Cotiviti Holdings, Inc. - FORM 10-Q

Attached files

file	filename
EX-32.2 - EX-32.2 - Cotiviti Holdings, Inc.	cotv-20160930ex32204662e.htm
EX-32.1 - EX-32.1 - Cotiviti Holdings, Inc.	cotv-20160930ex32188f4a8.htm
EX-31.2 - EX-31.2 - Cotiviti Holdings, Inc.	cotv-20160930ex312051bf2.htm
EX-31.1 - EX-31.1 - Cotiviti Holdings, Inc.	cotv-20160930ex311adc643.htm
EX-10.1 - EX-10.1 - Cotiviti Holdings, Inc.	cotv-20160930ex101be591f.htm

Table of Contents

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, DC 20549

Form 10-Q

(Mark One)

☑ QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2016
OR

◻ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

Cotiviti Holdings, Inc.

(Exact name of registrant as specified in its charter)

Delaware

(State or other jurisdiction of incorporation)

001-37787 (Commission File Number)	46-0595918 (IRS Employer Identification No.)
115 Perimeter Center Place Suite 700 Atlanta, GA 30346 (Address of principal executive offices)	30346 (Zip Code)

(770) 379-2800

(Registrant’s telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes ☒ No ☐

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes ☒ No ☐

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b‑2 of the Exchange Act. (Check one):

Large accelerated filer	☐	Accelerated filer	☐

Non-accelerated filer	☒ (Do not check if a smaller reporting company)	Smaller reporting company	☐

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ☐ No ☒

The number of shares of the registrant’s common stock, $0.001 par value, outstanding as of September 30, 2016 was 90,170,462.

Table of Contents

INDEX


ITEM 1.	Consolidated Financial Statements	1
ITEM 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	21
ITEM 3.	Quantitative and Qualitative Disclosures About Market Risk	40
ITEM 4.	Controls and Procedures	41

PART II - OTHER INFORMATION

ITEM 1.	Legal Proceedings	42
ITEM 1A.	Risk Factors	42
ITEM 2.	Unregistered Sales of Equity Securities and Use of Proceeds	42
ITEM 3.	Defaults Upon Senior Securities	42
ITEM 4.	Mine Safety Disclosures	42
ITEM 5.	Other Information	42
ITEM 6.	Exhibits	43

Table of Contents

PART I - FINANCIAL INFORMATION

ITEM 1. Consolidated Financial Statements

Cotiviti Holdings, Inc.

Consolidated Balance Sheets

(In thousands, except share and per share amounts)


	September 30,		December 31,
	2016		2015
	(Unaudited)
ASSETS
Current assets:
Cash and cash equivalents	$	43,770	$	149,365
Restricted cash		10,202		10,741
Accounts receivable, net of allowance for doubtful accounts of $1,561 and $1,053 at September 30, 2016 and December 31, 2015, respectively; and net of estimated allowance for refunds and appeals of $31,887 and $33,406 at September 30, 2016 and December 31, 2015, respectively		83,345		78,856
Prepaid expenses and other current assets		23,313		24,044
Deferred tax assets		33,346		32,919
Total current assets		193,976		295,925
Property and equipment, net		63,768		57,452
Goodwill		1,196,350		1,197,044
Intangible assets, net		548,593		594,410
Other long-term assets		2,866		2,176
TOTAL ASSETS	$	2,005,553	$	2,147,007
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Current maturities of long-term debt	$	18,000	$	21,099
Customer deposits		10,202		10,741
Accounts payable and accrued other expenses		28,331		29,521
Accrued compensation costs		41,520		42,902
Estimated liability for refunds and appeals		70,596		67,775
Total current liabilities		168,649		172,038
Long-term liabilities:
Long-term debt		766,042		1,012,971
Other long-term liabilities		9,454		12,199
Deferred tax liabilities		152,967		162,203
Total long-term liabilities		928,463		1,187,373
Total liabilities		1,097,112		1,359,411
Commitments and contingencies (Note 6)
Stockholders’ equity:
Common stock ($0.001 par value; 600,000,000 and 122,000,000 shares authorized, 90,177,862 and 77,237,711 issued, and 90,170,462 and 77,230,311 outstanding at September 30, 2016 and December 31, 2015, respectively)		90		77
Additional paid-in capital		905,963		807,419
Retained earnings (deficit)		8,625		(14,935)
Accumulated other comprehensive loss		(6,139)		(4,867)
Treasury stock, at cost (7,400 shares at September 30, 2016 and December 31, 2015)		(98)		(98)
Total stockholders’ equity		908,441		787,596
TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY	$	2,005,553	$	2,147,007

See accompanying notes to consolidated financial statements.

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Cotiviti Holdings, Inc.

Consolidated Statements of Comprehensive Income (Loss)

(In thousands, except share and per share amounts)

(Unaudited)


	Three Months Ended				Nine Months Ended
	September 30,				September 30,
	2016		2015		2016		2015
Net revenue	$	156,241	$	136,936	$	457,250	$	389,880
Cost of revenue (exclusive of depreciation and amortization, stated separately below):
Compensation		58,517		46,424		167,263		132,928
Other costs of revenue		6,658		5,646		17,331		14,629
Total cost of revenue		65,175		52,070		184,594		147,557
Selling, general and administrative expenses (exclusive of depreciation and amortization, stated separately below):
Compensation		32,496		16,997		74,782		52,586
Other selling, general and administrative expenses		13,978		16,351		44,152		44,423
Total selling, general and administrative expenses		46,474		33,348		118,934		97,009
Depreciation and amortization of property and equipment		5,218		3,773		14,864		9,270
Amortization of intangible assets		15,203		15,437		45,618		46,256
Transaction-related expenses		16		354		909		354
Impairment of intangible assets		—		27,826		—		27,826
Total operating expenses		132,086		132,808		364,919		328,272
Operating income		24,155		4,128		92,331		61,608
Other expense (income):
Interest expense		9,625		16,180		40,345		49,855
Loss on extinguishment of debt		9,349		—		16,417		4,084
Other non-operating (income) expense		(113)		(187)		(771)		(384)
Total other expense (income)		18,861		15,993		55,991		53,555

Income (loss) from continuing operations before income taxes		5,294		(11,865)		36,340		8,053
Income tax expense (benefit)		711		(4,571)		12,780		3,932
Income (loss) from continuing operations		4,583		(7,294)		23,560		4,121
Gain on discontinued operations, net of tax		—		—		—		559
Net income (loss)	$	4,583	$	(7,294)	$	23,560	$	4,680
Other comprehensive (loss) income, net of tax:
Foreign currency translation adjustments		14		(1,045)		(657)		(1,284)
Change in fair value of derivative instruments		(49)		(1,061)		(615)		(2,629)
Total other comprehensive (loss) income		(35)		(2,106)		(1,272)		(3,913)
Comprehensive income (loss)	$	4,548	$	(9,400)	$	22,288	$	767

Earnings (loss) per share from continuing operations:
Basic	$	0.05	$	(0.09)	$	0.28	$	0.05
Diluted		0.05		(0.09)		0.27		0.05
Earnings per share from discontinued operations:
Basic	$	—	$	—	$	—	$	0.01
Diluted		—		—		—		0.01
Total earnings (loss) per share:
Basic	$	0.05	$	(0.09)	$	0.28	$	0.06
Diluted		0.05		(0.09)		0.27		0.06

See accompanying notes to consolidated financial statements.

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Cotiviti Holdings, Inc.

Consolidated Statements of Cash Flows

(In thousands)

(Unaudited)


	Nine Months Ended
	September 30,
	2016		2015
Cash flows from operating activities:
Net income	$	23,560	$	4,680
Adjustments to reconcile net income to net cash provided by operating activities:
Deferred income taxes		(8,682)		(11,596)
Depreciation and amortization		60,482		55,526
Stock-based compensation expense		21,544		1,624
Amortization of debt issuance costs		3,618		4,274
Accretion of asset retirement obligations		138		108
Loss on impairment of intangible assets		—		27,826
Loss on extinguishment of debt		16,417		4,084
Gain on discontinued operations		—		(900)
Changes in operating assets and liabilities:
Restricted cash		539		9,801
Accounts receivable		(4,489)		(4,984)
Other current assets		(451)		(23,624)
Other long-term assets		(690)		117
Customer deposits		(539)		(9,801)
Accrued compensation		(1,382)		(3,250)
Accounts payable and accrued other expenses		(4,352)		(16,180)
Estimated liability for refunds and appeals		2,821		(5,966)
Other long-term liabilities		146		(221)
Other		(335)		(1,110)
Net cash provided by operating activities		108,345		30,408
Cash flows from investing activities:
Expenditures for property and equipment		(22,578)		(11,022)
Other investing activities		1,181		406
Net cash used in investing activities		(21,397)		(10,616)
Cash flows from financing activities:
Net proceeds from issuance of common stock		226,963		—
Proceeds from exercise of stock options		56		210
Proceeds from issuance of debt		800,000		—
Dividends paid		(150,000)		—
Payment of debt issuance costs		(6,327)		(1,086)
Repayment of debt		(1,062,850)		(6,075)
Net cash used in financing activities		(192,158)		(6,951)
Effect of foreign exchanges on cash and cash equivalents		(385)		(623)
Net (decrease) increase in cash and cash equivalents		(105,595)		12,218
Cash and cash equivalents at beginning of period		149,365		118,612
Cash and cash equivalents at end of the period	$	43,770	$	130,830
Supplemental disclosures of cash flow information:
Cash paid for income taxes	$	24,377	$	32,714
Cash paid for interest		35,927		45,154
Noncash investing activities (accrued property and equipment purchases)		12,000		5,485
Noncash financing activities (accrued debt issuance costs)		979		—

See accompanying notes to consolidated financial statements

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Cotiviti Holdings, Inc.

Notes to the Financial Statements

(In thousands, except shares and per share amounts)

(Unaudited)

Note 1. Description of Business

Cotiviti Holdings, Inc. (collectively with its subsidiaries, “we,” “our,” “Cotiviti” or the “Company”) is a leading provider of analytics‑driven payment accuracy solutions, focused primarily on the healthcare sector. Our integrated solutions help clients enhance payment accuracy in an increasingly complex healthcare environment. We leverage our robust technology platform, configurable analytics, proprietary information assets and expertise in healthcare reimbursement to help our clients enhance their claims payment accuracy. We help our healthcare clients identify and correct payment inaccuracies. We work with over 40 healthcare organizations, including eight of the ten largest U.S. commercial, Medicaid and Medicare managed health plans, as well as the Centers for Medicare and Medicaid Services (“CMS”). We are also a leading provider of payment accuracy solutions to over 35 retail clients, including eight of the ten largest retailers in the United States.

Note 2. Summary of Significant Accounting Policies

Basis of Presentation

Our accompanying unaudited consolidated financial statements have been prepared in accordance with U.S. Generally Accepted Accounting Principles (“GAAP”). All significant intercompany balances and transactions have been eliminated in consolidation. These consolidated financial statements are unaudited and have been prepared by us following the rules and regulations of the U.S. Securities and Exchange Commission. In our opinion they reflect all adjustments, including normal recurring items, that are necessary to present fairly the results of interim periods. Certain information and footnote disclosures normally included in financial statements prepared in accordance with GAAP have been condensed or omitted as permitted by such rules and regulations; however, we believe that the disclosures are adequate to make the information presented not misleading. Operating results for the periods presented herein are not necessarily indicative of the results that may be expected for other interim periods or the entire fiscal year. Certain prior year amounts have been reclassified to conform to the current year presentation.

Revenue Recognition, Unbilled Receivables and Estimated Liability for Refunds and Appeals

We provide services under contracts that contain various fee structures, including performance fee‑based contracts and fixed fee arrangements. Revenue is recognized when a contract exists, services have been provided to the client, the fee is fixed and determinable and collectability is reasonably assured.

We recognize revenue on performance fee-based contracts based upon the specific terms of the underlying contract. The contract terms generally specify: (a) time periods covered by the work to be performed; (b) nature and extent of services we are to provide; (c) the client’s duties in assisting and cooperating with us; and (d) fees payable to us. Our fees are most often expressed as a percentage of our findings. Generally, our services are rendered when our clients realize the economic benefits from our services. Our clients realize economic benefits when they take credits against their existing accounts payable based on when we identify cost savings, when they receive refund checks based on overpayments, or when they acknowledge payment reductions based on cost savings.

We derive a relatively small portion of revenue on contracts with fixed fee arrangements. We recognize revenue on these contracts ratably over the contract term and once all of the above criteria have been satisfied.

Historically, there has been a certain amount of revenue with respect to which, even though we had met the requirements of our revenue recognition policy, the claim is ultimately rejected. In such cases, our clients may request a refund or offset if their providers or vendors ultimately reject the payment inaccuracies we find or if our clients determine not to pursue reimbursement from their providers or vendors even though we may have collected fees. We record any such refund as a reduction of revenue. We record an estimate for refund liabilities at any given time based on actual historical refund data by client type. We satisfy such refund liabilities either by offsets to accounts receivable or by cash payments to clients.

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Cotiviti Holdings, Inc.

Notes to the Financial Statements (continued)

(In thousands, except shares and per share amounts)

(Unaudited)

In addition to the refund liabilities, we calculate client specific reserves when we determine an additional reserve may be necessary.

The estimated liability for refunds and appeals representing our estimate of claims that may be overturned related to revenue which had already been received was $70,596 and $67,775 at September 30, 2016 and December 31, 2015, respectively. The estimated allowance for refunds and appeals representing our estimate of claims that may be overturned related to amounts in accounts receivable was $31,887 and $33,406 at September 30, 2016 and December 31, 2015, respectively.

Under the Medicare Recovery Audit Program, in which we are one of the four Recovery Audit Contractors (“Medicare RAC”) for CMS, healthcare providers have the right to appeal a claim and may pursue additional appeals if the initial appeal is found in favor of CMS. We accrue an estimated liability for appeals based on the amount of fees that are subject to appeals, closures or other adjustments and those which we estimate are probable of being returned to CMS following a successful appeal by the providers. Our estimates are based on our historical experience with the Medicare RAC appeal process.

This estimated liability for Medicare RAC appeals is an offset to revenue in our Consolidated Statements of Comprehensive Income. The liability is included in the estimated liability for refunds and appeals on our Consolidated Balance Sheets. See Note 6 for further information regarding the estimated liability for appeals related to the Medicare RAC program.

Unbilled receivables represent revenue recognized related to claims for which clients have received economic value that were not invoiced at the balance sheet date. Unbilled receivables were approximately $51,762 and $51,799 as of September 30, 2016 and December 31, 2015, respectively and are included in accounts receivable on our Consolidated Balance Sheets.

Certain unbilled receivables arise when a portion of our earned fee is deferred at the time of the initial invoice. At a later date (which can be up to a year after original invoice, and at other times during the year after completion of the audit period based on contractual terms or as agreed with our client), we invoice the unbilled receivable amount. Notwithstanding the deferred due date, our clients acknowledge we have earned this unbilled receivable at the time of the original invoice, but we have agreed to defer billing the client for the related services. Unbilled receivables of this nature were approximately $5,828 and $6,431 as of September 30, 2016 and December 31, 2015, respectively, and are included in accounts receivable on our Consolidated Balance Sheets.

We record periodic changes in unbilled receivables and refund liabilities as adjustments to revenue.

Recently Issued Accounting Standards

In August 2016, the FASB issued ASU 2016-15, Classification of Certain Cash Receipts and Cash Payments (“ASU 2016-15”) which addresses eight specific cash flow issues in order to reduce diversity in practice. The guidance is effective for public companies with annual reporting periods beginning after December 15, 2017, and interim periods within those annual periods. Early adoption is permitted. We are evaluating this guidance and its impact on our consolidated financial statements and related disclosures.

In March 2016, the FASB issued ASU 2016-09, Improvements to Employee Share-Based Payment Accounting (“ASU 2016-09”) which simplifies several aspects of the accounting for share based compensation. ASU 2016-09 changes several aspects of the accounting for share based payment award transactions, including 1) accounting for income taxes, 2) classification of excess tax benefits on the statement of cash flows, 3) forfeitures, 4) minimum statutory tax withholding requirements and 5) classification of employee taxes paid on the statement of cash flows when an employer withholds shares for tax-withholding purposes. We early adopted ASU 2016-09 on a prospective basis during the third quarter of 2016, which did not result in any significant changes to our current or prior period consolidated financial statements. In conjunction with adopting ASU 2016-09, we made an accounting policy election to account for forfeitures as they occur.

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Cotiviti Holdings, Inc.

Notes to the Financial Statements (continued)

(In thousands, except shares and per share amounts)

(Unaudited)

In February 2016, the FASB issued ASU 2016-02, Leases (“ASU 2016-02”) which changes the accounting recognition, measurement and disclosure for leases in order to increase transparency. ASU 2016-02 requires lease assets and liabilities to be recognized on the balance sheet and key information about leasing arrangements to be disclosed. The guidance is effective for public companies with annual reporting periods beginning after December 15, 2018, including interim periods within that reporting period. Early adoption is permitted. We are evaluating this new guidance and its impact on our consolidated financial statements and related disclosures.

In January 2016, the FASB issued ASU 2016-01, Recognition and Measurement of Financial Assets and Financial Liabilities (“ASU 2016-01”) which changes the current financial instruments model primarily impacting the accounting for equity investments, financial liabilities under the fair value option, and the presentation and disclosure requirements for financial instruments. The guidance is effective for public companies with annual reporting periods beginning after December 15, 2017, including interim periods within that reporting period. We are evaluating this new guidance and do not believe it will have a material impact on our consolidated financial statements and related disclosures.

In November 2015, the FASB issued ASU 2015‑17, Balance Sheet Classification of Deferred Taxes, (“ASU 2015‑17”) which requires entities with a classified balance sheet to present all deferred tax assets and liabilities as noncurrent. The guidance is effective for public companies with annual and interim periods beginning after December 15, 2016. Early adoption is permitted. We are evaluating this new guidance and its impact on our consolidated balance sheets and related disclosures and expect the adoption of this ASU will reduce our total current assets and net working capital.

In April 2015, the FASB issued ASU 2015-05, Customer’s Accounting for Fees Paid in a Cloud Computing Arrangement (“ASU 2015-05”) which established guidance regarding the accounting for software licenses. ASU 2015-05 is effective for annual reporting periods, including interim periods, beginning after December 15, 2015. We prospectively adopted the provisions of ASU 2015-05 as of January 1, 2016 and have not yet had any material contracts that were impacted by this new guidance.

In April 2015, the FASB issued ASU 2015‑03, Simplifying the Presentation of Debt and Issuance Costs (“ASU 2015‑03”) which establishes guidance to simplify the presentation of debt issuance costs by requiring debt issuance costs related to a recognized debt liability be presented in the balance sheet as a direct deduction from the carrying amount of that liability, consistent with debt discounts. Prior to the issuance of ASU 2015-03, debt issuance costs were required to be presented as an asset in the balance sheet. The guidance is effective for annual reporting periods beginning after December 15, 2015, and interim periods within that reporting period. We adopted the provisions of ASU 2015-03 as of January 1, 2016 and prior period amounts have been reclassified to conform to the current period presentation. As of December 31, 2015, $20,975 of debt issuance costs were reclassified in the consolidated balance sheet from debt issuance costs, net to long-term debt. The adoption of ASU 2015-03 did not materially impact our consolidated financial position, results of operations or cash flows.

In May 2014, the FASB issued ASU No. 2014‑09, Revenue from Contracts with Customers (Topic 606) (“ASU 2014‑09”) which supersedes existing revenue recognition guidance and provides clarification of principles for recognizing revenue from contracts with customers. The guidance is effective for public companies with annual periods beginning after December 15, 2017 and interim periods within that reporting period. We are evaluating this new guidance, the method of adoption we will take and the impact, if any, on our consolidated financial statements and related disclosures.

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Cotiviti Holdings, Inc.

Notes to the Financial Statements (continued)

(In thousands, except shares and per share amounts)

(Unaudited)

Note 3. Property and Equipment

Property and equipment by major asset class for the periods presented consisted of the following:


	September 30,		December 31,
	2016		2015
Computer equipment	$	38,492	$	31,496
Software		33,607		26,412
Furniture and fixtures		8,201		7,916
Leasehold improvements		4,051		3,488
Projects in progress		15,108		10,434
Property and equipment, gross	$	99,459	$	79,746
Less: Accumulated depreciation and amortization		35,691		22,294
Property and equipment, net	$	63,768	$	57,452

In December 2015, we purchased a perpetual software license, which is included in the software total above. We will pay for this software over a two year period. As such there is approximately $3,318 included in accounts payable and accrued other expenses and $3,193 included in other long-term liabilities on our Consolidated Balance Sheets as of September 30, 2016. The amount included in other long-term liabilities represents the present value of payments that will ultimately be made.

Total depreciation and amortization expense related to property and equipment, including capitalized software costs, was $5,218 and $3,773 for the three months ended September 30, 2016 and 2015, respectively and $14,864 and $9,270 for the nine months ended September 30, 2016 and 2015, respectively.

Note 4. Intangible Assets

Intangible asset balances by major asset class for the periods presented were as follows:


									Weighted
	Gross						Net		Average
	Carrying		Accumulated				Carrying		Amortization
	Amount		Amortization		Impairment		Amount		Period
September 30, 2016:
Customer relationships	$	640,196	$	133,059	$	—	$	507,137	13.7	years
Acquired software		82,400		45,144		—		37,256	6.2	years
Connolly trademark		4,200		—		—		4,200	indefinite-lived
Total	$	726,796	$	178,203	$	—	$	548,593	12.8	years
December 31, 2015:
Customer relationships	$	640,503	$	97,857	$	—	$	542,646	13.7	years
Acquired software		82,400		34,836		—		47,564	6.2	years
Connolly trademark		24,500		—		20,300		4,200	indefinite-lived
iHealth trademark		8,600		1,074		7,526		—	11.0	years
Total	$	756,003	$	133,767	$	27,826	$	594,410	12.8	years

Amortization expense was $15,203 and $15,437 for the three months ended September 30, 2016 and 2015, respectively and $45,618 and $46,256 for the nine months ended September 30, 2016 and 2015, respectively.

As a result of our rebranding in September 2015, we recorded an impairment of intangible assets of $27,826 related to our legacy trademarks during the three and nine months ended September 30, 2015. The remaining trademark value as of September 30, 2016 of $4,200 is related to our retail business that we continue to operate as Connolly, a division of Cotiviti.

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Cotiviti Holdings, Inc.

Notes to the Financial Statements (continued)

(In thousands, except shares and per share amounts)

(Unaudited)

As of September 30, 2016 amortization expense for the next 5 years is expected to be:


Remainder of 2016	$	15,202
2017		57,837
2018		53,908
2019		53,908
2020		53,908

Note 5. Goodwill

Total goodwill in our Consolidated Balance Sheets was $1,196,350 and $1,197,044 as of September 30, 2016 and December 31, 2015, respectively.

Changes in the carrying amount of goodwill by our Healthcare and Global Retail and Other segments for the nine months ended September 30, 2016 were as follows:


			Global Retail
	Healthcare		and Other
December 31, 2015	$	1,147,771	$	49,273
Foreign currency translation and other		—		(694)
September 30, 2016	$	1,147,771	$	48,579

There was no impairment related to goodwill for any period presented.

Note 6. Commitments and Contingencies

We may be involved in various legal proceedings and litigation arising in the ordinary course of business. While any legal proceeding or litigation has an element of uncertainty, management believes the ultimate disposition of these matters will not have a material adverse effect on our consolidated financial position, results of operations, or liquidity.

Medicare RAC Contract Contingency

In August 2014, CMS announced it would allow providers to remove all eligible claims currently pending in the appeals process by offering to pay hospitals 68% of the original claim amount. This settlement was offered to the providers and it was unknown what, if any, impact there would be for the Medicare RACs. On July 1, 2015, CMS issued a Technical Direction Letter to the Medicare RACs, including ourselves, indicating that Medicare RACs will only be entitled to the contract contingency fee on the settled amounts of the claims, or 32% of the original inpatient claim amounts. Based on the initial lists of finalized settlements provided by CMS, we would be required to refund CMS approximately $22,308 due to the related adjustments in Medicare RAC contingency fees. CMS further advised that as the hospital settlement project continues, additional settlement lists will be matched to Medicare RAC claims which may result in updated refund amounts to those initially provided. While there are uncertainties in any dispute resolution and results are uncertain, we have disputed CMS’s findings based on our interpretation of the terms of the Medicare RAC contract and our belief that the backup data provided by CMS is inaccurate and/or incomplete. Our liability for estimated refunds and appeals includes amounts for these settled claims based on our best estimates of the amount we believe will be ultimately payable to CMS based on our interpretation of the terms of the Medicare RAC contract. We believe that it is possible that we could be required to pay an additional amount up to approximately $11,800 in excess of the amount we accrued as of September 30, 2016 based on the claims data we have received from CMS to date. As CMS completes its settlement process with the providers and updated files are provided to us, the potential amount owed by us may change. On September 28, 2016, CMS announced a second settlement process to allow eligible providers to settle their inpatient claims currently under appeal beginning December 1, 2016. This second settlement process could result in additional amounts owed to CMS. The amount of any such additional claims cannot presently be determined.

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Cotiviti Holdings, Inc.

Notes to the Financial Statements (continued)

(In thousands, except shares and per share amounts)

(Unaudited)

Note 7. Long‑term Debt

In September 2016, in order to benefit from favorable market conditions, we entered into and executed the Amended and Restated First Lien Credit Agreement (the “Restated Credit Agreement”), which replaced our then outstanding first and second lien credit facilities, lowered total debt outstanding by $22,700 and provides for lower applicable interest rates. The Restated Credit Agreement consists of (a) a Term Loan A in the amount of $250,000 (the “Term Loan A”), (b) a Term Loan B in the amount of $550,000 (the “Term Loan B”) and (c) a revolving credit facility (the “Revolver”) in the amount of up to $100,000. As a result of this refinancing, we recognized a loss on extinguishment of debt of $9,349 during the three and nine months ended September 30, 2016, which is included in our Consolidated Statements of Comprehensive Income.

In June 2016, we repaid $223,000 in outstanding principal under our then outstanding second lien credit facility (the “May 2014 Second Lien”) using proceeds from our Initial Public Offering (“IPO”). We also made a voluntary prepayment of $13,100 of outstanding principal under the May 2014 Second Lien. As a result of these repayments, we recognized a loss on extinguishment of debt of $7,068 during the nine months ended September 30, 2016, which is included in our Consolidated Statements of Comprehensive Income.

In May 2015, in order to benefit from favorable market conditions, we entered into and executed the First and Second Amendments to the then outstanding first lien credit facilities (the “May 2014 First Lien”), which, among other things, provide for lower applicable interest rates associated with the May 2014 First Lien by 50 basis points. As a result, we recorded a loss on extinguishment of debt of $4,084 during the nine months ended September 30, 2015, which is included in our Consolidated Statements of Comprehensive Income.

Long‑term debt for the periods presented was as follows:


	September 30,		December 31,
	2016		2015
Term Loan A(a)	$	249,808	$	—
Term Loan B(b)		545,556		—
Revolver(c)		—		—
May 2014 First Lien		—		792,167
May 2014 Second Lien		—		262,878
May 2014 Revolver		—		—
Total debt		795,364		1,055,045
Less: debt issuance costs		11,322		20,975
Less: current portion		18,000		21,099
Total long-term debt	$	766,042	$	1,012,971

(a)

The Term Loan A matures on September 28, 2021 and requires quarterly principal payments of $3,125 for the fourth quarter of 2016, $3,125 per quarter in 2017 and 2018, $4,688 per quarter in 2019, $6,250 per quarter in 2020 and $9,375 per quarter for the first two quarters of 2021. The remainder of the outstanding Term Loan A borrowings are due on September 28, 2021. Any mandatory or voluntary prepayment will be applied against the remaining scheduled installments of principal payments in direct order of maturity, unless other direction of application is provided by us. Based on our periodic election, borrowings under the Term Loan A bear interest at either (a) the Alternate Base Rate (“ABR”) plus, based on our Secured Leverage Ratio (as defined in the Restated Credit Agreement), 1.25% - 2.00% for ABR loans or (b) the LIBO Rate (“LIBOR”) plus, based on our Secured Leverage Ratio, 2.25% to 3.00% for LIBOR loans. The ABR is equal to the highest of (i) the New York Federal Reserve Bank rate in effect on such date plus 0.50%, (ii) the LIBOR plus 1.00% and (iii) the prime commercial lending rate of the administrative agent as in effect on the relevant day. The interest period applicable to any LIBOR borrowing is one, two, three or six months, at the election of the borrower. Interest on LIBOR loans is payable the last day of the applicable interest period and, in the case of an interest period of more than three months’ duration, each day on which interest would have been payable had successive interest periods of three months’s duration been applicable to such borrowing. The interest rate in effect was 3.6% at September 28, 2016.

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Cotiviti Holdings, Inc.

Notes to the Financial Statements (continued)

(In thousands, except shares and per share amounts)

(Unaudited)

(b)

The Term Loan B matures September 28, 2023 and requires quarterly principal payments of $1,375 with all remaining borrowings due on September 28, 2023. Based on our periodic election, borrowings under the Term Loan B bear interest at either (a) the ABR plus 1.75% for ABR loans or (b) the LIBOR plus 2.75% for LIBOR loans. The ABR is equal to the highest of (i) the New York Federal Reserve Bank rate in effect on such date plus 0.50%, (ii) LIBOR plus 1.00%, (iii) the prime commercial lending rate of the administrative agent as in effect on the relevant day and (iv) 1.75%. LIBOR is equal to the higher of (a) the published LIBOR or (b) 0.75%. If our corporate credit rating from Moody’s Investor Service, Inc. is Ba3 or better and our corporate family rating from Standard & Poor’s Financial Services, LLC is BB- or better, the margin will be reduced by 0.25% per annum for as long as such ratings are maintained. The interest period applicable to any LIBOR borrowing is one, two, three or six months, at the election of the borrower. Interest on LIBOR loans is payable the last day of the applicable interest period and, in the case of an interest period of more than three months’ duration, each day on which interest would have been payable had successive interest periods of three months’s duration been applicable to such borrowing.The interest rate in effect was 3.6% at September 28, 2016.

(c)

The Revolver expires September 28, 2021. Interest for any borrowings under the Revolver is payable over one, two, three or six months at our election. A commitment fee is payable quarterly based on the unused portion of the Revolver commitment which ranges from 0.30% to 0.50% per annum based on certain financial tests. Based on our periodic election, borrowings under the Revolver bear interest at either (a) ABR plus, based on our Secured Leverage Ratio, 1.25% - 2.00% for ABR loans or (b) LIBOR plus, based on our Secured Leverage Ratio, 2.25% to 3.00% for LIBOR loans. The ABR is equal to the highest of (i) the New York Federal Reserve Bank rate in effect on such date plus 0.50%, (ii) the LIBOR plus 1.00% and (iii) the prime commercial lending rate of the administrative agent as in effect on the relevant day. There were no borrowings outstanding under the Revolver as of September 30, 2016. The interest rate in effect was 3.6% at September 28, 2016.

The Restated Credit Agreement includes certain binding affirmative and negative covenants, including delivery of financial statements and other reports, maintenance of existence and transactions with affiliates. The negative covenants restrict our ability, among other things, to incur indebtedness, grant liens, make investments, sell or otherwise dispose of assets or enter into a merger, pay dividends or repurchase stock. Beginning December 31, 2016, there is a required financial covenant applicable only to the Revolver and the Term Loan A, pursuant to which we agree not to permit our Secured Leverage Ratio to exceed 5.50:1.00 through September 2018, 5.25:1.00 through September 2019 and 5.00:1.00 through June 2021. In addition, the Restated Credit Agreement includes certain events of default including payment defaults, failure to perform affirmative covenants, failure to refrain from actions or omissions prohibited by negative covenants, the inaccuracy of representations or warranties, bankruptcy and insolvency related defaults and a change of control default. We were in compliance with all such covenants as of September 30, 2016 and similar affirmative and negative covenants applicable to our then outstanding credit facilities as of December 31, 2015.

The Restated Credit Agreement requires mandatory prepayments based upon annual excess cash flows commencing with the year ended December 31, 2017. The mandatory prepayment is contingently payable based on an annual excess cash flow calculation as defined within the Restated Credit Agreement.

As of September 30, 2016, the aggregate maturities of long‑term debt for each of the next five years are expected to be $4,500 for the remainder of 2016, $18,000 in 2017 and 2018, $24,250 in 2019 and $30,500 in 2020.

Note 8. Derivative Instruments

We are exposed to fluctuations in interest rates on our long‑term debt. We manage our exposure to fluctuations in the 3‑month LIBOR through the use of interest rate cap agreements designated as cash flow hedges. We are meeting our objective by hedging the risk of changes in cash flows related to changes in LIBOR by capping the interest on our floating rate debt linked to LIBOR to approximately 3%. We do not utilize derivatives for speculative or trading purposes.

As of September 30, 2016 and December 31, 2015, we had $630,000 in notional debt outstanding related to these interest rate caps, which cover quarterly interest payments through September 2019. The notional amount decreases over time.

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Cotiviti Holdings, Inc.

Notes to the Financial Statements (continued)

(In thousands, except shares and per share amounts)

(Unaudited)

All of our outstanding interest rate cap contracts qualify for cash flow hedge accounting treatment in accordance with ASC 815, Derivatives and Hedging. Cash flow hedge accounting treatment allows for gains and losses on the effective portion of qualifying hedges to be deferred in accumulated other comprehensive (loss) income until the underlying transaction occurs, rather than recognizing the gains and losses on these instruments in earnings during each period they are outstanding. When the actual interest payments are made on our variable rate debt and the related derivate contract settles, any effective portion of realized interest rate hedging derivative gains and losses previously recorded in accumulated other comprehensive (loss) income is recognized in interest expense. We recognized interest expense of $56 and $23 related to interest rate caps during the three months ended September 30, 2016 and 2015, respectively and $200 and $55 during the nine months ended September 30, 2016 and 2015, respectively.

Ineffectiveness results, in certain circumstances, when the change in total fair value of the derivative instrument differs from the change in the fair value of our expected future cash outlays for the related interest payment and is recognized immediately in interest expense. There was no ineffectiveness recorded during the three and nine months ended September 30, 2016 and 2015, respectively. Likewise, if the hedge does not qualify for hedge accounting, the periodic changes in its fair value are recognized in the period of the change in interest expense. All cash flows related to our interest rate cap agreements are classified as operating cash flows.

Any outstanding derivative instruments expose us to credit loss in the event of nonperformance by the counterparties to the agreements, but we do not expect that the counterparty will fail to meet their obligations. The amount of such credit exposure is generally the positive fair value of our outstanding contracts. To manage credit risks, we select counterparties based on credit assessments, limit our overall exposure to any single counterparty and monitor the market position of any counterparty.

The table below reflects quantitative information related to the fair value of our derivative instruments and where these amounts are recorded in our consolidated financial statements as of the period presented:


	September 30,		December 31,
	2016		2015
Liability fair value recorded in other long-term liabilities	$	2,428	$	2,310
Liability fair value recorded in accounts payable and accrued other expenses		1,070		1,086
Estimated amount of existing losses expected to be reclassified into earnings in the next 12 months		(1,287)		(283)

We record deferred hedge premiums which are being paid over the life of the hedge in accumulated other comprehensive (loss) income until the related hedge ultimately settles and interest payments are made on the underlying debt. As of September 30, 2016, we have made payments of $2,204 related to these deferred premiums. We expect to pay an additional $4,190 in deferred premiums through 2019 related to our outstanding interest rate cap agreements which is reflected in the fair value of these derivatives in the table above.

Comprehensive income includes changes in the fair value of our interest rate cap agreements which qualify for hedge accounting. Changes in other comprehensive income for the periods presented related to derivative instruments classified as cash flow hedges were as follows:


	Three Months Ended September 30,
	2016		2015

Balance at beginning of period, July 1	$	(3,534)	$	(2,191)
Reclassifications in earnings, net of tax of $21 and $9, respectively		35		14
Change in fair value of derivative instrument, net of tax of $45 and $483, respectively		(84)		(1,075)
Balance at end of period, September 30	$	(3,583)	$	(3,252)

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Cotiviti Holdings, Inc.

Notes to the Financial Statements (continued)

(In thousands, except shares and per share amounts)

(Unaudited)


	Nine Months Ended September 30,
	2016		2015

Balance at beginning of period, January 1	$	(2,968)	$	(623)
Reclassifications in earnings, net of tax of $76 and $22, respectively		124		33
Change in fair value of derivative instrument, net of tax of $463 and $1,015, respectively		(739)		(2,662)
Balance at end of period, September 30	$	(3,583)	$	(3,252)

Note 9. Fair Value Measurements

We measure assets and liabilities at fair value based on assumptions market participants would use in pricing an asset or liability in the principal or most advantageous market. Authoritative guidance on fair value measurements establishes a consistent framework for measuring fair value whereby inputs are assigned a hierarchical level. The hierarchical levels are:

Level 1: Unadjusted quoted prices in active markets for identical assets or liabilities accessible to the reporting entity at the measurement date.

Level 2: Observable prices, other than quoted prices included in Level 1 inputs for the asset or liability, either directly or indirectly, for substantially the full term of the asset or liability.

Level 3: Unobservable inputs for the asset or liability used to measure fair value to the extent observable inputs are not available, thereby allowing for situations in which there is little, if any, market activity for the asset or liability at measurement date.

The following table summarizes our financial instruments measured at fair value within the Consolidated Balance Sheets:


	September 30, 2016						December 31, 2015
	Level 1		Level 2		Level 3		Level 1		Level 2		Level 3
Assets:
Available-for-sale securities	$	—	$	—	$	—	$	1,181	$	—	$	—
Liabilities
Long-term debt		—		—		795,364		—		—		1,055,045
Interest rate cap agreements		—		3,498		—		—		3,396		—
Total	$	—	$	3,498	$	795,364	$	1,181	$	3,396	$	1,055,045

Investments are classified as available‑for‑sale and carried at fair value in the accompanying Consolidated Balance Sheets. As of December 31, 2015, our investments consisted of money market securities valued using quoted market prices for identical assets in active markets. As of September 30, 2016, we no longer hold any available-for-sale securities.

The fair value of our private debt is determined based on fluctuations in current interest rates, the trends in market yields of debt instruments with similar credit ratings, general economic conditions and other quantitative and qualitative factors. The carrying value of our debt approximates its fair value.

The fair value of the interest rate cap agreements is determined using the market standard methodology of discounting the future expected variable cash receipts that would occur if interest rates rose above the strike rate of the caps. The analysis reflects the contractual terms of the derivatives, including period to maturity and remaining deferred premium payments, and uses observable market‑based inputs, including interest rates and implied volatilities. The variable cash receipts are based on an expectation of future interest rates (forward curves) derived from observable

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Cotiviti Holdings, Inc.

Notes to the Financial Statements (continued)

(In thousands, except shares and per share amounts)

(Unaudited)

market interest rates. As such, the estimated fair values of these liabilities are classified as Level 2 in the fair value hierarchy.

Note 10. Income Taxes

The following table presents our income tax provision and effective income tax rate:


	Three Months Ended						Nine Months Ended
	September 30,						September 30,
	2016			2015			2016			2015
Income tax provision	$	711		$	(4,571)		$	12,780		$	3,932
Effective income tax rate		13.4	%		38.5	%		35.2	%		48.8	%

Our effective income tax rate from continuing operations was 13.4% and 38.5% for the three months ended September 30, 2016 and September 30, 2015, respectively. During the three months ended September 30, 2016, we recorded a $1,300 tax benefit primarily related to the settlement of an uncertain tax position recorded in a prior period. The impact of this tax benefit relative to the pre-tax income for the three months ended September 30, 2016 resulted in the decrease to the effective tax rate.

Our effective income tax rate from continuing operations was 35.2% and 48.8% for the nine months ended September 30, 2016 and September 30, 2015, respectively. The decrease in the effective tax rate is primarily due to a $1,300 tax benefit related to the settlement of an uncertain tax position recorded in a prior period.

We are currently under audit with the Internal Revenue Service for the tax year ended December 31, 2014. In addition we are currently under audit for iHealth Technologies, Inc. for the tax years ended December 31, 2012, December 31, 2013 and May 13, 2014. As a result, it is reasonably possible that the audits will conclude or reach the stage where a change in unrecognized income tax benefits may occur within the next twelve months. At that time, we will record any adjustment to income tax expense as required.

Note 11. Stockholders’ Equity

Issuance of Common Stock

On May 13, 2016 our Certificate of Incorporation was amended and the number of shares of common stock authorized to be issued by the Company was increased from 122,000,000 to 600,000,000.

On May 25, 2016 we consummated our IPO in which we issued and sold a total of 12,936,038 shares of common stock, including a portion of the underwriter overallotment, at a public offering price of $19.00 per share. We received net proceeds of approximately $226,963 after deducting underwriting discounts and commissions and other offering expenses of approximately $18,822.

A summary of the current rights and preferences of holders of our common stock are as follows:

Voting

Common stockholders are entitled to one vote per share of common stock held on all matters on which such common stockholder is entitled to vote.

Dividends

Common stockholders are eligible to receive dividends on common stock held when funds are available and as approved by the Board of Directors. The Restated Credit Agreement contains negative covenants that limit our ability to pay dividends.

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Cotiviti Holdings, Inc.

Notes to the Financial Statements (continued)

(In thousands, except shares and per share amounts)

(Unaudited)

Liquidation Rights

In the event of liquidation or dissolution, common stockholders are entitled to receive all assets available for distribution to stockholders.

Registration Rights

The Second Amended and Restated Stockholders Agreement contains (i) demand registration rights for Advent, subject to a cap of two requests in any 12 month period; (ii) piggy-back registration rights for any stockholder holding at least $500,000 worth of shares (each, a “Holder”), subject to a pro rata reduction if the total amount of shares requested to be included exceeds the amount of securities which in the opinion of the underwriters can be sold; and (iii) shelf registration rights for Holders, subject to a required anticipated aggregate offering price, net of selling expenses, of $5.0 million, subject to a cap of two requests for shelf registrations, for all Holders in the aggregate, in any 12 month period. Holders that are capable of selling all of their registrable securities pursuant to Rule 144 under the Securities Act in a single transaction without timing or volume limitations will not have piggy-back registration rights. We will be responsible for fees and expenses in connection with the registration rights, other than underwriters’ discounts and brokers’ commissions, if any, relating to any such registration and offering.

Common Stock Split

On May 13, 2016 we effected a 6.1-for-1 stock split of all outstanding shares of our common stock. All share, option and per share information presented in the accompanying consolidated financial statements and notes thereto have been adjusted to reflect the stock split on a retroactive basis for all periods presented and all share information is rounded up to the nearest whole share after reflecting the stock split.

Common Stock Dividends

On May 25, 2016 we paid a special cash dividend of $150,000, or $1.94 per share of common stock outstanding prior to the IPO, to holders of record of our common stock on the dividend record date. In connection with the special cash dividend we lowered the exercise price of then outstanding stock options by $1.94 per share in order to preserve the intrinsic value of the options giving effect to the special cash dividend.

Note 12. Earnings per Share

Basic earnings per share (“EPS”) is computed based on the weighted average number of shares of common stock outstanding during the period. Diluted EPS is computed based on the weighted average number of shares of common stock plus the effect of dilutive potential common shares outstanding during the period. For all periods presented, potentially dilutive outstanding shares consisted solely of our common stock options. Our potential common shares consist of the incremental common shares issuable upon the exercise of the options. The dilutive effect of outstanding stock options is reflected in diluted earnings per share by application of the treasury stock method. For all periods presented, all outstanding common stock consisted of a single‑class.

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Cotiviti Holdings, Inc.

Notes to the Financial Statements (continued)

(In thousands, except shares and per share amounts)

(Unaudited)

Basic and diluted earnings per share are computed as follows:


	Three Months Ended				Nine Months Ended
	September 30,				September 30,
	2016		2015		2016		2015
Net income available to common stockholders	$	4,583	$	(7,294)	$	23,560	$	4,680

Weighted average outstanding shares of common stock		90,170,462		77,224,463		83,275,206		77,211,354
Dilutive effect of stock-based awards		3,783,441		—		3,582,720		503,591
Adjusted weighted average outstanding and assumed conversions for diluted EPS		93,953,903		77,224,463		86,857,926		77,714,945

Earnings (loss) per share from continuing operations:
Basic	$	0.05	$	(0.09)	$	0.28	$	0.05
Diluted		0.05		(0.09)		0.27		0.05

Earnings per share from discontinued operations:
Basic	$	—	$	—	$	—	$	0.01
Diluted		—		—		—		0.01

Total earnings (loss) per share:
Basic	$	0.05	$	(0.09)	$	0.28	$	0.06
Diluted		0.05		(0.09)		0.27		0.06

Employee stock options and restricted stock units (“RSUs”) that were excluded from the calculation of diluted earnings per share because their effect is anti‑dilutive for the periods presented were as follows:


	Three Months Ended		Nine Months Ended
	September 30,		September 30,
	2016	2015	2016	2015

Employee stock-based awards	35,737	12,292	327,880	672,617

The criteria associated with all of our outstanding performance-based stock options as defined in the terms of the applicable award agreements, were satisfied as of September 30, 2016 and, as a result, 2,746,592 performance-based stock options were included in the calculation of diluted earnings per share for the three and nine months ended September 30, 2016. Performance-based stock options of 2,234,217 were not included in the calculation of diluted earnings per share for the three and nine months ended September 30, 2015 as the vesting conditions had not yet been satisfied.

Note 13. Stock‑Based Compensation

Equity Incentive Plans

In 2012, we adopted an equity incentive plan (“2012 Plan”) pursuant to which our Board of Directors (or committee as designated by the Board of Directors) may grant options to purchase shares of our stock, restricted stock and certain other equity awards to directors, officers and key employees. We only granted stock options that can be settled in shares of our common stock under the 2012 Plan. The 2012 Plan had a total of 7,243,330 shares authorized for issuance. Upon completion of the IPO in May 2016, issuances under the 2012 Plan were suspended. At that time we adopted the 2016 Equity Incentive Plan (“2016 Plan” and collectively with the 2012 Plan, the “Plans”), pursuant to which our Board of Directors (or a committee or sub-committee designated by the Board of Directors) may grant options to purchase shares of our stock, restricted stock and certain other equity awards to directors, officers and key employees.

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Cotiviti Holdings, Inc.

Notes to the Financial Statements (continued)

(In thousands, except shares and per share amounts)

(Unaudited)

The 2016 Plan was established with the authorization for grants of up to 5,490,000 shares of authorized but unissued shares of common stock.

No stock options were granted under the 2012 Plan after December 31, 2015. Awards granted under the 2012 Plan will remain outstanding until the earlier of exercise, forfeiture, cancellation or expiration. To the extent outstanding options under the 2012 Plan are forfeited, cancelled or terminated, the common stock subject to such options will be available for future issuance under the 2016 Plan. As of September 30, 2016, there are no shares available for future issuance under the 2012 Plan as the 776,839 shares that were available were discontinued upon adoption of the 2016 Plan. As of September 30, 2016 the total number of shares available for future issuance under the Plans is 5,248,202.

Stock Options

Under the terms of the 2016 Plan, we may issue options to purchase shares of our common stock at a price equal to 100% of the market price on the date of grant. Issuances under the 2012 Plan, prior to its suspension, were under terms similar to issuances under the 2016 Plan. Stock options granted are subject to either time of service (service-based awards) or performance (performance-based awards) criteria. Service-based awards typically vest ratably over a five year service period from the date of grant under the 2012 Plan and typically vest ratably over a four year service period from the date of grant under the 2016 Plan. In the event of a change in control, any outstanding, unvested service-based awards will vest immediately. Performance-based awards vest in accordance with the specific performance criteria espoused in the executed award agreements. The term of any stock option shall not exceed ten years from the date of grant. However, an incentive stock option granted to an employee who, at the time of grant, owns stock possessing more than 10% of the total combined voting power of all classes of our stock may not have a term exceeding five years from the date of grant.

The following is a summary of stock option activity under the Plans:


	Nine Months Ended September 30,
	2016			2015
		Weighted			Weighted
		average			average
		exercise			exercise
	Shares	price		Shares	price
Outstanding at beginning of period	6,441,573	$	9.59	5,012,034	$	7.97
Granted	264,976		19.14	24,584		11.33
Exercised	(4,113)		13.06	(25,620)		6.26
Forfeited	(99,326)		12.91	(492,880)		10.09
Expired	(1,220)		11.33	—		—
Outstanding at end of period	6,601,890	$	9.92	4,518,118	$	7.77


							Average
		Weighted			Weighted		Remaining
	Service-	average		Performance-	average		Contractual	Aggregate
	based	exercise		based	exercise		Term	Intrinsic
	Shares	price		Shares	price		(in years)	Value
Stock options outstanding as of September 30, 2016	3,840,828	$	10.55	2,761,062	$	9.05	7.50	$	155,844
Stock options vested and exercisable as of September 30, 2016	2,031,919	$	8.95	2,746,592	$	9.02	7.20	$	117,257

The criteria associated with 2,746,592 of our outstanding performance-based stock options as defined in the terms of the award agreements, was satisfied as of September 30, 2016 and therefore these stock options all became vested and exercisable.

Aggregate intrinsic value represents the difference between our estimated fair value of common stock and the exercise price of outstanding in‑the‑money options. The fair value per share of common stock was $33.53 as of

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Cotiviti Holdings, Inc.

Notes to the Financial Statements (continued)

(In thousands, except shares and per share amounts)

(Unaudited)

September 30, 2016 based upon the closing price of our common stock on the NYSE. The total intrinsic value of options exercised for the three and nine months ended September 30, 2016 and 2015 was insignificant. The total fair value of stock options vested was $19,153 and $1,831 during the three months ended September 30, 2016 and 2015, respectively, and $22,159 and $2,014 during the nine months ended September 30, 2016 and 2015, respectively.

Restricted Stock Units

Restricted stock units provide participants the right to receive a payment based on the value of a share of common stock. RSUs may be subject to vesting requirements, restrictions and conditions to payment. Such requirements may be based on the continued service for a specified time period or on the attainment of specified performance goals as specified in the award agreements. RSUs are payable in cash or in shares or a combination of both. Under the terms of the Plans, RSUs have a grant date fair value equal to the closing price of our stock on the grant date. The units typically vest ratably over a four year service period. We began issuing RSUs upon adoption of the 2016 Plan; no RSUs were issued under the 2012 Plan.

The following is a summary of RSU activity under the 2016 Plan:


	Nine Months Ended September 30,
	2016
		Weighted
		average
		grant date
	Shares	fair value
Nonvested at beginning of period	—	$	—
Granted	62,904		25.38
Vested	—		—
Forfeited	—		—
Nonvested at end of period	62,904	$	25.38

Stock Compensation Expense

The fair value of each stock option award is estimated on the date of grant using a Black-Scholes-Merton option pricing model. The expected term of the option represents the period the stock-based awards are expected to be outstanding. We use the simplified method under the provisions of ASC 718, Stock Based Compensation for estimating the expected term of the options. Since our shares were not publicly traded until May 2016 and were rarely traded privately, at the time of each grant, there was insufficient volatility data available. Accordingly, we calculate expected volatility using comparable peer companies with publicly traded shares over a term similar to the expected term of the options issued. We do not intend to pay dividends on our common shares, therefore, the dividend yield percentage is zero. The risk-free interest rate is based on the U.S. Treasury constant maturity interest rate whose term is consistent with the expected life of our stock options.

We used the following weighted average assumptions to estimate the fair value of stock options granted for the periods presented as follows:


	Nine Months Ended September 30,
	2016			2015
Expected term (years)		6.25			6.25
Expected volatility		50	%		50	%
Expected dividend yield		0	%		0	%
Weighted average risk-free interest rate		1.34	%		1.61	%
Weighted average grant date fair value	$	9.39		$	5.49

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Cotiviti Holdings, Inc.

Notes to the Financial Statements (continued)

(In thousands, except shares and per share amounts)

(Unaudited)

We recorded total stock‑based compensation expense of $17,042 and $405 for the three months ended September 30, 2016 and 2015, respectively, and $21,544 and $1,624 for the nine months ended September 30, 2016 and 2015, respectively. Stock-based compensation expense during the three and nine months ended September 30, 2016 includes $15,898 related to the vesting of substantially all outstanding performance based stock options. Stock-based compensation expense during the nine months ended September 30, 2016 also includes $2,257 related to the accelerated vesting of certain stock options as the result of the IPO. We had not previously adjusted stock-based compensation expense for estimated forfeitures as there has been insignificant forfeiture activity to date. Based on the adoption of ASU 2016-09, we will account for forfeitures as they occur. As of September 30, 2016, we had total unrecognized compensation cost related to 1,857,783 unvested service‑based stock options and RSUs under the Plans of $15,081 which we expect to recognize over the next 3.2 years.

Note 14. Segment Information

Operating segments are components of an enterprise for which separate financial information is available that is evaluated regularly by our Chief Operating Decision Maker (“CODM”) in deciding how to allocate resources and in assessing financial performance. We conduct our business through two reportable business segments: Healthcare and Global Retail and Other.

The Healthcare segment provides claims accuracy solutions to health insurance payers and payer‑related entities. All of our healthcare service offerings focus on generating economic benefits for our clients by identifying errors, reducing improper payments and improving efficiency of business process related to healthcare industry payment networks. The Global Retail and Other segment primarily provides retrospective claims accuracy solutions to large and mid‑size retailers. Our services primarily result in cost recoveries based on the audit of our clients’ supply chain information as well as improved efficiency and effectiveness of our clients’ payment networks.

We evaluate the performance of each segment based on segment net revenue and segment operating income. Operating income is calculated as net revenue less operating expenses and is not affected by other expense (income) or by income taxes. Indirect costs are generally allocated to the segments based on the segments’ proportionate share of revenue and expenses directly related to the operation of the segment. We do not allocate interest expense, other non‑operating (income) expense or the provision for income taxes, since these items are not considered in evaluating the segment’s overall operating performance. Our CODM does not receive or utilize asset information to evaluate performance of operating segments. Accordingly, asset‑related information has not been presented.

Our operating segment results for the periods presented were as follows:


	Three Months Ended				Nine Months Ended
	September 30,				September 30,
	2016		2015		2016		2015
	(unaudited)				(unaudited)
Net Revenue
Healthcare	$	138,470	$	119,127	$	403,643	$	336,683
Global Retail and Other		17,771		17,809		53,607		53,197
Consolidated net revenue	$	156,241	$	136,936	$	457,250	$	389,880
Operating Income
Healthcare	$	22,544	$	4,288	$	85,879	$	55,812
Global Retail and Other		1,611		(160)		6,452		5,796
Consolidated operating income	$	24,155	$	4,128	$	92,331	$	61,608

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Cotiviti Holdings, Inc.

Notes to the Financial Statements (continued)

(In thousands, except shares and per share amounts)

(Unaudited)

Operating segment net revenue by product type for the periods presented was as follows:


	Three Months Ended September 30,						Nine Months Ended September 30,
	2016		%	2015		%	2016		%	2015		%
	(unaudited)						(unaudited)
Healthcare
Retrospective claims accuracy	$	78,133	50.0	$	62,369	45.5	$	224,335	49.1	$	178,818	45.9
Prospective claims accuracy		57,233	36.6		53,419	39.1		169,632	37.1		147,335	37.8
Transaction services		3,104	2.0		3,339	2.4		9,676	2.1		10,530	2.7
Total Healthcare		138,470	88.6		119,127	87.0		403,643	88.3		336,683	86.4
Retail
Retrospective claims accuracy		17,039	10.9		17,292	12.6		51,730	11.3		51,546	13.2
Other		732	0.5		517	0.4		1,877	0.4		1,651	0.4
Total Global Retail and Other		17,771	11.4		17,809	13.0		53,607	11.7		53,197	13.6
Consolidated net revenue	$	156,241	100.0	$	136,936	100.0	$	457,250	100.0	$	389,880	100.0

Note 15. Employee Benefit Plans

Contributions expensed and included in compensation on our Consolidated Statements of Comprehensive Income for employee benefit plans are detailed below:


	Three Months Ended				Nine Months Ended
	September 30,				September 30,
	2016		2015		2016		2015
401(k) Plan (a)	$	1,010	$	651	$	2,768	$	2,386
Profit Share Plan (b)		—		62		220		438
Provident Plan (c)		132		112		396		316
Total	$	1,142	$	825	$	3,384	$	3,140

(a)

We sponsor defined contribution retirement plans in accordance with Section 401(k) of the Internal Revenue Code, which cover substantially all U.S. employees, subject to certain minimum age and service requirements. The plans provide for a contribution based on a percentage of eligible employee contributions.

(b)

We had a nonqualified profit sharing incentive compensation plan for certain eligible employees. Contributions were made within 90 days following the last day of the plan to a brokerage account in an amount determined at our discretion for employees who had completed 1,000 hours of service and were employed at the time of the contribution. This plan was discontinued after the 2014 plan year, with the final payout occurring in June

2016 and therefore we did not have a liability under the plan as of September 30, 2016. Our liability under the plan was $893 at December 31, 2015, which is included in accrued compensation costs in the accompanying Consolidated Balance Sheets.

(c)

Eligible employees of our subsidiary located in India are covered by the Provident Fund, contributions which are based on a percentage of eligible employees’ salaries, and the Payment of Gratuity Act, which provides for benefits to be paid to eligible employees upon termination of employment (collectively, the “India Plan”). Benefits under the Plan are administered by the Indian Government. As of September 30, 2016 and December 31, 2015 we had an accrued benefit obligation relating to the India Plan of $714 and $535, respectively.

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Cotiviti Holdings, Inc.

Notes to the Financial Statements (continued)

(In thousands, except shares and per share amounts)

(Unaudited)

Note 16. Discontinued Operations

In February 2015, we received payment on a $900 note receivable related to a business that was disposed of in 2012. Since the date of sale, we had elected to fully reserve the note receivable as the collectability was determined to be uncertain. This gain from the collection of the note receivable, net of tax, is reflected as a gain on discontinued operations on our Consolidated Statements of Comprehensive Income. The estimated impact to diluted EPS as a result of this gain on discontinued operations was $0.01 per diluted share for the nine months ended September 30, 2015.

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ITEM 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

The following discussion and analysis of the financial condition and results of our operations should be read together with the financial statements and the related notes of Cotiviti Holdings, Inc. included in Item 1 of this Quarterly Report on Form 10-Q and with our audited financial statements and the related notes included in our final prospectus (the “Prospectus”), dated May 25, 2016, filed with the Securities and Exchange Commission (the “SEC”) pursuant to Rule 424(b) of the Securities Act of 1933, as amended (the “Securities Act”), which is deemed to be part of the Company’s Registration Statement on Form S-1 (File No. 333-211022), as amended, as well as the section of the Prospectus entitled “Management’s Discussion and Analysis of Financial Condition and Results of Operations.” On June 1, 2016, the Company completed the initial public offering (the “IPO”) of shares of the common stock, par value $0.001 per share (the “Common Stock”) of the Company, for cash consideration of $19.00 per share ($17.77 per share net of underwriting discounts). On June 29, 2016 the Company completed the sale of additional shares of its common stock, par value $0.001 per share to the underwriters of its initial public offering at the public offering price of $19.00 per share pursuant to the partial exercise of the overallotment option granted to the underwriters in connection with the Company’s initial public offering.

As used in this Quarterly Report on Form 10-Q, except where the context otherwise requires or where otherwise indicated, the terms “Company,” “Cotiviti,” “we,” “our” and “us” refer to Cotiviti Holdings, Inc.

This discussion and analysis contains forward-looking statements regarding the industry outlook, our expectations for the performance of our business, our liquidity and capital resources and other non-historical statements. These forward-looking statements are subject to numerous risks and uncertainties, including but not limited to the risks and uncertainties described in “—Cautionary Note Regarding Forward-Looking Statements” and “Risk Factors.” Our actual results may differ materially from those contained in or implied by these forward-looking statements.

Overview

We are a leading provider of analytics-driven payment accuracy solutions, focused primarily on the healthcare sector. Our integrated solutions help clients enhance payment accuracy in an increasingly complex healthcare environment. We leverage our robust technology platform, configurable analytics, proprietary information assets and expertise in healthcare reimbursement to help our clients enhance their claims payment accuracy. We help our healthcare clients identify and correct payment inaccuracies, which resulted in over $2.7 billion in savings in 2015. We work with over 40 healthcare organizations, including eight of the ten largest U.S. commercial, Medicare and Medicaid managed health plans, as well as the Centers for Medicare and Medicaid Services (“CMS”). We are also a leading provider of payment accuracy solutions to over 35 retail clients, including eight of the ten largest retailers in the United States.

We have multiple strategies for achieving our continued growth. There are significant opportunities to grow our business within our existing client base by increasing the volume of claims we review with our solutions, expanding the utilization of our solutions within these claims and cross-selling our prospective and retrospective solutions. As a result of the merger of Connolly Superholdings, Inc. (“Connolly”) and iHealth Technologies, Inc. (“iHealth Technologies”) in May 2014 (the “Connolly iHealth Merger”), we have cross-sell opportunities across more than half of our healthcare client base. We have a long history of innovation in improving our existing solutions, developing new solutions and expanding the scope of our services. We intend to expand our client base by targeting healthcare payers who utilize competing third party or internal payment accuracy solutions. Additionally, we plan to selectively pursue acquisitions and strategic partnerships in payment accuracy and adjacent markets.

As a result of the meaningful savings we deliver to our clients, we have increased our client base and strengthened our long-standing relationships with many of the leading healthcare payers in the United States. The average length of our relationships with our ten largest healthcare clients is approximately 11 years and, since January 1, 2013, we have successfully retained all of our healthcare clients except one, who represented less than 2% of our revenue. We have also substantially increased the annual savings captured by our healthcare clients over time. As a result, we believe our revenue is highly recurring and we have strong visibility into our revenue.

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We are also a leading provider of payment accuracy solutions to the retail market. Retailers process and validate extremely high volumes of transactions with disparate suppliers on varying terms. We work with retail clients in the United States (“U.S.”), Canada and the United Kingdom (“U.K.”) to realize their negotiated allowances, concessions, rebates and other incentives associated with merchandise procurement, logistics and other service transactions. In 2015, we generated over $500 million in savings for our retail clients.

Factors Affecting Our Results of Operations

Recent Developments – 2016 Highlights

In October 2016, CMS announced that we were awarded two Medicare Recovery Audit Contracts (“Medicare RAC”) to provide retrospective payment accuracy services for Medicare Parts A and B (other than durable medical equipment, prosthetics, orthotics, and supplies claims). Pursuant to these awards we will be the Recovery Audit Contractor for Region 2 (Central US) and Region 3 (Southeast US). The announcement represents the conclusion of CMS’s Medicare RAC reprocurement process. The date on which our auditing work will commence has not yet been determined.

In September 2016, we refinanced our then outstanding credit facilities and entered into the Restated Credit Agreement (as defined below). This refinancing lowered our current interest rate by approximately 83 basis points. As a result of the refinancing, we recognized a loss on extinguishment of debt totaling $9.3 million during the three and nine months ended September 30, 2016.

In September 2016, the vesting criteria associated with outstanding performance-based stock options were satisfied, which resulted in approximately $15.9 million in stock-based compensation expense during the three and nine months ended September 30, 2016.

In June 2016, we repaid $223.0 million in outstanding principal under our then outstanding second lien credit facility using the net proceeds from our IPO. We also made a voluntary prepayment of $13.1 million of outstanding principal under the second lien credit facility. As a result of these payments, we recognized a loss on extinguishment of debt totaling $7.1 million during the nine months ended September 30, 2016.

In May 2016, we launched our IPO, issuing 12,500,000 shares at $19.00 per share. In June 2016, the IPO underwriters partially exercised their option to purchase additional shares from us and we issued an additional 436,038 shares at the IPO price. We received net proceeds from the IPO after the underwriters’ discount and other offering expenses of approximately $227.0 million.

In May 2016, we paid a special cash dividend to pre-IPO shareholders of $150.0 million.

We continued to execute on our strategy, increasing volume and expanding the adoption of our solutions within our existing healthcare clients which contributed to healthcare revenue growth of 16% in the third quarter 2016 and 20% year-to-date 2016 compared to the same periods in 2015.

Growth in our healthcare business has also benefitted from the addition of new clients and our successful cross-sell efforts. During the nine months ended September 30, 2016, we generated $13.1 million in revenue from five new clients added within the past year and from an additional four existing clients who have adopted either prospective or retrospective solutions.

During the second quarter 2016, we generated approximately $5.0 million in healthcare revenue from special projects that are not expected to reoccur in the second half of the year.

The strengthening U.S. dollar has resulted in a negative impact on growth in our retail segment due to our foreign operations in the United Kingdom and Canada.

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Dollar Amount of Claims Reviewed

Revenue in our Healthcare segment in a given period is impacted by the dollar amount of claims we review for our clients, which impacts inaccurate payments that we identify for our clients and the amount of revenue we receive under our performance fee-based contracts. The dollar amount of claims that we review is driven by the scope of claims submitted to us by our clients. The dollar amount of inaccurate payments we identify is also dependent upon the type and number of our solutions used by our clients. As a result of our long-standing relationships with our clients, we have a highly recurring revenue base.

In our Global Retail and Other segment, our revenue is dependent on (i) the amount of payments that we review for our retail clients and (ii) the timing of our payment reviews, which typically are completed on a batch processing basis following the lapse of a period of time after payment.

Healthcare Industry and General Economic Conditions

A majority of our business is directly related to the healthcare industry and is affected by healthcare spending and complexity in the healthcare industry, as follows:

Healthcare Spending by Payers. Changing demographics, the shift to managed care plans within government healthcare and increased healthcare coverage may lead to an increase in healthcare spending by our payer clients. From 2004 to 2014, healthcare costs in the United States grew at a 4.8% compounded annual growth rate to $3.0 trillion and are projected to total $3.2 trillion in 2015. According to CMS, healthcare costs are expected to continue to grow at an average annual rate of 5.9% through 2024. Our revenue is impacted by the expansion or contraction of healthcare coverage and spending, which directly affects the number of payments available for our review.

Complexity in the Healthcare Industry. We believe reimbursement models may become more complex as healthcare payers accommodate new markets and lines of business and as advancements in medical care increase the number of testing and treatment options available. The adoption of the ICD-10 coding framework in October 2015 has resulted in a nearly five times increase of possible diagnosis codes to approximately 68,000, further complicating the claims process. In addition, the Patient Protection and Affordable Care Act, as amended by the Health Care and Education Affordability Reconciliation Act (the “Affordable Care Act”) has increased the number of individuals with Medicaid and private insurance coverage. As reimbursement models grow more complex and healthcare coverage increases, the complexity and number of claims may also increase, which could impact the demand for our payment accuracy solutions. Also, many of the changes promulgated by the Affordable Care Act require implementing regulations that have not yet been drafted or have been released only as proposed rules. Such changes could have a further impact on our results of operations.

In addition, our Global Retail and Other segment is impacted by general economic conditions. For example, in a difficult economy, consumers may be willing to spend less and retailers may reduce their purchasing accordingly, thereby reducing their overall payments available for review. Alternatively, in an expanding economy, retailers may increase their purchasing to meet expected increasing demand resulting in increased payments subject to review using our solutions.

Components of Results of Operations

Net revenue

Our net revenue is generated from contracts with our clients. Our client contracts generally provide for performance fees that are based on a percentage of the inaccurate payments that we prevent through our prospective claims accuracy solutions or the payment recoveries received by our clients that use our retrospective claims accuracy solutions. We derive less than 5% of our revenue on a “fee-for-service” basis whereby billing is based upon a flat fee or a fee per hour. Our clients may request a refund or offset if their providers or vendors ultimately reject the payment inaccuracies we find or if our clients determine not to pursue reimbursement from their providers or vendors even though we may have collected fees. We record

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an estimate for refund liabilities at any given time based on actual historical refund data by client type. In such cases, we record any such refund as a reduction of revenue.

Historically, there has been a seasonal pattern to our healthcare revenue with the revenues in the first quarter generally lower than the other quarters and revenues in the fourth quarter generally being higher than the other quarters. Accordingly, the comparison of revenue from quarter to quarter may fluctuate and is dependent on various factors, including, but not limited to, reset of member liability, timing of special projects and timing of inaccurate payments being prevented or recovered as well as the aforementioned seasonal considerations. Consequently, you should not rely on our revenue for any one quarter as an indication of our future performance.

Cost of revenue

Our cost of revenue is comprised of:

Compensation, which includes the total compensation and benefit-related expenses, including stock-based compensation expense, for employees who provide direct revenue generating services to clients; and

Other costs of revenue, which primarily include expenses related to the use of subcontractors, costs associated with the retrieval of medical records and facilities-related costs associated with locations that are used strictly for revenue generating activities. Cost of revenue does not include depreciation and amortization, which is stated separately in our consolidated statement of operations.

Selling, general and administrative expenses

Our selling, general and administrative expenses are comprised of:

Compensation, which includes total compensation and benefit-related expenses, including stock-based compensation expense, for our employees who are not directly involved in revenue generating activities including those involved with developing new service offerings; and

Other selling, general and administrative expenses, which include all of our general operating costs. These costs include, but are not limited to, rent and occupancy costs for facilities associated with locations that are used for employees not serving in revenue generating roles, telecommunications costs, information technology infrastructure costs, software licensing costs, advertising and marketing expenses, costs associated with developing new service offerings and expenses related to the use of certain subcontractors and professional services firms. Selling, general and administrative expenses do not include depreciation and amortization, which is stated separately in our consolidated statement of operations.

We expect to incur significant additional legal, accounting and other expenses associated with being a public company, including costs associated with our compliance with the Sarbanes-Oxley Act of 2002 (the “Sarbanes-Oxley Act”).

Depreciation and amortization of property and equipment

Depreciation and amortization of property and equipment consists of depreciation related to our investments in property and equipment, including claims accuracy solutions software, as well as amortization of capitalized internal-use software and software development costs.

Amortization of intangible assets

Amortization of intangible assets includes amortization of customer relationships, acquired software and certain trademarks.

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Transaction-related expenses

Transaction-related expenses consist primarily of professional services and other expenses associated with the preparation for our IPO and certain expenses associated with certain corporate development activity.

Impairment of intangible assets

Impairment of intangible assets includes charges resulting from the impairment of certain trademarks as a result of their carrying value exceeding their estimated fair values.

Interest expense

Interest expense consists of accrued interest and related payments on our outstanding long-term debt as well as the amortization of debt issuance costs. Additionally, interest expense includes any effective portion of realized interest rate hedging derivative gains and losses previously recorded in accumulated other comprehensive (loss) income when the actual interest payments are made on our variable rate debt and the related derivate contract settles.

Loss on extinguishment of debt

Loss on extinguishment of debt consists of fees paid and write-offs of unamortized debt issuance costs and original issue discount in connection with the 2015 repricing of our long-term debt, the 2016 early repayment of a portion of our long-term debt and the 2016 refinancing of our long-term debt.

Other non-operating (income) expense

Other non-operating (income) expense primarily consists of foreign exchange gains and losses. In addition, income received for certain sub-leases, interest income and realized gains and losses, interest and dividends on available-for-sale securities are included in other non-operating (income) expense.

Income tax expense

Income tax expense consists of federal, state, local and foreign taxes based on earnings in multiple jurisdictions. Our income tax expense is impacted by the pre-tax earnings in jurisdictions with varying tax rates and any related foreign tax credits or deductions that may be available to us. Our current and future provision for income taxes will vary from statutory rates due to the impact of income tax incentives and holidays, certain non-deductible expenses, valuation allowances in certain countries, withholding taxes and other discrete items.

Stock-based compensation expense

We grant stock-based compensation awards to certain employees, officers and non-employee directors as long-term incentive compensation. We recognize the related expense for service-based awards ratably over the applicable vesting period and expense related to performance-based awards upon the satisfaction of the related vesting criteria. Such expense is recognized in either cost of revenue or selling, general and administrative expenses based upon the function of the optionee. The following table shows the allocation of stock-based compensation expense among our expense line items for the periods presented:


	Three Months Ended				Nine Months Ended
	September 30,				September 30,
	2016		2015		2016		2015
	(unaudited)				(unaudited)
Cost of revenue	$	4,153	$	193	$	4,738	$	584
Selling, general and administrative expenses		12,889		212		16,806		1,040
Total	$	17,042	$	405	$	21,544	$	1,624

As of September 30, 2016, we had total unrecognized stock-based compensation expense related to unvested service-based awards of $15.1 million, which we expect to recognize over the next 3.2 years. Stock-based compensation

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expense during the three months ended September 30, 2016 includes approximately $15.9 million as a result of the vesting of performance awards, of which approximately $3.9 million is included in cost of revenue above and the remaining $12.0 million is included in selling, general and administrative expenses above. Additionally, during the nine months ended September 30, 2016, stock-based compensation expense includes approximately $2.3 million related to the accelerated vesting of certain stock options as the result of the IPO.

Foreign currency translation adjustments.

The assets and liabilities of our foreign subsidiaries with a functional currency other than the U.S. Dollar are translated into U.S. Dollars using applicable exchange rates at the balance sheet date. Revenue and expenses are translated at average exchange rates effective during the year. The resulting foreign currency translation gains and losses are included as a component of other comprehensive (loss) income. Foreign currency translation adjustments were insignificant for the three months ended September 30, 2016 compared to downward foreign currency translation adjustments of $1.0 million for the three months ended September 30, 2015. We had downward foreign currency translation adjustments of $0.7 million and $1.3 million, for the nine months ended September 30, 2016 and 2015, respectively. The downward translation adjustments were the result of the strengthening of the U.S. Dollar against the Canadian Dollar and British Pound over the corresponding period.

Change in fair value of derivative instruments, net of related taxes.

We are a party to interest rate cap agreements that hedge the potential impact fluctuations in interest rates may have on payments we make pursuant to our First Lien Credit Facilities (as defined below). We had a downward net change in fair value of derivative instruments, net of related taxes, of approximately $0.1 million and $1.1 million for the three months ended September 30, 2016 and 2015, respectively, and $0.6 million and $2.6 million for the nine months ended September 30, 2016 and 2015, respectively. The downward changes were the result of fluctuations in three-month London inter-bank offered rate.

How We Assess Our Performance

Adjusted EBITDA

We believe Adjusted EBITDA, a measure that is not calculated in accordance with U.S. generally accepted accounting principles (“GAAP”), is useful to investors as a supplemental measure to evaluate our overall operating performance. Management uses Adjusted EBITDA as a measurement to compare our operating performance to our peers and competitors. We define Adjusted EBITDA as net income (loss) before depreciation and amortization, impairment of intangible assets, interest expense, other non-operating (income) expense such as foreign currency translation, income tax expense (benefit), gain on discontinued operations, transaction-related expenses and other, stock-based compensation and loss on extinguishment of debt. See the notes to our consolidated financial statements included in Item 1 of this Quarterly Report on Form 10-Q for additional information regarding these adjustments. Management believes Adjusted EBITDA is useful because it provides meaningful supplemental information about our operating performance and facilitates period-to-period comparisons without regard to our financing methods, capital structure or other items that we believe are not indicative of our ongoing operating performance. By providing this non-GAAP financial measure, management believes we are enhancing investors’ understanding of our business and our results of operations, as well as assisting investors in evaluating how well we are executing our strategic initiatives. Management believes that Adjusted EBITDA is frequently used by securities analysts, investors and other interested parties as a supplemental measure of financial performance within our industry. In addition, the determination of Adjusted EBITDA is consistent with the definition of a similar measure in our First Lien Credit Facilities other than adjustments for severance costs and non-income based taxes permitted by the First Lien Credit Facilities but not considered by management in evaluating our performance using Adjusted EBITDA.

Adjusted EBITDA has important limitations as an analytical tool and you should not consider it in isolation or as a substitute for analysis of our results as reported under GAAP. Some of these limitations are:

Adjusted EBITDA does not reflect our cash expenditures or future requirements for capital expenditures or contractual commitments;

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Adjusted EBITDA does not reflect changes in, or cash requirements for, our working capital needs;

Although depreciation is a non-cash charge, the assets being depreciated will often have to be replaced in the future, and Adjusted EBITDA does not reflect any cash requirements for such replacements;

Adjusted EBITDA does not reflect the impact of stock-based compensation upon our results of operations;

Adjusted EBITDA does not reflect the significant interest expense, or the cash requirements necessary to service interest or principal payments on our debt;

Adjusted EBITDA does not reflect our income tax expense (benefit) or the cash requirements to pay our income taxes; and

Other companies in our industry may calculate Adjusted EBITDA differently than we do, limiting its usefulness as a comparative measure.

In evaluating Adjusted EBITDA, you should be aware that in the future we may incur expenses similar to those eliminated in this presentation.

The following table presents net income (loss), Adjusted EBITDA and a reconciliation of Adjusted EBITDA to net income (loss) for the periods presented:


	Three Months Ended				Nine Months Ended
	September 30,				September 30,
	2016		2015		2016		2015
(in thousands)	(unaudited)				(unaudited)
Net income (loss)	$	4,583	$	(7,294)	$	23,560	$	4,680
Depreciation and amortization		20,421		19,210		60,482		55,526
Impairment of intangible assets(a)		—		27,826		—		27,826
Interest expense		9,625		16,180		40,345		49,855
Other non-operating (income) expense(b)		(113)		(187)		(771)		(384)
Income tax expense (benefit)		711		(4,571)		12,780		3,932
Gain on discontinued operations, net of tax(c)		—		—		—		(559)
Transaction-related expenses and other(d)		16		354		909		354
Stock-based compensation(e)		17,042		405		21,544		1,624
Loss on extinguishment of debt(f)		9,349		—		16,417		4,084
Adjusted EBITDA	$	61,634	$	51,923	$	175,266	$	146,938

^(a)

Represents an impairment during the quarter ended September 30, 2015 as a result of our rebranding and the related impact to our tradenames.

^(b)

Represents other non‑operating (income) expense that consists primarily of gains and losses on transactions settled in foreign currencies. Income received for certain sub‑leases is included herein.

^(c)

Represents payment on a $900 note receivable ($559 net of taxes) related to a business that was disposed of in 2012. This note receivable had been reported in the loss on discontinued operations in 2012 upon the sale of that business. Since the date of sale, we had elected to fully reserve the note receivable as the collectability was determined to be uncertain.

^(d)

Represents transaction‑related expenses that consist primarily of certain expenses associated with the preparation for our IPO and certain corporate development activity.

^(e)

Represents expense related to stock‑based compensation awards granted to certain employees, officers and non‑employee directors as long‑term incentive compensation. We recognize the related expense for these awards ratably

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over the vesting period. During the three months ended September 30, 2016, performance awards vested resulting in stock compensation expense of $15.9 million.

^(f)

Represents loss on extinguishment of debt that consists primarily of fees paid and write‑offs of unamortized debt issuance costs and original issue discount in connection with the repricing of our long‑term debt in 2015, the early repayment of a portion of our long-term debt in 2016 and the refinancing of our long-term debt in 2016.

Dollar Amount of Inaccurate Payments Prevented or Recovered

The majority of our net revenue consists of performance fees earned under our client contracts. Our performance fees generally represent a specified percentage of inaccurate payments that are either prevented prior to payment using our prospective claims accuracy solutions or recovered by our clients after they are identified using our retrospective claims accuracy solutions. For those clients where we identify any payment inaccuracies in advance of payment to the providers, the clients reduce the amount paid to the providers based upon the inaccuracies that we have identified. For those clients where we identify payment inaccuracies using our retrospective claims accuracy solutions after the client has made payment, clients generally recover claims either by taking credits against outstanding payables to healthcare providers or retail vendors, or future purchases from the related retail vendors, or receiving refund checks directly from those healthcare providers or retail vendors.

The dollar amount of inaccurate payments prevented or recovered in a given period is impacted by the dollar amount of claims or payments reviewed, the scope of claims or payments that we review, the success of our cross-selling efforts, our ability to retain existing clients and obtain new clients and our ability to enhance our existing solutions or create new solutions.

We believe the dollar amount of inaccurate payments prevented or recovered is useful to measure our overall operating performance and how well we are executing on our client contracts.

Debt Refinancings, Repayments and Repricing

In connection with our various debt refinancings, we incurred significant debt issuance costs, primarily associated with the new indebtedness. These debt issuance costs are amortized utilizing the effective interest method over the associated life of the related indebtedness and recorded as interest expense. Unamortized debt issuance costs were $11.3 million as of September 30, 2016.

In May 2015, we repriced our then outstanding first lien credit facilities which reduced the related interest rates. We incurred $4.1 million in debt extinguishment costs in the nine months ended September 30, 2015 in connection with the repricing primarily related to accelerated recognition of the unamortized portion of debt issuance costs and original issue discount related to indebtedness that was repaid to certain lenders.

In June 2016, we repaid $223.0 million in outstanding principal under our then outstanding second lien credit facility using proceeds from our IPO. We also made a voluntary prepayment of $13.1 million of outstanding principal under the second lien credit facility. As a result of these repayments, we recognized a loss on extinguishment of debt totaling $7.1 million during the nine months ended September, 30, 2016 primarily related to the accelerated recognition of the unamortized portion of debt issuance costs and original issue discount.

In September 2016, we completed a refinancing of our then existing first and second lien credit facilities and entered the Amended and Restated First Lien Credit Agreement (the “Restated Credit Agreement”), which provides for first lien credit facilities (the “First Lien Credit Facilities” consisting of a (a) Term Loan A in the amount of $250,000, (b) Term Loan B in the amount of $550,000 and (c) revolving credit facility (the “Revolver”) in the amount of up to $100,000, reducing our total debt principal outstanding by $22.7 million and reducing the interest rates. As a result of this refinancing, we recognized a loss on extinguishment of debt of $9.3 million during the three months ended September 30, 2016, primarily related to the payment of certain fees and the accelerated recognition of the unamortized portion of debt issuance costs and original issue discount related to indebtedness that was repaid to certain lenders.

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Our Segments

We report our results of operations in two segments, (i) Healthcare and (ii) Global Retail and Other. Through our Healthcare segment, we offer prospective and retrospective claims accuracy solutions to healthcare payers in the United States. We also provide analytics-based solutions unrelated to our healthcare payment accuracy solutions, on a limited basis in the United States. Through our Global Retail and Other segment, we provide retrospective claims accuracy solutions to retailers primarily in the United States, Canada and the U.K., as well as solutions that improve efficiency and effectiveness of payment networks for a limited number of clients.

We evaluate the performance of each segment based on segment net revenue and segment operating income. The cost of revenue for each segment is based on direct expenses associated with revenue generating activities of each segment. We allocate selling, general and administrative expenses to each segment based on the segments’ proportionate share of revenue and expenses directly related to the operation of the segment as determined by management. The following table sets forth the net revenue and operating income for our Healthcare and Global Retail and Other segments for the periods presented (in thousands).


	Three Months Ended				Nine Months Ended
	September 30,				September 30,
	2016		2015		2016		2015
	(unaudited)				(unaudited)
Net Revenue
Healthcare	$	138,470	$	119,127	$	403,643	$	336,683
Global Retail and Other		17,771		17,809		53,607		53,197
Consolidated net revenue	$	156,241	$	136,936	$	457,250	$	389,880
Operating Income
Healthcare	$	22,544	$	4,288	$	85,879	$	55,812
Global Retail and Other		1,611		(160)		6,452		5,796
Consolidated operating income	$	24,155	$	4,128	$	92,331	$	61,608

The following table sets forth our segment net revenue and percentage of consolidated net revenue by product type for the periods presented (in thousands):


	Three Months Ended September 30,						Nine Months Ended September 30,
	2016		%	2015		%	2016		%	2015		%
	(unaudited)						(unaudited)
Healthcare
Retrospective claims accuracy	$	78,133	50.0	$	62,369	45.5	$	224,335	49.1	$	178,818	45.9
Prospective claims accuracy		57,233	36.6		53,419	39.1		169,632	37.1		147,335	37.8
Transaction services		3,104	2.0		3,339	2.4		9,676	2.1		10,530	2.7
Total Healthcare		138,470	88.6		119,127	87.0		403,643	88.3		336,683	86.4
Retail
Retrospective claims accuracy		17,039	10.9		17,292	12.6		51,730	11.3		51,546	13.2
Other		732	0.5		517	0.4		1,877	0.4		1,651	0.4
Total Global Retail and Other		17,771	11.4		17,809	13.0		53,607	11.7		53,197	13.6
Consolidated net revenue	$	156,241	100.0	$	136,936	100.0	$	457,250	100.0	$	389,880	100.0

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Results of Operations

Three Months Ended September 30, 2016 compared to Three Months Ended September 30, 2015


	Three Months Ended September 30,
			Percentage of			Percentage of	Percentage
			Net Revenue			Net Revenue	Change Period
(unaudited)	2016		(%)	2015		(%)	to Period (%)
Net revenue	$	156,241	100.0	$	136,936	100.0	14.1
Cost of revenue (exclusive of depreciation and amortization, stated separately below):
Compensation		58,517	37.5		46,424	33.9	26.0
Other costs of revenue		6,658	4.3		5,646	4.1	17.9
Total cost of revenue		65,175	41.8		52,070	38.0	25.2
Selling, general and administrative expenses (exclusive of depreciation and amortization, stated separately below):
Compensation		32,496	20.8		16,997	12.4	91.2
Other selling, general and administrative expenses		13,978	8.9		16,351	11.9	14.5
Total selling, general and administrative expenses		46,474	29.7		33,348	24.3	39.4
Depreciation and amortization of property and equipment		5,218	3.3		3,773	2.8	38.3
Amortization of intangible assets		15,203	9.7		15,437	11.3	1.5
Transaction-related expenses		16	0.0		354	0.3	95.5
Impairment of intangible assets		—	—		27,826	20.3	100.0
Total operating expenses		132,086	84.5		132,808	97.0	0.5
Operating income		24,155	15.5		4,128	3.0	485.2
Other expense (income):
Interest expense		9,625	6.2		16,180	11.7	40.5
Loss on extinguishment of debt		9,349	6.0		—	—	—
Other non-operating (income) expense		(113)	(0.1)		(187)	(0.1)	39.6
Total other expense (income)		18,861	12.1		15,993	11.6	17.9

Income (loss) from continuing operations before income taxes		5,294	3.4		(11,865)	(8.6)	144.6
Income tax expense (benefit)		711	0.5		(4,571)	(3.3)	115.6
Net income (loss)	$	4,583	2.9	$	(7,294)	(5.3)	162.8

Net revenue

Net revenue was $156.2 million for the three months ended September 30, 2016 as compared to $136.9 million for the three months ended September 30, 2015. The increase of $19.3 million was the result of increased Healthcare segment revenue while our Global Retail and Other segment revenue remained flat. See “Segment net revenue and operating income.”

Cost of revenue

Cost of revenue related to compensation was $58.5 million for the three months ended September 30, 2016 as compared to $46.4 million for the three months ended September 30, 2015. The increase of $12.1 million was primarily the result of $7.2 million in additional payroll related expenses due to increased headcount and growth of our Healthcare segment. Stock-based compensation also increased by approximately $4.0 million primarily due to the vesting of performance-based stock options during the three months ended September 30, 2016 as well as additional stock option

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grants. Employee benefit costs increased approximately $0.9 million due to rising healthcare coverage costs and the increase in number of employees.

Other costs of revenue were $6.7 million for the three months ended September 30, 2016 as compared to $5.6 million for the three months ended September 30, 2015. The increase of $1.1 million was primarily the result of a $2.1 million increase in variable costs to support our growing operations partially offset by a $1.0 million decrease in the cost to retrieve medical records due to reduced volume.

Selling, general and administrative expenses

Selling, general and administrative expenses related to compensation was $32.5 million for the three months ended September 30, 2016 as compared to $17.0 million for the three months ended September 30, 2015. The increase of $15.5 million was primarily related to a $12.7 million increase in stock-based compensation due to the vesting of performance-based stock options during the three months ended September 30, 2016 as well as additional stock option grants. Additionally, compensation related expenses increased $2.2 million primarily due to an increase in the number of employees to support our growing operations, including the hiring of certain key positions associated with being a public company. Employee benefit costs increased approximately $0.6 million due to rising healthcare coverage costs and the increase in number of employees.

Other selling, general and administrative expenses were $14.0 million for the three months ended September 30, 2016 as compared to $16.4 million for the three months ended September 30, 2015. The decrease of $2.4 million was primarily due to a $2.9 million decrease in other variable costs including professional and consulting fees as our current need to leverage external resources has been reduced. This decrease was partially offset by a $0.5 million increase in IT infrastructure and telecommunications costs to support our growing operations.

Depreciation and amortization of property and equipment

Depreciation and amortization of property and equipment was $5.2 million for the three months ended September 30, 2016 as compared to $3.8 million for the three months ended September 30, 2015. The increase of $1.4 million was due to continued investments in capital expenditures over the past year.

Amortization of intangible assets

Amortization of intangible assets was $15.2 million for the three months ended September 30, 2016 as compared to $15.4 million for the three months ended September 30, 2015. The decrease of $0.2 million was the result of the impairment of our legacy trademarks related to the Cotiviti rebranding in September 2015.

Transaction-related expenses

Transaction-related expenses for the three months ended September 30, 2016 were insignificant. Transaction-related expenses were $0.4 million for the three months ended September 30, 2015 primarily related to expenses incurred in connection with our IPO.

Impairment of Intangible Assets

Impairment of intangible assets was $27.8 million for the three months ended September 30, 2015 related to our Connolly and iHealth trademarks as a result of our Cotiviti rebranding in September 2015. We had no impairment of intangible assets for the three months ended September 30, 2016.

Interest expense

Interest expense was $9.6 million for the three months ended September 30, 2016 as compared to $16.2 million for the three months ended September 30, 2015. In May 2015 we repriced our then outstanding first lien term loan, lowering the interest rate by 50 basis points. In June 2016 we repaid $236.1 million of outstanding borrowings under our then outstanding second lien credit facility. In September 2016, we refinanced our long-term debt, reducing our outstanding

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principal by $22.7 million and reducing our interest rates by approximately 83 basis points overall. The decrease in interest expense of $6.6 million was the result of the reduction in principal, which contributed approximately $3.7 million of the interest expense decrease, and the lower interest rates, which contributed the remaining $2.9 million interest expense decrease.

Loss on extinguishment of debt

Loss on extinguishment of debt was $9.3 million for the three months ended September 30, 2016 related to the payment of fees and write-off of unamortized debt issuance costs and original issue discount as a result of the refinancing of our long-term debt. We did not have a loss on extinguishment of debt for the three months ended September 30, 2015.

Other non-operating income

We had other non-operating income of $0.1 million for the three months ended September 30, 2016 as compared to $0.2 million for the three months ended September 30, 2015. The decrease was primarily the result of foreign exchange losses related to our operations in India.

Income tax expense

We had a total income tax expense of $0.7 million for the three months ended September 30, 2016 as compared to a tax benefit of $4.6 million for the three months ended September 30, 2015. The increase in income tax expense for the three months ended September 30, 2016 as compared to the three months ended September 30, 2015 was a result of the increase in pre-tax income. The effective tax rate for the three months ended September 30, 2016 was 13.4% compared to 38.5% for the three months ended September 30, 2015. During the three months ended September 30, 2016, we recorded a $1.3 million tax benefit primarily related to the settlement of an uncertain tax position recorded in a prior period. The impact of this tax benefit relative to the pre-tax income for the three months ended September 30, 2016 resulted in the decrease to the effective tax rate.

Segment net revenue and operating income

Healthcare segment net revenue was $138.5 million for the three months ended September 30, 2016 as compared to $119.1 million for the three months ended September 30, 2015. The increase of $19.4 million was primarily the result of a net increase of $14.6 million due to increased penetration and extended scope of services provided to our existing client base and a $4.8 million increase due to the addition of new clients and the success of our cross-sell efforts.

Global Retail and Other segment net revenue was $17.8 million for both the three months ended September 30, 2016 and three months ended September 30, 2015. Revenue from our retail client base increased approximately $0.4 million primarily related to timing and nature of the claims reviewed which was offset by a decrease of $0.4 million as a result of foreign currency fluctuations due to the strengthening U.S. dollar.

Healthcare segment operating income was $22.5 million for the three months ended September 30, 2016 as compared to $4.3 million for the three months ended September 30, 2015. The increase in operating income of $18.2 million was the result of the increase in net revenue noted above. This was partially offset by an increase in compensation expense of $11.1 million related to an increase in the number of employees in our growing Healthcare segment and a $15.4 million increase in stock-based compensation expense primarily due to the vesting of performance-based stock options. Our ongoing investment in strategic initiatives contributed an additional $0.7 million in expense primarily related to an increase in IT infrastructure costs. Rent and occupancy related costs increased $0.8 million as a result of additional leased office space needed to support our growing operations. Depreciation and amortization expenses increased by $1.2 million due to our continued investments in capital expenditures. These increases were offset by an impairment of intangible assets of $26.3 million for the three months ended September 30, 2015 related to our Connolly and iHealth trademarks as a result of our Cotiviti rebranding in September 2015, a $1.0 million decrease in the costs to retrieve medical records due to reduced volume, a $0.5 million decrease in certain variable costs and a $0.3 million decrease in transaction-related expenses primarily related to costs associated with the IPO.

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Global Retail and Other segment operating income was $1.6 million for the three months ended September 30, 2016 as compared to an operating loss of $0.2 million for the three months ended September 30, 2015. The increase in operating income of $1.8 million was the result of a $1.5 million impairment of intangible assets for the three months ended September 30, 2015 related to our Connolly trademark as a result of our Cotiviti rebranding in September 2015 and a decrease of $1.5 million in certain variable costs. These decreased expenses were offset by a $1.2 million increase in stock-based compensation expense primarily due to the vesting of performance-based stock options.

Nine Months Ended September 30, 2016 Compared to Nine Months Ended September 30, 2015


	Nine Months Ended September 30,
			Percentage of			Percentage of	Percentage
			Net Revenue			Net Revenue	Change Period
(unaudited)	2016		(%)	2015		(%)	to Period (%)
Net revenue	$	457,250	100.0	$	389,880	100.0	17.3
Cost of revenue (exclusive of depreciation and amortization, stated separately below):
Compensation		167,263	36.6		132,928	34.1	25.8
Other costs of revenue		17,331	3.8		14,629	3.7	18.5
Total cost of revenue		184,594	40.4		147,557	37.8	25.1
Selling, general and administrative expenses (exclusive of depreciation and amortization, stated separately below):
Compensation		74,782	16.4		52,586	13.5	42.2
Other selling, general and administrative expenses		44,152	9.6		44,423	11.4	0.6
Total selling, general and administrative expenses		118,934	26.0		97,009	24.9	22.6
Depreciation and amortization of property and equipment		14,864	3.2		9,270	2.4	60.3
Amortization of intangible assets		45,618	10.0		46,256	11.9	1.4
Transaction-related expenses		909	0.2		354	0.1	156.8
Impairment of intangible assets		—	—		27,826	7.1	100.0
Total operating expenses		364,919	79.8		328,272	84.2	11.2
Operating income		92,331	20.2		61,608	15.8	49.9
Other expense (income):
Interest expense		40,345	8.8		49,855	12.8	19.1
Loss on extinguishment of debt		16,417	3.6		4,084	1.0	302.0
Other non-operating (income) expense		(771)	(0.2)		(384)	(0.1)	100.8
Total other expense (income)		55,991	12.2		53,555	13.7	4.5

Income from continuing operations before income taxes		36,340	8.0		8,053	2.1	351.3
Income tax expense		12,780	2.8		3,932	1.0	225.0
Income from continuing operations		23,560	5.2		4,121	1.1	471.7
Gain on discontinued operations, net of tax		—	—		559	0.1	100.0
Net income	$	23,560	5.2	$	4,680	1.2	403.4

Net revenue

Net revenue was $457.3 million for the nine months ended September 30, 2016 as compared to $389.9 million for the nine months ended September 30, 2015. The increase of $67.4 million was the result of increased Healthcare segment revenue of $67.0 million and increased Global Retail and Other segment revenue of $0.4 million. See “Segment net revenue and operating income.”

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Cost of revenue

Cost of revenue related to compensation was $167.3 million for the nine months ended September 30, 2016 as compared to $132.9 million for the nine months ended September 30, 2015. The increase of $34.4 million was primarily the result of approximately $27.5 million in additional payroll related expenses due to increased headcount and growth of our Healthcare segment. Stock-based compensation increased by approximately $4.2 million due to the vesting of performance-based stock options during the nine months ended September 30, 2016 as well as additional stock option grants. Employee benefit costs increased approximately $2.7 million due to rising healthcare coverage costs and the increase in the number of our employees.

Other costs of revenue were $17.3 million for the nine months ended September 30, 2016 as compared to $14.6 million for the nine months ended September 30, 2015. The increase of $2.7 million was primarily the result of an increase in variable costs to support our growing operations of $4.4 million partially offset by a $1.7 million decrease in the cost to retrieve medical records due to reduced volume.

Selling, general and administrative expenses

Selling, general and administrative expenses related to compensation was $74.8 million for the nine months ended September 30, 2016 as compared to $52.6 million for the nine months ended September 30, 2015. The increase of $22.2 million was primarily related to a $15.8 million increase in stock-based compensation due to the vesting of performance-based stock options and the accelerated vesting of certain stock options as a result of the IPO during the nine months ended September 30, 2016 as well as additional stock option grants. Compensation related expenses increased $5.3 million primarily due to an increase in the number of employees to support our growing operations, including the hiring of certain key positions associated with being a public company. Employee benefit costs increased approximately $1.1 million due to rising healthcare coverage costs and the increase in number of employees.

Other selling, general and administrative expenses were $44.2 million for the nine months ended September 30, 2016 as compared to $44.4 million for the nine months ended September 30, 2015. The decrease of $0.2 million was primarily due to a decrease of $3.3 million in other variable costs including professional and consulting fees as our current need to leverage external resources has been reduced. This decrease was partially offset by a $3.1 million increase in IT infrastructure and telecommunications costs to support our growing operations.

Depreciation and amortization of property and equipment

Depreciation and amortization of property and equipment was $14.9 million for the nine months ended September 30, 2016 as compared to $9.3 million for the nine months ended September 30, 2015. The increase of $5.6 million was due to continued investments in capital expenditures over the prior year.

Amortization of intangible assets

Amortization of intangible assets was $45.6 million for the nine months ended September 30, 2016 as compared to $46.3 million for the nine months ended September 30, 2015. The decrease of $0.7 million was the result of the impairment of our legacy trademarks related to the Cotiviti rebranding in September 2015.

Transaction-related expenses

Transaction-related expenses were $0.9 million for the nine months ended September 30, 2016 primarily related to expenses incurred in connection with our IPO as well as certain expenses related to corporate development activity. Transaction-related expenses were $0.4 million for the nine months ended September 30, 2015 primarily related to expenses incurred in connection with our IPO.

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Impairment of Intangible Assets

Impairment of intangible assets was $27.8 million for the nine months ended September 30, 2015 related to our Connolly and iHealth trademarks as a result of our Cotiviti rebranding in September 2015. We had no impairment of intangible assets for the nine months ended September 30, 2016.

Interest expense

Interest expense was $40.3 million for the nine months ended September 30, 2016 as compared to $49.9 million for the nine months ended September 30, 2015. In May 2015 we repriced our then outstanding first lien term loan, lowering the interest rate by 50 basis points. In June 2016, we repaid $236.1 million of outstanding borrowings under our then outstanding second lien credit facility. In September 2016, we refinanced our long-term debt, reducing our outstanding principal by $22.7 million and reducing our interest rates by approximately 83 basis points overall. The decrease in interest expense of $9.6 million was the result of the reduction in principal, which contributed approximately $5.1 million of the interest expense decrease, and the lower interest rates, which contributed the remaining $4.5 million interest expense decrease.

Loss on extinguishment of debt

Loss on extinguishment of debt was $16.4 million for the nine months ended September 30, 2016 related to the payment of fees and write-off of unamortized debt issuance costs and original issue discount as a result of the refinancing of our long-term debt in September 2016 and the early payment on our outstanding borrowings under our then outstanding second lien credit facility in June 2016. During the nine months ended September 30, 2015 we recognized a loss on extinguishment of $4.1 million related to the write-off of unamortized debt issuance costs and original issue discount as a result of the repricing of our then outstanding first lien credit facility.

Other non-operating income

We had other non-operating income of $0.8 million for the nine months ended September 30, 2016 as compared to $0.4 million for the nine months ended September 30, 2015. The increase of $0.4 million was primarily the result of $0.2 million in foreign exchange gains related to our operations in India and $0.1 million in interest income driven by higher cash balance.

Income tax expense

We had a total income tax expense of $12.8 million for the nine months ended September 30, 2016 as compared to $3.9 million for the nine months ended September 30, 2015. The increase in income tax expense for the nine months ended September 30, 2016 as compared to the nine months ended September 30, 2015 was a result of the increase in pre-tax income. The effective tax rate for the nine months ended September 30, 2016 was 35.2% compared to 48.8% for the nine months ended September 20, 2015. The decrease in the effective tax rate is primarily due to a $1.3 million tax benefit related to the settlement of an uncertain tax position recorded in a prior period.

Segment net revenue and operating income

Healthcare segment net revenue was $403.6 million for the nine months ended September 30, 2016 as compared to $336.7 million for the nine months ended September 30, 2015. The increase of $67.0 million was primarily the result of a net increase of $53.9 million due to increased penetration and extended scope of services provided to our existing client base which includes approximately $5.0 million relating to special projects that we do not expect to reoccur and a $13.1 million increase due to the addition of new clients and the success of our cross-sell efforts.

Global Retail and Other segment net revenue was $53.6 million for the nine months ended September 30, 2016 as compared to $53.2 million for the nine months ended September 30, 2015. The increase of $0.4 million was the result of a $1.2 million increase in revenue from our retail client base primarily related to the timing and nature of the claims reviewed partially offset by the negative impact of certain regulatory changes in the U.K. This increase was partially offset by $0.8 million decrease as a result of foreign currency fluctuations due to the strengthening U.S. dollar.

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Healthcare segment operating income was $85.9 million for the nine months ended September 30, 2016 as compared to $55.8 million for the nine months ended September 30, 2015. The increase in operating income of $30.1 million was the result of an increase in net revenue noted above. This was partially offset by an increase in compensation expense of $36.1 million related to an increase in the number of employees in our growing Healthcare segment. Additionally, stock-based compensation expense increased approximately $18.5 million due to the vesting of performance-based stock options and the accelerated vesting of certain stock options upon our IPO. Our ongoing investment in strategic initiatives contributed an additional $3.1 million in expense primarily related to an increase in IT infrastructure costs. Rent and occupancy related costs increased $1.7 million as a result of additional leased office space needed to support our growing operations. Depreciation and amortization expenses increased by $4.9 million due to our continued investments in capital expenditures. Transaction-related expenses increased $0.5 million primarily related to the costs of the IPO. Additionally, certain variable costs increased approximately $0.1 million. These increased expenses were offset by an impairment of intangible assets of $26.3 million for the nine months ended September 30, 2015 related to our Connolly and iHealth trademarks as a result of our Cotiviti rebranding in September 2015 and a $1.7 million decrease in the costs to retrieve medical records due to reduced volume.

Global Retail and Other segment operating income was $6.5 million for the nine months ended September 30, 2016 as compared to $5.8 million for the nine months ended September 30, 2015. The increase in operating income of $0.7 million was the result the increase in net revenue noted above. This increase was partially offset by a $1.5 million increase in stock-based compensation primarily related to the vesting of performance-based stock options and a $0.5 million increase in compensation related expenses. Additionally there was a $0.1 million increase in expenses related to the ongoing costs associated with our IT infrastructure initiatives. Depreciation and amortization expenses increased $0.1 million due to our continued investments in capital expenditures. These increased expenses were partially offset by a $1.5 million impairment of intangible assets for the nine months ended September 30, 2015 related to our Connolly trademark as a result of our Cotiviti rebranding in September 2015 and a decrease of $0.8 million in certain variable costs.

Liquidity and Capital Resources

Overview

Our primary sources of liquidity are our existing cash and cash equivalents, cash provided by operating activities and borrowings under our First Lien Credit Facilities. As of September 30, 2016, we had cash and cash equivalents of $43.8 million and availability under the revolving portion of our First Lien Credit Facilities of $99.5 million. Our total indebtedness was $800.0 million as of September 30, 2016.

Our principal liquidity needs have been, and will continue to be, debt service, capital expenditures, working capital and potential mergers and acquisitions. In addition, on May 26, 2016 we paid a one-time, special cash dividend of $150.0 million in aggregate, to holders of record of our common stock as of May 24, 2016.

Our capital expenditures support investments in our underlying infrastructure to enhance our solutions and technology for future growth. Our capital expenditures were $22.6 million and $11.0 million for the nine months ended September 30, 2016 and 2015, respectively. The increase is primarily due to expenditures associated with enhancing our IT platform. We do not expect our capital expenditures to continue to increase. However, our strategy includes the expansion of our existing solutions and the development of new solutions, which will require cash expenditures over the next few years and will be funded primarily with cash provided by operating activities. Accordingly, we expect our annual capital expenditures to continue to remain high as compared to the year ended December 31, 2015.

We believe that our cash flow from operations, availability under our First Lien Credit Facilities and available cash and cash equivalents will be sufficient to meet our liquidity needs for at least the foreseeable future. We anticipate that to the extent that we require additional liquidity, it will be funded through the incurrence of additional indebtedness, the issuance of equity financings, or a combination thereof. We cannot assure you that we will be able to obtain this additional liquidity on reasonable terms, or at all. Additionally, our liquidity and our ability to meet our obligations and fund our capital requirements are also dependent on our future financial performance, which is subject to general economic, financial and other factors that are beyond our control. Accordingly, we cannot assure you that our business will generate sufficient cash

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flow from operations or that future borrowings will be available from additional indebtedness or otherwise to meet our liquidity needs. If we decide to pursue one or more significant acquisitions, we may incur additional debt or sell additional equity to finance such acquisitions, which could possibly result in additional expenses or dilution.

Summary of Cash Flows

The following table provides a summary of cash flows from operating, investing and financing activities for the periods presented (in thousands):



	Nine Months Ended
	September 30,
	2016		2015
	(unaudited)
Net cash provided by operating activities	$	108,345	$	30,408
Net cash used in investing activities		(21,397)		(10,616)
Net cash used in financing activities		(192,158)		(6,951)

Operating Activities

Net cash provided by operating activities was $108.3 million and $30.4 million for the nine months ended September 30, 2016 and 2015, respectively. The increase in cash provided by operating activities for the nine months ended September 30, 2016 as compared to the nine months ended September 30, 2015 primarily was due to a $31.3 million increase in net income adjusted for the exclusion of non-cash expenses, a $0.9 million gain on discontinued operations in the prior year and approximately a $45.7 million increase related to the effect of changes in operating assets and liabilities.

Net income adjusted for the exclusion of non-cash expenses was approximately $116.7 million for the nine months ended September 30, 2016 as compared to $85.4 million for the nine months ended September 30, 2015. The increase was primarily due to the growth in our Healthcare operations.

The effect of changes in operating assets and liabilities was a decrease of $8.4 million for the nine months ended September 30, 2016 compared to a decrease of $54.1 million for the nine months ended September 30, 2015. The most significant drivers contributing to this increase relate to the following:

An $8.3 million reduction in taxes paid in the current year compared to the prior year. Additionally, approximately $10.0 million in tax payments made in prior periods were applied to our tax liabilities for the nine months ended September 30, 2016;

A payment of $22.3 million to the former stockholders of iHealth Technologies during the nine months ended September 30, 2015, which had been recorded as a liability in accounts payable and accrued other expenses;

Changes in accounts receivable primarily driven by increased revenue and timing of collections. Accounts receivable, net of the allowance for doubtful accounts, increased $3.0 million during the nine months ended September 30, 2016 as compared to an increase of $12.1 million during the nine months ended September 30, 2015; and

Changes in accrued compensation primarily driven by an increase in the number of employees and timing of payments. Accrued compensation decreased $1.4 million during the nine months ended September 30, 2016 as compared to a decrease of $3.3 million during the nine months ended September 30, 2015.

Investing Activities

Net cash used in investing activities was $21.4 million and $10.6 million for the nine months ended September 30, 2016 and 2015, respectively. The increase in cash used in investing activities during the nine months ended September 30, 2016 as compared to the nine months ended September 30, 2015 primarily was due to an increase in capital

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expenditures due to our ongoing investments, particularly as it relates to enhancing our information technology infrastructure and platforms to support our growing operations.

Financing Activities

Net cash used in financing activities was $192.2 million for the nine months ended September 30, 2016 compared to $7.0 million for the nine months ended September 30, 2015. The increase in cash used in financing activities during the nine months ended September 30, 2016 as compared to the nine months ended September 30, 2015 was primarily due to (a) the payment of a special cash dividend of $150.0 million on May 26, 2016; (b) the repayment of $236.1 million of outstanding borrowings under our then outstanding second lien credit facility in June 2016; (c) the net payment of $22.7 million of outstanding indebtedness as a result of the September 2016 refinancing of our long-term debt; and (d) scheduled debt principal payments of $4.1 million partially offset by net cash proceeds from our IPO of $227.0 million.

Off-Balance Sheet Arrangements

Except for operating leases and certain letters of credit entered into in the normal course of business, we do not have any off-balance sheet arrangements that have or are reasonably likely to have a current or future effect on our financial condition, changes in financial condition, revenue or expenses, results of operations, liquidity, capital expenditures or capital resources that is material to investors.

Contractual Obligations

In September 2016, we refinanced our long-term debt. As a result, our contractual obligations related to principal payments of debt and interest on long-term debt upon their original scheduled maturity have been modified accordingly. Refer to Note 7 Long-term Debt to our consolidated financial statements for further details on the modifications.

Critical Accounting Policies and Estimates

The preparation of financial statements in conformity with GAAP requires us to make estimates and assumptions that affect reported amounts and disclosure of contingent assets and liabilities. There have been no significant changes in the critical accounting policies and estimates described in the Prospectus.

Jumpstart Our Business Act of 2012

We are an “emerging growth company” as defined in the Jumpstart Our Business Startups Act of 2012 (the “JOBS Act”). We will remain an emerging growth company until the earlier of (1) the last day of our fiscal year (a) following the fifth anniversary of the completion of our IPO, (b) in which we have total annual gross revenue of at least $1.0 billion, or (c) in which we are deemed to be a large accelerated filer, which means the market value of our Common Stock that is held by non-affiliates exceeds $700.0 million as of the last business day of our most recently completed second fiscal quarter, and (2) the date on which we have issued more than $1.0 billion in non-convertible debt securities during the prior three-year period. An emerging growth company may take advantage of specified reduced reporting and other burdens that are otherwise applicable generally to public companies.

Recently Issued Accounting Pronouncements

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requirements and 5) classification of employee taxes paid on the statement of cash flows when an employer withholds shares for tax-withholding purposes. We early adopted ASU 2016-09 on a prospective basis during the third quarter of 2016, which did not result in any significant changes to our current or prior period consolidated financial statements. In conjunction with adopting ASU 2016-09 we made an accounting policy election to account for forfeitures as they occur.

Cautionary Note Regarding Forward-Looking Statements

This Quarterly Report on Form 10-Q contains forward-looking statements within the meaning of the U.S. Private Securities Litigation Reform Act of 1995. Forward-looking statements can be identified by words such as “anticipates,” “intends,” “plans,” “seeks,” “believes,” “estimates,” “expects” and similar references to future periods, or by the inclusion of forecasts or projections. Examples of forward-looking statements include, but are not limited to, statements we make regarding the outlook for our future business and financial performance.

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Forward-looking statements are based on our current expectations and assumptions regarding our business, the economy and other future conditions. Because forward-looking statements relate to the future, by their nature, they are subject to inherent uncertainties, risks and changes in circumstances that are difficult to predict. As a result, our actual results may differ materially from those contemplated by the forward-looking statements. Important factors that could cause actual results to differ materially from those in the forward-looking statements include regional, national or global political, economic, business, competitive, market and regulatory conditions and the following: our inability to successfully leverage our existing client base by expanding the volume of claims reviewed and cross-selling additional solutions; improvements to healthcare claims and retail billing processes reducing the demand for our solutions or rendering our solutions unnecessary; healthcare spending fluctuations; our clients declining to renew their agreements with us or renewing at lower performance fee levels; inability to develop new clients; delays in implementing our solutions; system interruptions or failures, including cyber-security breaches, identity theft or other disruptions that could compromise our information; our failure to innovate and develop new solutions for our clients; our failure to comply with applicable privacy, security and data laws, regulations and standards; changes in regulations governing healthcare administration and policies, including governmental restrictions on the outsourcing of functions such as those that we provide; loss of a large client; consolidation among healthcare payers or retailers; slow development of the healthcare payment accuracy market; negative publicity concerning the healthcare payment industry or patient confidentiality and privacy; significant competition for our solutions; our inability to protect our intellectual property rights, proprietary technology, information, processes and know-how; compliance with current and future regulatory requirements; declines in contracts awarded through competitive bidding or our inability to re-procure contracts through the competitive bidding process; our failure to accurately estimate the factors upon which we base our contract pricing; our inability to manage our growth; our inability to successfully integrate and realize synergies from the Connolly iHealth Merger (as defined below) or any future acquisitions or strategic partnerships; our failure to maintain or upgrade our operational platforms; our failure to renew our Medicare Recovery Audit Contractor program contracts or if the terms of the Medicare RAC program contracts are substantially changed; our rebranding may not be successful; litigation, regulatory or dispute resolution proceedings, including claims or proceedings related to intellectual property infringements; our inability to expand our retail business; our inability to manage our relationships with information suppliers, software vendors or utility providers; fluctuations in our results of operations; changes in tax rules; risks associated with international operations; our inability to realize the book value of intangible assets; our success in attracting and retaining qualified employees and key personnel; general economic, political and market forces and dislocations beyond our control; risks related to our substantial indebtedness and holding company structure; volatility in bank and capital markets; our status as a controlled company and as an emerging growth company; and provisions in our amended and restated certificate of incorporation.

For the reasons described above, as well as factors identified in “Item 1A – Risk Factors” in this Quarterly Report on Form 10-Q and the section of the Prospectus entitled “Risk Factors,” we caution you against relying on any forward-looking statements. Any forward-looking statement made by us in this Quarterly Report on Form 10-Q speaks only as of the date on which it is made. Factors or events that could cause our actual results to differ may emerge from time to time, and it is not possible for us to predict all of them. Given these uncertainties, you should not place undue reliance on these forward-looking statements. We undertake no obligation to publicly update or revise any forward-looking statement, whether as a result of new information, future developments or otherwise, except as may be required by law.

ITEM 3. Quantitative and Qualitative Disclosures About Market Risk

Except as set forth below, there have been no material changes to our quantitative and qualitative disclosures about market risk compared to the quantitative and qualitative disclosure about market risk described in the Prospectus.

We are exposed to interest rate risk on our First Lien Credit Facilities, which bear interest at variable rates. As of September 30, 2016, we had $800.0 million of borrowings outstanding under our long-term debt and $630.0 million notional debt outstanding related to interest rate cap agreements. Based on our outstanding debt as of September 30, 2016, and assuming that our mix of debt instruments, interest rate caps and other variables remain the same, the annualized effect of a one percentage point change in variable interest rates would have an annualized pretax impact on our earnings and cash flows of approximately $7.6 million.

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ITEM 4. Controls and Procedures

Evaluation of Disclosure Controls and Procedures

Our management has evaluated, with the participation of our Chief Executive Officer and Chief Financial Officer, the effectiveness of our disclosure controls and procedures, as defined in Rule 13(a)-15(e) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), as of the end of the period covered by this Quarterly Report on Form 10-Q pursuant to Rule 13a-15(b) of the Exchange Act. Based on that evaluation, our Chief Executive Officer and Chief Financial Officer have concluded that our disclosure controls and procedures as of the end of the period covered by this Quarterly Report on Form 10-Q are effective at a reasonable assurance level in ensuring that information required to be disclosed in our Exchange Act reports is (1) recorded, processed, summarized and reported in a timely manner and (2) accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosure. While our disclosure controls and procedures are designed to provide reasonable assurance of their effectiveness, because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within the Company have been detected.

Changes in Internal Control over Financial Reporting

There were no changes to our internal control over financial reporting during the nine months ended September 30, 2016 that have materially affected, or that are reasonably likely to materially affect, our internal control over financial reporting.

We have not engaged an independent registered accounting firm to perform an audit of our internal control over financial reporting as of any balance sheet date or for any period reported in our financial statements. Our independent public registered accounting firm will first be required to attest to the effectiveness of our internal controls over financial reporting for our Annual Report on Form 10-K for the first year we are no longer an “emerging growth company.” In addition, as a newly public company, our management is not presently required to perform an annual assessment of the effectiveness of our internal controls over financial reporting until our second annual report on Form 10-K for the period ended December 31, 2017.

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PART II - OTHER INFORMATION

ITEM 1. Legal Proceedings

None.

ITEM 1A. Risk Factors

For a discussion of potential risks and uncertainties related to our Company and our business see the information in Part II, Item 1A “Risk Factors” of our Quarterly Report on Form 10-Q for the quarter ended June 30, 2016 as well as the Prospectus. There have been no material changes to the risk factors previously disclosed in our Quarterly Report on Form 10-Q for the quarter ended June 30, 2016.

ITEM 2. Unregistered Sales of Equity Securities and Use of Proceeds

None.

ITEM 3. Defaults Upon Senior Securities

Not applicable.

ITEM 4. Mine Safety Disclosures

Not applicable.

ITEM 5. Other Information

None.

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ITEM 6. Exhibits


Exhibit No.		Description of Exhibits
3.1		Amended and Restated Certificate of Incorporation of Cotiviti Holdings, Inc. (incorporated by reference from Exhibit 3.1 to the Company’s Current Report on Form 8-K (File No. 001-37787) filed on June 3, 2016).

3.2		Amended and Restated Bylaws of Cotiviti Holdings, Inc. (incorporated by reference from Exhibit 3.2 to the Company’s Current Report on Form 8-K (File No. 001-37787) filed on June 3, 2016).

4.1		Second Amended and Restated Stockholders Agreement, by and among Cotiviti Holdings, Inc. and certain stockholders named therein (incorporated by reference from Exhibit 4.1 to the Company’s Current Report on Form 8-K (File No. 001-37787) filed on June 3, 2016).

10.1*		Restatement Agreement No. 1, dated September 28, 2016, to the First Lien Credit Agreement, dated May 14, 2014, among Cotiviti Corporation, Cotiviti Domestic Holdings, Inc., Cotiviti Intermediate Holdings, Inc., the other Loan Parties party thereto, the Lenders party thereto and JPMorgan Chase Bank, N.A., as Successor Agent, and Goldman Sachs Bank USA, as Resigning Agent.

31.1*		Certification of Chief Executive Officer pursuant to Rule 13a-14(a) or 15d-14(a) of the Securities Exchange Act of 1934, as amended, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

31.2*		Certification of Chief Financial Officer pursuant to Rule 13a-14(a) or 15d-14(a) of the Securities Exchange Act of 1934, as amended, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

32.1*		Certification of Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

32.2*		Certification of Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

**101.INS		XBRL Instance Document.

**101.SCH		XBRL Taxonomy Extension Schema Document.

**101.CAL		XBRL Taxonomy Extension Calculation Linkbase Document.

**101.DEF		XBRL Taxonomy Extension Definition Linkbase Document.

**101.LAB		XBRL Taxonomy Extension Label Linkbase Document.

**101.PRE		XBRL Taxonomy Extension Presentation Linkbase Document.

* Filed herewith.

** Submitted electronically with this Report.

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SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.


	COTIVITI HOLDINGS, INC.

Date: November 10, 2016	By:	/S/ STEVE SENNEFF
		Name:	Steve Senneff
		Title:	Senior Vice President and Chief Financial Officer (Principal Financial Officer and Principal Accounting Officer)

Cotiviti Holdings, Inc. - FORM 10-Q - November 10, 2016

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Cotiviti Holdings, Inc. Reports