it's going to hit a run rate that starts to achieve that paid for need.

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Brian Hogan, William Blair & Company - Analyst [22]

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Thanks for that color, we appreciate it. The Great Lakes consolidating the USA funds, from what I understand USA funds was quite large, can you actually size up that opportunity? Obviously, there's a lot of puts and takes there. Can you just size that for us please?

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Lisa Im, Performant Financial Corporation - CEO [23]

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I hesitate to give you sort or sizing up the opportunity, what I can tell you is that it is publicly available information but in terms of overall student loans and student loan portfolios, Great Lakes is about $30 billion and [UCF] is about $50 billion.

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Brian Hogan, William Blair & Company - Analyst [24]

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I assume they have the same delinquency rates. Because they are so large.

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Lisa Im, Performant Financial Corporation - CEO [25]

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You know, I don't have those actually at hand but I don't think there would be too much difference between those.

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Brian Hogan, William Blair & Company - Analyst [26]

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Staying in education with the GAO protest, what happens if you or the other 42 protests are successful? Is it rebid or an individual case basis? In that scenario what happens?

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Lisa Im, Performant Financial Corporation - CEO [27]

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There are several paths that any federal agency can take if they are ordered by the GAO to take corrective action. That corrective action could be -- and I will give you examples from historical cases -- some agencies have added the contractors who protested. It's unlikely that will be the case here because of the number of protests that are outstanding.

The agency could choose to cancel the procurement and hit a reset button and that for Department of Education could come in the form of reissuing and RFP which you know is public or an RFQ which is a more focused search for vendor partners and one that they have historically taken prior to this particular procurement. They could do that. And then the third is try to negotiate but I doubt any of those paths will be taken.

It depends on what decision they make. What the GAO instructs them to do and Department of Education could also send out a clarification to the responses in the RFP. For example, if there were some flaw in the procurement that GAO pointed out specifically, the Department of Education could choose to send an amendment to the procurement and ask vendors for clarifying sections to be resubmitted. There are several different paths that could be taken.

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Brian Hogan, William Blair & Company - Analyst [28]

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Thoughts on the federal student lending program in general given the change in the administration and as it relates to this contract as well, do you have any thoughts?

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Lisa Im, Performant Financial Corporation - CEO [29]

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I have many thoughts but I think you've read as much as I have. Much of the criticism of what the old administration left behind. What I would tell you is I've read a lot of -- and probably agree more with what the Wall Street Journal has printed in terms of what the liability is for the federal government.

There is a specific article that was posted January 22 which, and I quote, the combination of cynicism and incompetence is what made the Obama administration's regulatory machine so destructive. One of the biggest messes it leaves behind is the government takeover of student loans that is likely to saddle taxpayers with hundreds of billions in lawsuits. The Trump administration now has to begin the cleanup job.

I think it is a very complex situation. When we have read comments by Mrs. Virginia Foxx who is the chair of the Education and Labor Workforce committee, she publicly stated that she would like to endeavor a more effective public-private partnership that would be of benefit to the government and the ultimate students as well. We are hopeful that there will be a chance for private-public partnership that does not look just like the old program but maybe more successful and better for taxpayers and for student loan borrowers.

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Brian Hogan, William Blair & Company - Analyst [30]

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You would have a partnership with a private [line] such as the GA, maybe partake in that?

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Lisa Im, Performant Financial Corporation - CEO [31]

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We will have to see what the structure looks like. I really could not speculate at this point what that structure is. This is certainly not something that would be done in the first 100 days but I think a bit longer term endeavor. Our hope is that there will be a good program that is constructed for future entitlement programs for future borrowers and for the government as well.

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Brian Hogan, William Blair & Company - Analyst [32]

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Shifting to health care the commercial healthcare in particular, you said you were ramping up and saw a nice ramp up in the fourth quarter. What is that trend and I know you gave some numbers like $15 million to $20 million total in healthcare, how much of that is commercial and trajectory of that, please?

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Hakan Orvell, Performant Financial Corporation - CFO [33]

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As Lisa mentioned the guidance we gave in the healthcare area is revenues of $15 million to $20 million. We expect the growth to come from commercial. We are today not being specific as far as how much is [vac] and how much is commercial but in total we are looking at guidance of $15 million to $20 million.

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Brian Hogan, William Blair & Company - Analyst [34]

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Okay and can you elaborate on the $25 million to $28 million of other revenue and why it is up 30%? That can't all be IRS since it's back end loaded.

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Lisa Im, Performant Financial Corporation - CEO [35]

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IRS is a very small part of that. We have a customer care contract that we are implementing and it's already implemented so we should see that revenue. That has given us an ability to see where we can play in that kind of market. So it's a new contract implementation and our efforts will continue during the course of this year.

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Brian Hogan, William Blair & Company - Analyst [36]

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Okay and finally for me, debt covenants, how are you progressing on those and what are your conversations with your lenders?

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Hakan Orvell, Performant Financial Corporation - CFO [37]

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First of all, as you know we amended our covenants last quarter through the end of 2017. The covenants are set and we feel good about meeting the covenants so no issues from that perspective.

What we are doing, as I mentioned in my opening remarks, is with the debts becoming due in March 2018 we started the process in evaluating options. I've been in contact with different financial advisors and investment bankers to come up with the best approach and best solution for Performant. That's the process right now.

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Brian Hogan, William Blair & Company - Analyst [38]

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And last one. The placements from the GAs is 0.6 in the quarter, is that what you expect going forward or is it going to be kind of lumpy or should we expect some growth?

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Hakan Orvell, Performant Financial Corporation - CFO [39]

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First of all it does fluctuate from quarter to quarter as you've seen over the last few years and we had in a couple of quarters ago we had placements in the GA space of $1.3 billion, so it does fluctuate. There were impacts on us and stay very focused. We are working very closely and performing with our GA clients and there are opportunities where we have been able to increase market share so that is a strong focus.

Then you have the opportunities through consolidation that are taking place in the past and some of our strategic clients, large GA clients are often times the aggregators of that business. Assuming there is business that is aggregated in, [in what we already have], that provides us again with placement pickups. With all of that said, we expect it's going to fluctuate by the nature of those moving parts but over all as you look year-over-year it's fairly stable.

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Brian Hogan, William Blair & Company - Analyst [40]

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All right thank you.

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Operator [41]

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Thank you.

(Operator Instructions)

We have no further questions at this time I would like to turn the conference back over to management for closing remarks.

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Lisa Im, Performant Financial Corporation - CEO [42]

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Thank you. Our 2016 results exceeded our expectations as we continue to execute improvements in productivity, grow share with our current clients and effectively manage our expenses. We are implementing the IRS and recovery audit contract awards and believe these evidence our ability to succeed in our markets and expand into close adjacencies so we can leverage our core skills.

We also believe these contracts have room to grow and become very valuable programs to our clients and to our business. Our competitive differentiation continues to be our overarching client-centric focus, our service value proposition, our consumer sensitivity and deep commitment to regulatory compliance.

Before I go I want to again thank our clients for letting us serve them and thank our employees for bringing their very best efforts to our organization. We thank you for being with us on the call today.

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Operator [43]

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Thank you. Ladies and gentlemen, this does conclude today's teleconference. You may disconnect your lines at this time and thank you for your participation.