Earnings Call Transcript - INNV Q2 2022

Operator, Operator

Good day and thank you for standing by. Welcome to the InnovAge Second Quarter 2022 Earnings Conference Call. At this time, all participants are in a listen-only mode. After the speaker presentation, there will be a question-and-answer session. I would now like to hand the conference over to your speaker today, Ryan Kubota, Director of Investor Relations. Please go ahead.

Ryan Kubota, Director of Investor Relations

Thank you, operator. Good afternoon and thank you all for joining InnovAge’s fiscal 2022 second quarter earnings call. With me today is Patrick Blair, the new President and CEO, who joined the Company on December 1st; Barb Gutierrez, CFO; and Dr. Melissa Welch, Chief Medical Officer, who will be joining the Q&A portion of the call. Today, after the market closed, we issued a press release containing detailed information on our quarterly results. You may access the release on our Company website, innovage.com. For those listening to the rebroadcast of this presentation, we remind you that the remarks made herein are as of today, Wednesday, February 9, 2022, and have not been updated subsequent to the initial earnings call. During this call, we will refer to certain non-GAAP measures. A reconciliation of these measures to the most directly comparable GAAP measures can be found in our fiscal second quarter 2022 press release, which is posted on the Investor Relations section of our website. We will also be making forward-looking statements, including statements related to our growth prospects, regulatory, and other expectations. Listeners are cautioned that all of our forward-looking statements involve certain assumptions that are inherently subject to risks and uncertainties that can cause our actual results to differ materially from our current expectations. We advise listeners to review the risk factors discussed in our Form 10-K annual report for fiscal year 2021 and subsequent reports filed with the SEC. After the completion of our prepared remarks, we will open the call to take your questions. I will now turn the call over to our President and CEO, Patrick Blair. Patrick?

Patrick Blair, President and CEO

Thank you very much, Ryan. I’d like to start with a warm welcome to everyone on the call. And before jumping in, I want to express my gratitude to our InnovAge employees who have bravely and selflessly pursued critically important work in the face of some unprecedented obstacles, and to our federal and state partners for their partnership during one of the most challenging times any of us have ever faced, and to our shareholders and investment community for their continued commitment, support and interest in the Company. Although my understanding of the organization is still evolving, I’ve already come to realize what our employees and participants already know: InnovAge is a special organization, working tirelessly and heroically to help some of the nation’s most vulnerable Americans. As many of you know, this is my first conference call as InnovAge’s CEO. I joined the Company as President on December 1st and was appointed to CEO on January 1st. This is a pivotal and important time for the Company, and I’m genuinely proud, excited, and prepared to be here today. You could say I’ve been preparing my whole career for this particular role at this particular time. It’s truly a privilege to be part of something so important with an organization that has so much to offer our participants and government partners. We’re going to take a slightly different approach to the call today. I will begin with opening remarks and then hand it off to Barbara, who will provide a more detailed review of our quarterly results. I will then provide remarks on our path forward before moving to Q&A. You can expect this new agenda going forward. Before briefly describing my background and what I’ve been up to in the last couple of months, I’d like to share the key reasons why I joined InnovAge, and in doing so, touch on the opportunities we have in front of us. I’m here for the same reason I think most people join companies like InnovAge: to have a transformational impact on people’s lives and to embrace the doctrine of doing well by doing good in such an important arena. Having seen firsthand the fragmentation in healthcare and the vexing challenge of helping our most vulnerable seniors to live healthy and independent lives, and the difference well-run integrated models of care can make, I feel strongly we have a responsibility to bring the PACE model to more seniors across the country. While I'm still coming up the learning curve on PACE, it’s clear we are fortunate to operate in a large and growing market with a steady tailwind and to be positioned at the intersection of where the federal and state governments increasingly need us most, offering lower cost, better quality, value-based home and community care. Despite our challenges, I believe InnovAge possesses the elements to continue to lead the way: the people, years of operational experience, distinctive capabilities and the high-quality care have allowed InnovAge to become a market leader, and those things are still very much intact. What’s more, we’re fortunate to possess a strong balance sheet, bolstered by an attractive operating margin that produces strong cash flow, allowing us to invest robustly in our leaders, workforce, processes, tools, infrastructure, and to innovate our offerings. In other words, the Company has a sturdy foundation and great potential. I also want to clearly acknowledge that while I fully embrace the Company’s advantages and potential, my principal focus right now must be on addressing the deficiencies identified in the recent CMS and state audits. While the situation we find ourselves in is serious and one I’ll be laser-focused on, from what I’ve witnessed in my last 60 days, I believe the deficiencies and opportunities for improvement identified by our regulatory partners are addressable. Before I provide some second quarter highlights, I’d like to share my fondness for programs focused on frail seniors and people with disabilities, on both the acute, and home and community sides of the house. I’ve had a few times around the track with these types of businesses, having spent the last three years leading government-sponsored health plans and the nation’s largest nonprofit home healthcare provider. These experiences have given me many opportunities to work closely with federal and state officials, frail seniors, their caregivers and advocates, community-based organizations, medical providers, and investors. I’ve drawn genuine inspiration from this experience, and it’s fueled a career-long passion for improving the lives of our most vulnerable seniors. What’s perhaps most distinguishing is that I pursued this mission by building passionate, high-performing teams and continually striving for peak clinical and operational performance, which naturally leads to attractive financial results. Since joining the Company, I’ve spent my first two months getting the lay of the land, visiting our centers, meeting with hundreds of employees across the Company to get adverse frontline input around our biggest opportunities and challenges. Part of getting grounded has included diving deep into the recent survey results to specifically understand employee perspectives on a broad range of issues, and it’s absolutely essential. I’ve been actively engaging with state officials in each of our existing states and in active expansion states to convey the seriousness of our commitment to be a model partner, as well as details around our approach and progress. To share a few initial observations for the first 60 days, I’ve been impressed with our people and our model of care. We’re committed to improving quality of life and increasing the autonomy and dignity of seniors. We’re helping them live in their own homes, their own communities, and, in many cases, preserving the integrity of their family units. The care delivered by our physicians, nurses, social workers, physical therapists, occupational therapists, dentists, hygienists, and pharmacists is compassionate, comprehensive, and participant-centered. It’s really been energizing to see us delivering a fully integrated end-to-end value-based model of care day in and day out across 18 centers for more than 7,000 participants that other providers, payers, and specialty companies try to replicate. There are, however, bona fide opportunities for improvement, specifically in the areas of care coordination and care documentation. Our regulators identified the need for better coordination of care between specialty providers and facilities. For example, we were inconsistent in our ability to transport participants, schedule follow-ups with coordinating entities, and communicate exchange information between our care teams and third parties. Our government partners also identified documentation as another category for remediation, as we’re expected to document all aspects of care in the medical record, consistent with standards of practice in the community and standards set forth by each state and CMS. We clearly need to do better here. That all said, I’ll reiterate that I believe these deficiencies are addressable with strong leadership, focus, and execution, all of which we plan to supply thoroughly. I will now provide a brief update on the status of our audits. As I mentioned earlier, I’ve been working closely with the compliance, operations, and clinical teams, and collaboratively with our regulators as we seek to remediate the deficiencies that were identified in the audits. In Sacramento, our corrective action plans were accepted by the state in CMS in early January, and we’ve moved into the monitoring phase of the sanction process. Once the corrective action plans have been implemented, we will be allowed to operate independently for a period before our regulators retest our operations to ensure the deficiencies identified in the audit have been corrected. Only then will the sanctions be lifted. In Colorado, we’re in the process of submitting and obtaining approval for each of our corrective action plans with state and federal agencies. Once the plans have been approved, we anticipate that the process to correct inefficiencies will be similar to the process we’re undertaking in Sacramento. Given the nature of these processes, we do not predict how long it will take to resolve the issues identified and lift the sanctions. Last quarter, we mentioned that New Mexico would begin a routine audit initiated by CMS. The initial audit work, which preliminarily identified deficiencies similar to Sacramento and Colorado is still underway and currently in the audit validation process. Lastly, in July of last year, we received a Civil Investigative Demand, or CID, from the Attorney General for the State of Colorado under Colorado Medicaid False Claims Act. We continue to fully cooperate with the Attorney General, and produced the requested information and documentation. This month, we also received a civil investigative demand from the Department of Justice or DOJ under the Federal False Claims Act. Similar in subject matter to the CID in Colorado, the federal demand requests information and documents in connection with all the Company’s PACE programs. We are fully cooperating with the DOJ to produce the requested information and documentation, and we’re currently unable to predict the outcome of either investigation. The team and I are laser-focused on working collaboratively with our regulators to strengthen relationships, to work diligently through our corrective action plans, and to regain trust. I’m committed to seizing the opportunity to strengthen our operations. And having been part of organizations that have done this successfully, I am confident we are prepared to overcome these challenges. Not to oversimplify, but I strongly believe the quickest road to recovery begins with a renewed energy and focus on the basics: our people, quality, and service. If our employees are properly positioned to deliver high-quality care and service, financial stability and growth will naturally follow. With that, I’ll transition to review the second quarter business drivers. We ended the quarter serving approximately 7,050 participants. This represents an increase of 5.6% compared to the second quarter of fiscal year 2021, after including the Sacramento census, which was not consolidated in the same fiscal quarter from a year ago. We reported second-quarter revenue of $175.4 million, an increase of nearly 11.5% compared to the previous fiscal year because of census growth and an increase in rates. We also reported a Center-level Contribution Margin of more than $41.4 million and a corresponding Center-level Contribution Margin ratio of 23.6%. The Omicron variant has led to another surge in COVID infections among InnovAge employees and participants. This surge began in December and has continued into the fiscal third quarter of 2022. As a result of this new wave, we’re seeing and anticipate seeing elevated participant cost trends, specifically inpatient, medical and social respite costs related to skilled nursing facilities are increasing due to higher morbidity resulting from COVID. Increased morbidity is driving higher external provider costs, primarily related to specialty costs as COVID complicates underlying conditions. Since we reopened our centers in early spring of 2021, we are continuing to see rising outpatient and specialist costs, as would be expected due to the delays in care experienced across the healthcare system seen throughout 2020. While a return to a pre-COVID baseline is an ideal scenario, we might not see a return to pre-COVID levels in the near term. As we look to the second half of fiscal year 2022, we expect that center-level costs will remain elevated, associated with the need for more durable medical equipment, oxygen, personal protective equipment as well as incremental costs associated with COVID protocols at our centers as the surge continues. While we have continued to grow our census, we’ve started to see enrollment growth pressure, particularly towards the end of the second quarter as a result of the recent surge of COVID. Specifically, COVID has impacted our ability to interact directly with potential new participants, for instance, to verify eligibility documentation, and has caused associated delays in the enrollment process. Despite the surge in elevated costs, we’re not anticipating the level of disruption we experienced in the early days of the pandemic. All centers remain open, and our employees are fully vaccinated. Labor will remain a key focus, though asymptomatic cases allow for employees to safely reenter work sooner, consistent with CDC guidelines and have helped us maintain more consistent staffing levels. Now, I will turn the call over to Barb to provide some additional detail on our quarterly results. Barb?

Barb Gutierrez, CFO

Thank you, Patrick. I want to provide some highlights from our second-quarter fiscal year 2022 performance. Given the impact on our results due to the recent surge of COVID transmission rates during the period, in some cases, I will refer to sequential comparisons to our first quarter of fiscal 2022 in order to provide a more meaningful picture of our performance. We ended the second quarter with 18 centers and a census of approximately 7,050 participants as of December 31, 2021. Compared to the prior year period, when including the Sacramento census, which was not consolidated in the fiscal second quarter of 2021, this represents an ending census increase of 5.6%. Compared to the first quarter of fiscal year 2022, this is an increase of approximately 1%. We reported nearly 21,200 member months for the second quarter, a 6.1% increase over the prior year. When including Sacramento census, and an increase of 1.4% over the first quarter of fiscal 2022. Enrollment growth in the second quarter started off strong. However, towards the end of the quarter, we experienced an increase in deaths, which is not uncommon during the winter months, coupled with enrollment growth pressure as a result of the recent COVID surge, both of which have continued into the fiscal third quarter. The COVID surge has impacted our ability to interact directly with potential new participants and has caused delays and lengthening of the enrollment process. Revenue in the second quarter of fiscal year 2022 increased to $175.4 million or approximately 11.5% compared to the second quarter of fiscal year 2021. The drivers of this growth are an increase in census, coupled with an increase in Medicaid rates. Additionally, we received a temporary fiscal year 2022 rate increase from the American Rescue Plan Act or ARPA for Virginia in December, which included a true-up of ARPA funds for July through November. We are in discussions with our other states regarding further ARPA rate increases. Looking forward, we received notification from the State of California that calendar year 2022 rates will experience a low to mid-single-digit decrease effective January 1, 2022. We have requested the state revisit their rate-setting methodology to exclude calendar year 2020 experience as we believe the rates are understated due to the shutdowns during the pandemic. Other states such as Colorado and Virginia excluded 2020 experience in setting their fiscal year 2022 rates. Regarding Medicare rates, effective January 1, 2022, we will see a mid-single-digit rate increase as a result of an increase in risk score as well as higher county rates. External provider costs in the second quarter were $91 million, a 21.1% increase compared to the second quarter of fiscal year 2021. Similar to my comments last quarter, while some of this variance is due to census growth, we continue to experience higher per participant cost in three areas: one, outpatient and specialist care as participants catch up on services that were delayed as a result of the pandemic; two, increased inpatient and respite utilization as a result of the Omicron surge; and three, increased housing rates as mandated by certain states. External provider costs in the second quarter of fiscal 2022 increased slightly by 1.1% compared to the first quarter. The pent-up demand for outpatient and specialist care that we experienced in the fourth quarter of fiscal 2021 and the first quarter of fiscal 2022 is leveling off, but is offset by costs associated with the Omicron surge. Our cost of care, excluding depreciation and amortization, was $42.9 million for the second quarter, a 12.7% increase over the second quarter of fiscal year 2021, driven by an increase in census and an increase in the overall cost per participant. The per member per month increase is associated with annual merit and market increases, coupled with an increase in operational costs due to the reopening of our centers. As reported in previous calls, the cost of care in the second quarter of fiscal 2021 was atypically low as a result of our center closures during the pandemic. Cost of care increased by 5.4% over the first quarter of fiscal 2022, primarily due to wage inflation as a result of the current labor market conditions. Occupancy-related costs such as repair and maintenance, and an increase in fleet expenses that correlates to an increase in average daily attendance. Center-level Contribution Margin, which we define as total revenue less external provider costs and cost of care excluding depreciation and amortization, was $41.4 million for the second quarter compared to $44.1 million in the second quarter of fiscal 2021 and $42.3 million in the previous quarter of fiscal 2022. As a percentage of revenue, Center-level Contribution Margin for the quarter was 23.6% compared to 28% in the second quarter of fiscal 2021 and 24.5% in the previous quarter of fiscal 2022. While leveling off, as we mentioned on the last earnings call, we continue to see elevated utilization levels as participants catch up on medical services delayed due to the pandemic. This medical cost normalization dynamic coupled with the increased utilization and cost from the recent Omicron surge are the primary drivers of the year-over-year decline in Center-level Contribution Margin as a percent of revenue. We also experienced an increase in cost of care and other occupancy-related expenses. Compared to the prior quarter, the major driver of the decline in Center-level Contribution Margin as a percent of revenue is related to an increase in cost of care as detailed earlier. Sales and marketing expense for the second quarter was $6.7 million, an increase of $2 million compared to the second quarter of fiscal 2021, primarily due to an increase in headcount and costs associated with marketing campaigns to support bringing PACE services to more seniors. Corporate general and administrative expense for the second quarter was $28.5 million, an increase of $12.8 million compared to the second quarter of fiscal 2021. The increase was primarily due to company growth, bringing PACE services to more seniors, additional costs associated with becoming a publicly traded company, compliance-related expenses, higher-than-expected legal expenses during the quarter, and executive recruiting and severance costs incurred during the quarter. Net income for the second quarter was $1.1 million compared to net income of $9.6 million in the second quarter of fiscal 2021. We reported earnings per share for the fiscal second quarter of $0.01 on both a basic and diluted basis. Our fully diluted share count was 135,516,513 shares for the fiscal second quarter ending December 31, 2021. Adjusted EBITDA, which we calculate by adding interest, taxes, depreciation and amortization, one-time adjustments for transaction and offering-related costs and other nonrecurring or exceptional costs to net income was $14.8 million for the second quarter, a 34.5% decrease year-over-year and a 19% decrease quarter-over-quarter. Our adjusted EBITDA margin was 8.4% for the second quarter compared to 14.5% for the second quarter of fiscal year 2021 and 10.5% for the first quarter of fiscal year 2022. The quarter-over-quarter change in adjusted EBITDA and adjusted EBITDA margin is primarily a function of, one, increased cost of care; and two, higher SG&A as a result of growth and higher-than-anticipated legal expenses in the quarter. We do not add back any losses incurred in connection with our de novo centers in the calculation of adjusted EBITDA. De novo center losses, which we define as net losses related to preopening and start-up ramp through the first 24 months of de novo operations were $0.6 million for the second quarter. Turning to our balance sheet. We ended the quarter with $218.5 million in cash and cash equivalents and had $87.1 million in total debt on the balance sheet, representing debt under our senior secured term loan plus capital leases and other commitments and a secured net leverage ratio of 0.95 times as calculated pursuant to our credit agreement. For the second quarter ended December 31, 2021, we generated $11 million of cash from operations, and we had $8.6 million of capital expenditures. For the quarter, we had free cash flow of $2.4 million, defined as cash from operations less capital expenditures. Late in the quarter, we announced that we withdrew guidance following the sanctions we received in Colorado and the subsequent enrollment freeze. At this time, we do not believe it is prudent to provide updated guidance due to the existing audits. We can, however, provide some insight into the trends we are seeing today, specifically related to the recent Omicron surge and the impact it is having on our business in several key areas. Starting with revenue. The recent COVID surge is likely to lengthen the time it takes us to enroll participants into the program due to disruption from potential or actual exposure for employees and potential participants. From a medical expense perspective, we expect elevated external provider costs due to Omicron. Specifically, we expect inpatient costs and medical and social respite costs at skilled nursing facilities to remain elevated due to higher morbidity of our participants. In some of our markets, where assisted living facilities are locked down, participants who have transitioned to short-term skilled nursing facilities and are ready to return to assisted living are unable to do so. Due to the frailty of the population that we serve, we also expect specialty costs to continue at current levels due to the existing underlying conditions that many of our participants already have. Finally, from a cost of care perspective, COVID protocols that we have put in place such as enhanced cleaning requirements at each of our centers will also continue. In addition, the ongoing surge will exacerbate the negative impact of the existing tight labor market as we manage our employee base to meet the needs of our participants. As a reminder, we included market wage adjustments when we provided our initial guidance. However, we are continuing to closely monitor wages to ensure we remain competitive. As Patrick mentioned, participant and employee safety remain our top concern, and we are closely monitoring all aspects of the recent surge to ensure we can continue to provide high-quality care to our participants. We believe the ongoing pandemic validates the need for PACE even more and that the PACE program will continue to grow as we build market awareness among eligible participants and the communities we serve. I will now turn the call back to Patrick for his comments on our path forward.

Patrick Blair, President and CEO

Thank you, Barb. While we are currently focused on correcting audit deficiencies, we are committed to our expansion plans. I understand the challenge of addressing these issues while also pursuing growth efforts. I want to emphasize that resolving audit findings is our primary concern. Dedicated teams are working to ensure that our focus remains strong. Nevertheless, the future of our organization involves expanding services to many more individuals nationwide who can gain from PACE programs. We are on track to open two new centers in Florida, in Tampa and Orlando. Additionally, we announced approval from the State of Indiana to develop a program for eligible seniors in the Terre Haute area, with anticipation of the center becoming operational in fiscal year 2024. We are also assessing other potential locations in California to expand our footprint. However, due to the current enrollment freeze in Sacramento, our expansion approval has been put on hold until the sanction is resolved. We have recently received notification from the regulator in Kentucky indicating they will not proceed with our agreement to become a PACE provider in that state. As this is a recent development, we do not have further details at this moment. I plan to meet with the regulators to understand and address the concerns that led to this change. I want to reiterate that compliance is our immediate priority. There is a pressing need for us to restore trust in InnovAge among all stakeholders and to resume enrollment in Sacramento and Colorado as soon as possible. We also need to focus on long-term initiatives to build and enhance our capabilities so that we can better serve participants, manage costs and quality, and stand out in the marketplace. Though this will be implemented with intent, it will not compromise our immediate compliance goals. Alongside these broader objectives, I will be reviewing our organizational structure, leadership, workforce, processes, tools, and infrastructure to ensure the right people are in key positions, aligning the organization with both our short-term goals and our ambitious vision for the company, enhancing our care delivery culture, and establishing mechanisms for executing effectively on focused priorities. In the coming months, I will engage with leaders and frontline employees to gain insights into InnovAge’s strengths, weaknesses, opportunities, and challenges to guide our path forward thoughtfully. While it is important to be thorough, the pace of market changes requires us to stay agile, action-oriented, and willing to reassess any elements of our culture or organization that hinder our effectiveness. On a brief note regarding diversity, equity, and inclusion, we have a remarkably diverse organization, both in senior leadership and in our markets, which we take pride in. This diversity will play a crucial role in our future success, and I am committed to further strengthening this foundation. In conclusion, I firmly believe we are heading in the right direction, and I am encouraged by the goals we are setting and the initiatives currently in progress. While we need to tackle the challenges we face with seriousness and discipline, we are also committed to building scalable capabilities for the future to serve more people. I am as prepared and excited for this challenge now as I was when I joined the Company. My confidence comes from believing in the significance of our work, knowing that our employees, participants, and their families rely on us, and from my experience with organizations that successfully navigated similar situations and emerged stronger. Now, operator, we will open the call for questions.

Operator, Operator

Our first question will come from the line of Jason Cassorla from Citi.

Jason Cassorla, Analyst

I guess, just to start, given what’s happened with the Sacramento and Colorado audits, the initial read with the New Mexico audit. And now with the stop of the de novo facility in Kentucky, can you help with the lessons you’re learning at this point from these audits and issues and how you’re thinking about applying these lessons maybe to the rest of your centers? Do you see any of them at risk at this point, or do you believe that they’re adequately compliant? Any guess on the rest of your center footprint would be helpful.

Patrick Blair, President and CEO

Well, thanks for your questions. There’s certainly a lot included in there. Let me start with, we definitely have issues we must address. As someone new to the Company, I am keenly interested in trying to identify whether there are themes emerging from what we’re seeing. As I mentioned in my opening remarks, there are areas that we have to improve, specifically in the areas of care coordination and care documentation. Our regulators specifically identified these two areas as areas that we need to get much better at. Clearly, we need to improve our ability to communicate and exchange information between our care teams and third parties. Documentation plays an important role in all of this. There are very high documentation standards for PACE programs that we’re fully committed to meeting, which exist both at the CMS level and the state level. I would also say that the challenge posed by the pandemic and the workforce challenges has contributed to the difficulties with care coordination and documentation. We clearly need to do better in both areas. I’ll reiterate that I believe these deficiencies are all addressable with strong leadership, focus, and execution. I’ve been through this in my prior life. It’s very challenging and difficult. But for those of us who lived through it, we got to see that we become a better company. I believe that’s exactly what’s going to happen at InnovAge. Regarding the question of whether we expect to see different outcomes in other states, it’s important to take away that there are nuances in every state. It’s difficult to extrapolate outcomes from one state to the next. Sacramento was a routine audit, and Colorado resulted from a complaint, while New Mexico was a routine audit like Sacramento. We’re working hard to understand all the issues and with time and I have complete confidence that we’ll be able to figure it out. I’m going to ask Melissa to weigh in as well.

Barb Gutierrez, CFO

Yes. I think one of the other parts of your question was what are we doing proactively in all of our regions. We added incremental resources to our compliance team as well as brought in a compliance officer. One of the benefits of doing that is all around being proactive. We are proactively auditing, self-auditing in every region around all of our disciplines and all of our workflows and processes to make sure and anticipate that we’re not seeing the same systematic findings. If we do, we start intervening now and not waiting.

Jason Cassorla, Analyst

Okay, got it. Thanks. I really appreciate the color there. Maybe just to switch gears a little bit here. Given the labor backdrop, can you give us an update around employee retention and the recruitment efforts following your wage adjustments you discussed last quarter and on this call? How are those faring as the labor backdrop is seeing incremental pressure? Are you seeing pressure or issues around retention or any incremental recruitment efforts at this point, or in ways that you’re helping to combat those would be helpful?

Patrick Blair, President and CEO

Yes. This is Patrick. I’ll start. Thanks for the question. I’ll start and then hand it to Barb. With respect to recruiting and attracting talent, I don’t believe our situation is having a material impact on our ability to attract people to the Company. It is something that we’ll have to watch. It’s such a mission-driven company and people who work here want to improve the lives of seniors, and we haven’t come up short on finding people who share those same goals. For folks who have worked in Medicare and Medicaid for a while, they understand that to be out of compliance for a period of time and still be a great place to work. The larger headwind is the impacts from the pandemic and the supply and demand dynamics around the workforce. Overall, I think our turnover has ticked up a bit. We’ve quoted voluntary turnover around 25% in the past, and it’s ticked up, but I think we primarily attribute it to the strain of the pandemic and the supply issues. I’m looking closely at it and so is Barb. I’ll ask her to say a few words.

Barb Gutierrez, CFO

Yes. As Patrick said, we believe it’s related to the strain of the pandemic and the overall tight labor market. We indicated in the prepared remarks and wanted to flag for you that we are seeing some wage pressures that we incurred in the second quarter, and we believe it will continue a bit into the back half of the year. So, we are actively addressing that. As we said in our guidance, we had included market adjustments some time ago, and we’re continuing to look at especially the mission-critical positions to ensure we’re addressing those from a market perspective.

Operator, Operator

Our next question will come from the line of Sarah James from Barclays.

Sarah James, Analyst

I wanted to go into more depth on the self-audit. Understanding how you guys are institutionalizing this, did you implement any technology that flags the key metrics up to the corporate level? How often are you auditing each market? And how long is the data lag? I’m trying to understand how quickly you can catch and address issues if they happen in current challenged markets or new ones?

Patrick Blair, President and CEO

Well, I’ll start, and I’ll have Melissa maybe weigh in. First, we’ve made a lot of progress identifying the root cause of the deficiencies in Sacramento and Colorado. So that’s really where it all starts. We’ve begun to execute on the work to fix the deficiencies, wherever they exist in the company. In terms of how we’ve done it, we’ve mobilized a cross-functional team at every level of the organization, representing compliance, quality, operations, technology, and regulatory. We’ve created a variety of tools that have helped with the tracking, auditing, and monitoring of everything we’re learning from CMS and our state partners. We’re making sure that we’re putting in place the right people, process, and technology to address it. We’ve also retained some highly experienced external partners to help us assist us in these efforts. I think Melissa will add some color to that.

Dr. Melissa Welch, Chief Medical Officer

Yes, I was going to extend those comments to say that we’ve taken the tools that we’ve submitted for the Sacramento CMS corrective action plan that has been recently accepted, and we’re applying those same tools across all of our markets in all the regions. This is being driven by our compliance department so that we’ll be held accountable to the same standards that CMS is holding us accountable to in our proactive action plans that have been accepted.

Sarah James, Analyst

Got it. Can you walk us through the moving pieces and enrollment? How much churn or involuntary disenrollment did you see in the markets where you are sanctioned? And how should we think about the impact of growth from digital channels this quarter, and to your overall long-term organic growth rate?

Barb Gutierrez, CFO

Sure. This is Barb. I’ll take the first part of that, and then Patrick can chime in on the digital. We’ve disclosed before that our overall disenrollment rate on average is around 2%. It varies a little bit depending on the time of the year and depending on the markets. As I indicated in the prepared remarks, we did see a little bit of a higher disenrollment rate toward the end of December and into the early part of Q3 related to deaths, which is not unusual during the winter months, coupled with some of the strength from the Omicron variant. As it relates to what we expect in the markets like Colorado and Sacramento, we expect those typical attrition rates at roughly 2% a month, give or take, depending on the time of the year.

Patrick Blair, President and CEO

Yes. Thank you, Barb. I would just add that as it relates to our digital marketing progress, we made some smart investments in new digital channels like programmatic display and video that I think we’re starting to see some sequential improvements in our acquisition cost per channel and our spend efficiency. It’s a little early in our capability build in this area. We need a couple more quarters to have confidence that we have the channels, the right KPIs and the right benchmarks. It’s important to note that friends and family continue to be our largest referral source, which speaks to how much our service continues to impact the individuals and communities we care for.

Operator, Operator

Our next question will come from the line of Jeff Garro from Piper Sandler.

Jeff Garro, Analyst

Maybe start off on a higher level. Patrick, you mentioned that you’ve been hearing from frontline workers and you’ve been reviewing the survey results, as well as getting input from state-level partners in different geographies. Could you touch on some of the commonalities and some of the differences that you might have heard from those different areas?

Patrick Blair, President and CEO

Thank you for the question. Let me start with our state partners. As I mentioned earlier, it’s been the number one priority for me to engage with our regulatory partners and reinforce our commitment to advance the goals of the PACE program. They have expressed concerns about the audit findings. However, I’ve been highly encouraged by the discussions. There’s a level of collaboration and support for this, including for me personally. They clearly want us to be successful, but they want to see us address the issues as soon as possible. We didn’t communicate with our partners as well as we should have in the past, and we’re going to fix that. I’m really excited about working with our states to help us become the best partner we can be. Regarding our employees, I couldn’t be more pleased with how welcoming and supportive the organization has been to me since joining the Company. It’s a tough time for employees. No one wants to be under sanction. However, I’m humbled by how focused the organization is on delivering great participant care. I see teams across the organization pulling together. There’s a strong commitment to making the necessary changes and working collaboratively with our regulatory partners. There’s a real desire to work closely with our partners to become a better company. After speaking with hundreds of employees, I sense a deep willingness to do whatever it takes within all hands-on deck attitude. I believe the mission orientation of the Company is a big advantage, creating a genuine emotional connection between the workforce and the company, which excites me.

Jeff Garro, Analyst

Excellent. That helps. To follow up, I want to ask about the blocking and tackling of remediating the deficiencies that have been identified and the consequences of that, mostly on the financial side. Will improving care coordination or other deficiencies identified in the audits result in higher fixed costs and maybe more specifically, higher staffing levels?

Patrick Blair, President and CEO

Thank you for the question. Right now, my focus is on making sure that our centers have everything they need to address the deficiencies we’re seeing. This is crucial to ensure everyone has the necessary resources to succeed in the market. I believe I have identified opportunities to rebalance resources and invest more in field-based functions, possibly to run a bit more efficiently in some corporate areas. We’re looking at non-center-level cost, non-labor costs, and overhead costs, with the goal of matching our cost structure to our business conditions. I’m committed to this.

Operator, Operator

Our next question will come from the line of Lisa Gill from JP Morgan.

Lisa Gill, Analyst

Patrick, I wanted to go back to when you talked about the three areas: inpatient specialty costs, inpatient respiratory due to COVID and then increased housing costs. Focusing on the first one, outpatient specialty cost. As we think about Omicron, would you expect that those costs would have come down? Are we moving towards the traditional baseline of those costs, or are you seeing accelerated cost because there was pent-up demand?

Dr. Melissa Welch, Chief Medical Officer

Yes, it’s Dr. Welch. I’ll start, and then I’ll hand it over to Barb. One thing to remember is we had Delta before Omicron, which came at a time when our trends were going downward. Omicron started to peak in late December and has continued into January. During COVID, everyone stayed indoors. We got a vaccine in early ‘21 and slowly opened up our centers, which resulted in pent-up demand showing itself in our costs about three months later. So, after July ‘21, when things were opening up, we faced Delta and Omicron. Costs began to rise again due to the complexity of our participants. They’re very sick when they go to the hospital. Unlike pre-COVID, where support could be sent home, they often need respite or skilled nursing facilities. We observe elevated specialty costs due to case complexities. I’ll turn it over to Barb now.

Barb Gutierrez, CFO

To put numbers to it: We saw peaks in Q4 ‘21 and Q1 of ‘22 driven by pent-up demand. Costs then leveled off and then surged again. Quarter-over-quarter, our costs in that area were fairly flat, only up about 1%. We see a mix of trends with tapering demand.

Operator, Operator

Our next question is from the line of Jamie Perse from Goldman Sachs.

Jamie Perse, Analyst

Hey, good afternoon, and Patrick, welcome to the team. I wanted to start with a question for you. You mentioned having identified root causes of these issues. Given that it’s now in four markets, it seems somewhat systemic. Could you share your thoughts on the root cause analysis that you’ve completed?

Patrick Blair, President and CEO

I’m still learning and processing the contributors to the current challenges. I don’t fully grasp all the historical context yet. I did share some emerging themes around care coordination and communications. Those can greatly impact our company, and we have high documentation standards for PACE programs that we’re committed to meeting at both the CMS and state levels. The pandemic's challenges and workforce issues have been contributing factors. We need to improve in these areas. I believe we can address all deficiencies with strong leadership, focus, and execution. There’s a lot to gain from this process.

Jamie Perse, Analyst

I guess, I should have been more specific. I get that the external provider costs are variable and correlate with patients. The cost of care at the center, can you describe the fixed versus variable components there? You still have to employ your whole disciplinary team. Can you help us understand how flexible those costs are over the next couple of quarters during this enrollment freeze?

Barb Gutierrez, CFO

In that cost of care component, our staff is based on staffing ratios and so it’s also variable to a large degree. Items like supplies and transportation costs are variable. Fixed costs are things like insurance and property taxes. Our staffing in centers is largely variable, especially in Colorado and Sacramento where we own the facilities. Regarding sales and marketing, we adjust staffing and expenditures relative to those markets. As we cannot enroll, we won’t spend ad dollars there.

Operator, Operator

Our next question will come from the line of Gary Taylor from Cowen.

Gary Taylor, Analyst

A lot of my questions have been asked. I guess, I wanted to start on just a few financial things. Barb, you’re talking about revenue pressures from mortality and enrollment delays, some elevated medical costs, and some higher center-level costs. Are all of those getting worse sequentially? It sounds like with Delta, a lot of those were impacting this fiscal quarter.

Barb Gutierrez, CFO

The sanctions for Colorado actually start effective February, as we were able to enroll through December. In the third quarter, we did see higher mortality, which is not atypical and with the Omicron surge. The center costs are staying at higher levels due to ongoing COVID protocols, not getting worse sequentially.

Gary Taylor, Analyst

On the Virginia ARPA payment, you were saying July through November was kind of five months of payment. Can you share a dollar amount?

Barb Gutierrez, CFO

It’s about $700,000. That was the catch-up payment received. We’ll receive it for the entire year of ‘22 and it’s about a 2.5% increase for us. We are in discussions with other states regarding their ARPA funds as well.

Gary Taylor, Analyst

On Colorado, the low single-digit rate decline. What’s the dollar impact?

Barb Gutierrez, CFO

It’s California, not Colorado. The decline is low-single-digit. We’ve asked the state to reconsider their rate-setting methodology because they used 2020 encounter data, which is artificially low due to the pandemic shutdowns.

Operator, Operator

Our last question will come from the line of Matt Larew from William Blair.

Matt Larew, Analyst

I first want to touch on a couple of the other states. Should we expect an enrollment freeze in New Mexico as the preliminary findings were similar to those in Colorado and Sacramento? What about Virginia and Pennsylvania, when are the most recent and next scheduled routine audits?

Patrick Blair, President and CEO

On New Mexico, it’s too early to know what the outcome will be. We’re working collaboratively with the state and are awaiting feedback without indication of what the outcome could be. Regarding audits in other states, it’s entirely at CMS's discretion to audit at any time, and we have no details on audits.

Matt Larew, Analyst

Okay. Regarding your corporate margins not being able to give an opinion as to what they might look like relative to historicals. I’m curious, at least on the Center-level Contribution Margin. I thought they’d be consistent long-term, but based on everything you’re saying about the need for resources and compliance, how should we consider margin profiles going forward?

Patrick Blair, President and CEO

A couple of things: we have to be careful carrying forward too many assumptions from the last two extraordinary years during the pandemic. The five years prior to COVID, the company achieved sufficient margins for robust investment in the business. With growing demand for PACE programs, I am confident that the margin profile of the business will continue to be attractive as the market expands.

Operator, Operator

Thank you. This concludes the Q&A portion and today’s conference call. Thank you for joining, everybody. You may now disconnect. Everyone, have a great day.