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Executives

Allen F. Wise - Chief Executive Officer

Shawn M. Guertin - Chief Financial Officer

Drew Asher - Senior Vice President, Corporate Finance

Analysts

Joshua Raskin - Barclays Capital

Justin Lake - UBS

Gregory Nersessian - Credit Suisse

Charles Boorady - Citigroup

Matthew Borsch - Goldman Sachs

Christine Arnold - Cowen & Co.

Scott Fidel - Deutsche Bank Securities

Anna Gupta - Sanford and Bernstein

Matthew Perry - Wachovia Capital Markets

Michael Baker - Raymond James

John Rex - J.P. Morgan

Coventry Health Care, Inc. (CVH) Q1 2009 Earnings Call April 28, 2009 8:00 AM ET

Operator

Good morning and welcome to the Coventry Health Care’s first quarter 2009 earnings conference call. (Operator Instructions). Today’s call will begin with opening remarks by the Chief Executive Officer of Coventry Health Care, Mr. Allen Wise after a brief forward-looking statement read by Mr. Drew Asher.

Drew Asher

Ladies and gentlemen, during this call we will make forward-looking statements. Certain risks and uncertainties as described in the company’s filings with the SEC on Form 10-K for the year ended December 31, 2008, may materially impact those statements and could cause actual future results to differ materially from those anticipated and discussed.

Allen F. Wise

Good morning and thank you for your interest in our company. As we discuss both Q1 results and our efforts to improve our businesses and our future opportunities. As is our normal process, I’ll have some brief comments which will be followed by Shawn Guertin, our CFO, with the Q1 specifics, and after that a brief question and answer.

With regard to Q1 Shawn will obviously provide the details you are looking for, but in general I’ll characterize the quarter as positive and settling down. By settling down I mean that we have improved insights into the results of each of our business and overall I believe we’re closer to our historical excellent grasp of financials rather than some of the challenges that we experienced in 2008.

In a quarter with regard to Medicare Part D and our Private-Fee-For-Service business, everything appears within the range of our expectations, but I’ll still be more comfortable after we have an additional quarter of experience given our ’08 Private-Fee-For-Service results and the huge growth in our Part D business in the enrollment period in ’09.

In general we view the future of many of our businesses having some challenges, but more than the challenges there are even more opportunities. The prior quarter has been on working toward improving operations on our business and preparation of both new programs and new people to do better in the future than we are today.

During the quarter we refined our operating structure to address today’s needs and tomorrow’s challenges. We strengthened our senior management team with both the return of some people who were very successful in our organization in the past and also began recruiting efforts for some senior management outside our organization. We conducted a strategic review of all of our businesses, both big and small. We performed a thorough review of every pending project in our IT area because it was clear that even though we have a staff of 2000 people our ability to grasp all the projects was not adequate. In reality, it wasn’t so much a review of IT, but a closer look at our business and a hard look at what our priorities will be in the future.

We’ve also put a huge effort toward cleaning up some operational issues in our Medicare business. During our last quarterly conference call I shared with you a view that we’ve had organizational and operational stress in our company which really resulted from the multiple years of very substantial revenue growth. As an example, during the enrollment period in 2009, we added approximately 650,000 new Part D members alone. The result of all this was significant administrative shortfalls in our enrollment area which affected our ability to provide accurate and timely information to CMS. Once our new Medicare team understood the shortfalls we devoted very substantial resources toward addressing all these issues and we feel that we’re now making rapid progress. We also believe our Medicare issues will be resolved in a maximum of 6 to 8 weeks.

So the result of our work in Q1 is a decision to better focus on 6 or 7 businesses which are the foundation for the future. Hopefully, some comments on each of these businesses will be helpful today.

The first is our commercial business with most of our future emphasis being on the small and midsize insured business which to us are the groups in the 5 to 250 life range. These businesses are overwhelmingly in geographic areas of very good cost structure and in areas where we’ve been successful for over 10 years. Our insured commercial business is beginning to show medical loss ratio improvement closer to our traditional margins, and what this means is that the 350 basis point increase in MLR that we experience in 2008 is now moving back in the right direction.

Membership is challenged because of end-group losses due to layoffs or employees not continuing coverage as well as the renewals of the very competitive midsize sector being more difficult than is ideal. So, it’s back to focus. We’re going to be all over the things that we have to do well on this market every day and I’m very confident that this is business that we clearly have a core competency in and that our company is moving in the right direction to do better. Stated differently, understandably a portion of the environment is changing in this market with groups and employees being able to afford coverage at all. Even so, we definitely have opportunities to improve results by better execution in many of our markets. Bottom line, this remains a very good business, we like our position, and we will fight for every profitable member.

The second area is Medicare and I’ll separate my comments between Private-Fee-For-Service, our network-based business, and Part D. With regard to Private-Fee-For-Service we are a few days away from a final decision, but I think it’s safe to assume we will not be pursuing any significant amount of this business in our 2010 filings. After Q1 my best guess is that 2009 results for Private-Fee-For-Service will be in the neighborhood of breakeven and this is consistent with our guidance. With the revenue reduction from CMS along with medical trend that leaves us with approximately 10% point hurdle and the result is that any product offered would likely not be competitive and/or profitable.

With regard to our traditional network-based Medicare which now numbers approximately 175,000 members we remain totally committed to continue growing this segment and to managing this product better in the future. In our Medicare network business we have a 5-point plan to address the revenue reduction and medical trends that will be evident in 2009. First, obviously we will be looking carefully a plan design and premium. Second, I think with best business practices we can substantially improve our process of achieving better risk-adjusted revenue and substantial efforts in this area will be in place.

Third, I think our focus on unit cost and traditional Coventry network business is going to benefit from increased attention and we’re developing a specific plan on a market-to-market basis. The fourth area is that we must and can do a much better job both for our members’ welfare and our medical cost by managing the chronic patients better. I think perhaps a better word than managing is helping as we will be putting substantial resources in a model to place help in the home in the form of social workers, nurses, and physicians to manage the sickest population. We understand that this will take substantial work, resources, and that we have much to learn. The last segment there or the last piece of our 5-point plan is SG&A improvement and I’ll comment on that a bit more as I close.

The third business is Medicare Part D and our Part D as I explained earlier has experienced dramatic growth and now carries approximately 1.5 million members, and while it’s early in the year we’re reasonably comfortable with Q1 results, and barring some dramatic change in the economics of the business, Part D will remain a focus for this company in the future. On January 1, in our Part D business, we move to relationship with Medco and at this stage we’re very pleased with how this has gone, both administratively and operationally, and as well with the information that this new relationship has brought to us.

So, commercial business, Medicare network-based business, and the Part D represent the first three areas of our core business. The fourth is our Medicaid business. We’ve been in this business for over 15 years and it’s one that we understand and one that has treated us well in the past. Our problem is that we have not been successful in winning enough new significant contracts in this area for far too many years. Our decision is therefore to put substantially more resources and efforts into winning this business as part of our every day process in the company with the resources, effort, commitment, and long-term focus to be competitive with specialty companies, and with other quality competitors. While we understand that the time between putting these resources in place and winning new states could be lengthy, we believe in long-term strategies and we will stay focused and put the effort necessary here until we’re successful.

We also feel that the ABD population might very well be attractive for our company as it’s consistent with the efforts that we’re going to be spending in the Medicare chronic care patients.

The fifth business for the future is workers’ comp. This is a very substantial business for us producing good results and we’re committed to doing all the things to make this a bigger and better business for the future. During Q1 we appointed a new Chief Executive Officer for this business, and I’m confident that he and his management team are doing the right things for the future. We changed the structure of this company to give the new management team more latitude in managing this business which I believe will produce even better results by giving the team a balance of resources from our company and at the same time the autonomy they need to run this separate business.

While increasing revenue of workers’ comp is a challenge in today’s employment market, I do feel confident that we’ll be able to improve our operating margins in the short term and when the employment market returns that we will be able to demonstrate revenue growth. In summary, it’s a good business and we’re absolutely committed to it.

Our sixth is network rental which is a business that has been characterized in the past as having good margins, but being challenged to improve top line growth. Our management team actually did improve revenue last year and I feel confident they can maintain this progress and that they have some good ideas there and that it’s going to be a good business for us in the future.

The last major business is our FEHBP business, a fee-based government program with mail handlers being the largest account and this too will continue to be a business that we pursue.

A few comments about SG&A. Our company became big and complicated very rapidly which places a stress and challenge to operating focus and the result of that is frequently increased SG&A. We understand here that we need to improve SG&A and our challenges are twofold. One is the likely loss of significant revenue from the Private-Fee-For-Service Medicare business and while we expect this business to be about breakeven in 2009 it obviously covers some SG&A cents. With a small likelihood of keeping any substantial piece of this business in 2010 we have to reduce the SG&A to cover the revenue loss obviously, and in addition, make progress in the remainder of the company. This is not easy, but we have the resources to address this. We have the people in place that have controlled these costs successfully in the past. We know how to do that. We know how to control cash; have done in the past, and we’ll do it in the future. It is the case of a no silver bullet. It takes time to improve basic business process which is the only way you can accomplish real lasting results and I think after our renewed focus on our core businesses that we have the culture to accomplish this and we know how to do it, and I would hope that the next conference call I would be able to provide some specifics along this line.

In summary, it’s been a good quarter. I believe we’re doing most of the activities to improve our business in the future; however, it’s clear that we still have a lot of work to do. I like our platform, I am proud of our management group, and I’m optimistic about this year. I think that many of my comments today reflect our efforts to make this a better company in 2010. Our management team understands the direction, understands the company isn’t for sale, and that we must execute both today and tomorrow to accomplish our long-term strategy.

So after this, Shawn Guertin has specific comments on Q1 which will be followed by some Q&A.

Shawn M. Guertin

As you have seen this morning, we reported earnings per share of $0.30 for the first quarter of 2009. From an overall earnings perspective, the quarter came in consistent with our expectations. In addition, the earnings quality metrics were very good with strong cash flow from operations and stables days and claims payable. As we discussed last quarter while all of our businesses are important, our 2009 financial results are going to hinge on two key areas. The first is the performance of our Medicare businesses which have experienced significant membership growth and the second is the performance of our commercial risk business particularly in the area of the medical loss ratio. I am going to start my comments off this morning with the Medicare business.

By now you’re all well aware that we’ve experienced significant membership growth in 2009 on all of our Medicare product lines; Part D, Private-Fee-For-Service, and coordinated care. In fact, this growth is even higher than we had previously forecast and we’ve updated our full year guidance for these higher volumes. More specifically on Part D, on a gross basis, we added almost 650,000 new members in 2009. About a third of this growth was in our low-income auto-assign eligible product which has a leaner formulary, strict utilization controls, and has historically performed very well for us.

The other two-thirds of this growth was in our retail products. Almost 95% of our retail growth is in our two leaner-design, historically best performing retail products. It was not in our two richer retail products. So, we’re growing in the right products.

Our guidance for the full year 2009 MLR was in the 84% to 85% range, essentially stable with the 2008 full year MLR result. Given the significant growth we’ve experienced, I was quite pleased to see the 2009 Q1 MLR coming very consistent with our internal expectations and slightly better than the result we experienced in last year’s first quarter. While this result in and of itself doesn’t make the full year MLR a certainty, it certainly is directionally consistent with our full year expectation for Part D, which given the strong growth would be a good outcome.

Turning to Medicare Advantage, the story here starts with strong top line growth as well. We focused a lot on Private-Fee-For-Service membership in past discussions on this topic, but it’s important to note that the coordinated care product grew membership over 25% on a net basis in the first quarter exceeding 175,000 members for the first time. In terms of MLR, the first quarter was largely in line with our full year expectation from Medicare Advantage of 90%. Again, we don’t have the real-time visibility into actual claim results like we do on Part D, but what we can see continues to be more encouraging that not. The products being purchased, the risk scores of new members, and the preliminary view into 2009 incurred claims can still be best described as we don’t see any major red flags yet. Having said that we added over 90,000 new individual Private-Fee-For-Service members in the first quarter and the proof will be in the pudding. Ultimately we will need to see mature incredible claim data here and that will be more of a second quarter event.

So, in summary on Medicare, we feel better about the early results on Part D and they seem to point in a direction consistent with our full year guidance. On Medicare Advantage given the growth and where we are in the calendar year, it’s still a little too early to declare victory just yet.

I’ll now turn to our group commercial risk business and start off with comments on the top line. I was pleased to see the results of our pricing action show up in the premium yield increase for the first quarter of 2009. Despite the fact that benefit buy-downs are elevated, we continue to see growth in the rate of increase and the premium yield. The Q1 year-over-year increase is higher than the rate of increase we saw in Q4 2008 and Q4 was up from the same-store increase experienced in Q3. So, we’re seeing the impacts of the proactive pricing push we started in 2008.

Clearly, we’re disappointed with the membership losses, but as you’ve seen already in the earnings season, there are some powerful macroeconomic forces at work here and we’re not alone in the industry related to challenges in this area. In fact, in the first quarter small group sales continued to exceed terminations, but net membership decreased due to a higher level of in-group attrition. Membership continues to be an area that would appear to be pressured for the balance of the year and we have adjusted our guidance downwards to reflect this pressure. Our previous guidance assumed a risk membership loss of 6% to 8% on our group business and we have now built in about a 10% loss on group risk membership by year end.

It is important not to misinterpret this as passive acceptance of this result, but rather a prudent forecast to reflect the difficulties in the current economic environment. In addition, rest assured that despite this membership pressure we’re maintaining our pricing discipline. Turning this membership dynamic around on the group business is one of the top priorities of the management team day in and day out.

On a more positive membership note, our individual commercial business grew by about 8000 members in the first quarter and we appear on track to grow this business by 30,000 members by the end of the year.

In contrast to the membership results, the story on commercial medical costs and the MLR in Q1 was certainly a bright spot. The medical cost trend results continue to tell a similar story to that which we shared with you last quarter. It continues to appear that cost trend peaked in Q2 2008 and we see no evidence of any further acceleration in trend in the subsequent periods. Thus, we continue to feel good about our macro view that 2009 trend will be stable versus 2008.

More specifically in Q1, the commercial MLR as expected came in sequentially better than Q4. We had expected sequential improvement and results from the fourth quarter due to calendar year deductible-based plan designs, and clearly the milder flu season was a tailwind here as well. While this is an encouraging result, at this stage we’re sticking to our previous 2009 MLR guidance of 82.5% to 83%. There is still too much of the year to play out and with the challenges we faced on the membership front, the macroeconomic pressures that exist, and changes like the COBRA subsidy out there, it would be irresponsible to get too exuberant about this result at this point in the calendar year. The implication of this guidance is that we expect the commercial MLR to Q2 through Q4 to be higher than that experienced in Q1 with Q4 being the highest quarter of the year.

Regarding the balance sheet and liquidity, I am pleased to report that our overall position in this area remains strong. We ended the quarter with approximately $500 million of free cash at corporate. In addition, our investment portfolio remained conservatively positioned with approximately $2 billion in cash, cash equivalents, and US Treasury securities. The portfolio once again ended the quarter in an overall unrealized gain position. Looking forward, I believe the current economic conditions dictate that we continue to be careful in this area and reassess market conditions regularly.

Let me now move on to guidance. First, let me start with a housekeeping note on the press release. We have redesigned some of the groupings in the press release tables to be more consistent with some of the organizational and management changes that have been made. I believe most if not all of the information we previously provided is there although it may be grouped a bit differently. As always, we’ll be available following the call to walk you through any changes in this area.

From an overall earnings perspective, we’re affirming our existing EPS range. We’ve updated the operating elements to incorporate an overall higher level of revenue driven by higher-than-previously-forecasted Medicare volumes, partially offset by lower-than-expected group commercial risk volume. We have maintained our previous outlook on Medical loss ratios and any change you see here is largely the result of product mix as opposed to a fundamental outlook change. We have also updated our SG&A view to reflect substantial reduction in network spend, but also to reflect the higher-than-expected overall volume of business. In fact, our estimated revenue is up almost $400 million from previous guidance. All in all you’ll see our estimated operating earnings are up about $16 million versus previous guidance.

Below operating earnings the key change is in the area of share count. I believe that prudence dictates given the current macroeconomic environment that we remove share buyback from our guidance at this stage. This does not mean it is a certainty we will not repurchase shares; rather given the unprecedented environment we are in, we should not premise our guiding commitment to you on having to do this.

So, in closing, we’re off to a solid start in 2009. In addition to the encouraging signs we saw in the first quarter on Part D and the commercial MLR, we also continue to experience profitable growth in our individual business and strong performance from our workers’ compensation business. We are in an excellent liquidity position. Our investment portfolio was conservatively positioned and our cash flow generation is excellent. So, while we feel better today than we did a quarter ago, there is an awful lot of the year still to play out, and that year will play out in the most difficult and uncertain economic environment in a generation.

Operator, we’ll now open up the call for questions.

Question-and-Answer Session

Operator

(Operator Instructions). We’ll go first to Joshua Raskin - Barclays Capital.

Joshua Raskin - Barclays Capital

First, on the Private-Fee-For-Service business and I don’t think it was a complete surprise that you guys were looking to exit some of that business, but two questions on it. What are we waiting for in terms of its final decision in the next couple of days? Is there a specific data-point that you are awaiting? Is it closing April or what have you? What exactly is the transition plan? You are talking about $3 billion to $4 billion of potential revenues just walking out of the door; is there a potential for some of that to be reined in through some of your coordinated care plan, and how are you exactly attacking the SG&A and how much of that is variable?

Allen F. Wise

With regard to your first question; a couple of events. I think the filing date with CMS is on Friday, but we have a Board meeting on the 30th which I believe is Thursday; that is an non-scheduled meeting and given the significant revenue and given our ’08 results, our Board of Directors at the time of our last meeting thought it warranted an in-person meeting. So, I along with the management group will be meeting with them on the 30th and present to them what our view is. So, step one, I want their ratification on something as important as this is to the company; and step two, there is still a little work continuing, but I think we can’t improve on the verbiage that we gave you which is that it’s unlikely that there will be much in the way of substantial piece left because of the 10-point hurdle there and because of our fast-performance there.

On the other hand on the network-based business, we have been there a long time; we’ve been in that business in some of the markets for 50 years. We think it’s important and the best way to deliver care for the future. We think we understand how to improve our cost structure. The effort to manage the patients is not rhetoric. It’s going to take a lot of work and a lot of time and a lot of resources, but I think that necessity is the mother of invention and we’ve been talking about this for a long time and that we will be doing what we can to grow that we’ll be doing whatever is necessary to manage it better.

Shawn M. Guertin

Josh, let me just sort of clean up a few of the numbers in your question and deal with the SG&A because that’s obviously important and something we spend some time on. First, the revenue volume in our guidance is probably closer to $2.7 billion to $2.8 billion for the full year ’09, and as we’ve talked about it, if that potentially is running in the mid 90s loss ratio and around breaking even, that might throw up a gross margin of about $170 million in our guidance, and when we look at our expense structure as you would suspect, this was a new product, it’s a fairly unique product, and so we have something on the tune of $150 million to $160 million of SG&A directly aligned behind that product, and in an essence sort of variable, to use your question. So, the vast majority of that is fairly easily identifiable. There is certainly some work to do on the shared elements of SG&A, but we’re in the zone there to work on that.

Joshua Raskin - Barclays Capital

I guess Shawn, when you talk about direct SG&A, does that include areas like real estate that may or may not involve a charge in terms of the line down?

Shawn M. Guertin

No, that would be more the people, the printing, etc. For example, about half of that is premium tax and commissions that easily falls away. So, we’ve tried to separate that into direct and indirect buckets.

Allen F. Wise

The work remains, Josh, for a year, and so I want to manage that in that over time a lot of people in the service centers, the high-quality people that normal attrition takes care of, over a 12-month period; some piece of this. So we have a year to do the right things for the people and get that cost out of here.

Joshua Raskin - Barclays Capital

A quick followup on the guidance, I want to make sure I understand the moving part; it looks like the top line is going up a lot, but the guidance was unchanged and because you’re not spending; obviously I assume you’re not spending any of that Private-Fee-For-Service network money in that or got any of those spent; should we assume that operating earnings are up a little bit, but the share count can’t pull that out; is that what happened there?

Shawn M. Guertin

In a nutshell you’ll see operating earnings are up $16 million and again the decision to take share buyback out of our guidance commitment in essence offsets that.

Operator

We’ll go next to Justin Lake - UBS.

Justin Lake - UBS

A quick followup on the Private-Fee-For-Service; given the membership number out there and how much sunk dollars you have as you mentioned on the commission side, is there any opportunity to sell that and actually realize something even if it is just from the membership list?

Shawn M. Guertin

We’ll examine in once again, but historically it’s been very difficult and historically CMS has not been positive about being able to accomplish that. To your point, because of the sheer volume and everything we will investigate it. When we get a decision made we will pursue it, but I wouldn’t be very optimistic about a positive result there.

Justin Lake - UBS

On the cost trend side, I guess just two pieces; one, can you give an update on the components of cost trend, and second, now that we’re getting towards a year past where you identified the increase in cost trends, I was just wondering if there’s anything more you can add as far as what you’ve been able to unearth as far as that spiking cost trends that you saw last year?

Shawn M. Guertin

Largely, the view on cost trends directionally adjust and isn’t all that different from where we’ve been. You have the facilities leading the pack with inpatient continuing to be driven by unit cost, unit cost pressures on outpatient, but a little more utilization pressure there, and then lower numbers on physician and pharmacy. Really, I wouldn’t change anything from our prior commentary nor would I say that we’ve found any silver bullet in hindsight. Many of the issues that we’ve talked to you about in the past continue to be some of the issues and we were actively working on medical management, contracting action plans to deal with all of the different issues that we saw and to try to make that better going forward. So, I wouldn’t say that there’s any new news there.

Operator

We’ll take our next question from Gregory Nersessian - Credit Suisse.

Gregory Nersessian - Credit Suisse

A quick question; Allen I was wondering if you could just clarify three subgroups of your enrollment; the group Private-Fee-For-Service; what’s the plan there? Do you plan to continue offering that product? If not, have you notified those groups that you’re going to discontinue that yet? The individual business, you didn’t mention that in your discussion, and then in the last quarter you indicated that you might consider retrenching some of the FEHB business that you have; where does that stand right now?

Allen F. Wise

With regard to the private fee group business, we have not made that decision, have not notified the groups, and it is part of the meeting on 30th. I think obviously we face some of the same challenges there and that’ll be on a group by group basis; I just don’t know, but we will soon. The retrenching, I believe, that we were just offered in places where we had the best cost structures. We’ll offer it every place that we can where we have existing delivery systems and where we have group business. We would not be taking it out nationally where our cost structure wouldn’t be consistent with some of network bases; plenty of opportunity in that area. Nothing new on that front; I think the decision was made 6 or 7 months ago and it was a good one.

Shawn M. Guertin

Greg, just to be clear on the FEHBP and especially given Allen’s comments on businesses; the comments there on FEHBP, we really have two buckets of that. We have the risk business that’s in our health plans and then we have in essence the self-funded business, mail handlers accounts and things like that. The discussion that we’ve had as you know is to look hard at the risk business and again make sure we’re getting a proper price and that we’re in a proper underwriting position on those accounts, and that’s something that’s actively going on right now for 2010.

Gregory Nersessian - Credit Suisse

Going back to the group Private-Fee-For-Service; is there a discussion around potentially migrating that business to coordinated care products; is that an alternative or it is either keeping it as Private-Fee-For-Service or walking away from it? Help us with that decision process.

Shawn M. Guertin

It’s an alternative, but obviously that’s in the employer’s camp more than ours, and so we’ll do that. Just as a followup to Josh’s question; we have I think in the neighborhood of 40,000 plus or minus individual members on private fee who line up with our health plan service areas, and so regardless of the decision we’ll also actively be working to convert those numbers into a coordinated care product, but going back to your question, we’re certainly open to group coordinated care offerings, but obviously the employer’s sponsor there has to feel that’s the right alternative for them as well.

Gregory Nersessian - Credit Suisse

So that initial spending that you had planned for the private fee versus network build, but is any of that still in your guidance based on potentially moving some of these group lines into network plans or has that $40 million to $50 million been taken out entirely?

Shawn M. Guertin

It has almost all been taken out. We’re doing a little bit of expansion as we normally do every year around our coordinated care network. So there’s a little bit of it left in there. That happens to line up around a couple of these accounts and a couple of our health plans, but in essence, that’s out.

Operator

We’ll take our next question from Charles Boorady - Citigroup.

Charles Boorady - Citigroup

First, you have the guidance roughly for operating cash flow and CapEx for the year?

Shawn M. Guertin

On cash flow Charles, as you know, we’ve said that our typical run rate would be 120 to 140. I think when you look at two things, the rate at which we’re going especially in Medicare and the reserve buildup and things like that and actually the relative level of our net income to the DNA, I actually think we’ll probably exceed that historical norm this year, and that’s just more of a function of both growth and where we are in earnings. Our CapEx would be in the neighborhood of last year which I think was around $60 million or $65 million.

Charles Boorady - Citigroup

A clarification on opening remarks that you and Allen both made; I think Allen mentioned improved visibility versus ’08, but also recognized the strong growth in Medicare Advantage presents a greater challenge in getting visibility, and you both pointed it to 2Q or waiting another quarter to feel better about it. I am wondering how did you achieve improved visibility versus last year and can you point to any specific changes that were made to your systems or procedures or did you grow the employee base that processes claims to help give you visibility; anything you can say about how you got better visibility this year versus what you were doing last year.

Allen F. Wise

I think the best example of that as we grew rapidly and started something characterized especially the company is that the numbers in the company were expressed as planned contribution as opposed to EBITDA numbers and what that means is there was about $800 million in SG&A that wasn’t allocated to businesses. So we spent a lot of time, both major and minor businesses, on getting those businesses on a standalone basis on an EBITDA basis, and I think we’ve been about more than 95% successful in giving all of the SG&A allocated. So, it’s much better visibility into how much resource they were using and what the actual contribution to the bottom line was. So, that was the first step and we learned a lot about cost structure and business practices when we took those businesses apart layer by layer to do that.

Shawn M. Guertin

Charles, you are on the right track. At a much more mundane level, the stability that we’ve had not only this year, but even in the last six months as we ended last year around claim processing especially around the Private-Fee-For-Service product; it is a step forward in at least being sorted, being able to assess paid claim levels and feeling a little bit better as you watch the stuff come through about what you’re seeing. Again, we’re not out of the woods on it, but that clearly is different this year certainly from where we were a year ago.

Charles Boorady - Citigroup

Is there anything that you can quantify to give us a sense for how much better visibility you have? For example, the number of days from date of service to date of payment, and any other metric, that you use to measure visibility and how much better it has gotten versus last year?

Shawn M. Guertin

I don’t know if this will convince you or not, but that number, on private fee and this is from the date of service to the date of payment settled out in the high 50s, and it has been there now for somewhere 3 to 6 months. I think at its peak, that number was well up into the 70s.

Charles Boorady - Citigroup

That’s helpful, and how did you think about it in light of the IBNR in the 1Q, and you both kind of pointed to 2Q is when you feel a lot better, but was there potential of may be book it greater continuously in the 1Q to reflect the high uncertainty in this quarter given the new growth?

Shawn M. Guertin

I won’t say that, I would say that we tried to close the year off with the appropriate amount of conservatism and we tried to maintain that level of conservatism in Q1.

Operator

We’ll go next to Matthew Borsch - Goldman Sachs.

Matthew Borsch - Goldman Sachs

Just a question on your plan to exit private fee for service or at least most of it, there’s been some discussion that may be there is a chance that the 2010 rates for Medicare Advantage would improve if a re-appeal of the physician fee schedule cut is enacted in the near future, and then Congress and CMS does something to take that into the 2010 rates, do you have any of your own assessment of the likelihood of that, and if that were to occur, would you re-think some of your strategy around the exit?

Allen F. Wise

Obviously, we don’t have any insights on the likelihood of that occurring, but several points in my comments today I probably used the word long-term strategies, and given our commitment to part D and given our commitment to doing the network-based business better, I just really think that while we can do more than one thing well around here, you can’t do everything, and I think we’re much better off to focus on a model for the future, and so I will be reluctant to think that it would make a lot of difference. Our track record historically has not been good. The ability to develop the wide space in the network-based business is expensive, time consuming, and I’m not certain, but if you look at the challenges on one side and the opportunities on the other side of the page, I’m just not certain as to the best place for us.

Shawn M. Guertin

Let me just follow on that, I think for simplicity purpose when Allen sort of talked about the 10% hurdle, he was thinking about the differential between rates going down 4% and may be trend being 5%, 5.5% or something, but when you think about it, our private fee business isn’t performing where it needs to perform consistent with our targets. So, our hurdle on private fee is even bigger than that; and so, even if that fix goes in, you’re left with a very uncertain sort of risk reward proposition given the magnitude of benefit in premium changes you’d have to put in.

Matthew Borsch - Goldman Sachs

And if I could just follow that with a couple of questions on the commercial side, can you tell us what are you seeing in terms of pricing in the market from competitors, if you can compare that to a year ago, I don’t know the extent that you may be soft in the intense price competition in late ’07, early 08, it’s the extent that you dare to be seeing some improvement from that or not?

Shawn M. Guertin

I would probably say we’re not more in that; there’s always little isolated pockets in a given geography, but it was very competitive and despite the fact that I think others have taken a stance on firming pricing, I still think it’s very very competitive out there. The one thing I would say that everybody would say they observe in the market is just given the economic condition, employer groups will move for less of a difference than they used to move, and that’s sort of probably the most noticeable difference in the market as opposed to sort of any one competitor’s behavior.

Matthew Borsch - Goldman Sachs

And last question here, what did you observe in terms of the benefit buy-downs or the uptake of high deductible products or raising deductibles on products which already had reasonably high deductibles?

Shawn M. Guertin

Two things, we’re probably seeing, you’ll recall, we tried to push in through price an extra 200 basis points of yield this year, and it would appear that we’ve had about 100 basis points of that through elevated buy-downs, and so, you were continuing to sort of grow the percentage of our business that’s with higher deductibles, these are just numbers, but they helped illustrate it; around 50% of our members in 2008 had a plan that didn’t have a deductible, that’s down to something closer to 40%, and you’ll conversely see about a light type increase for members who have a deductible over 1000; so, that’s sort of going on in a big way but that’s not new, it’s really been a continuation of the trends, may be accelerated a little bit because of pricing in the economy.

Operator

We’ll take our next question from Christine Arnold - Cowen & Co.

Christine Arnold - Cowen & Co.

Couple of questions, can you help me think about how much of this $150 to $160 million is fixed cost; is it reasonable to think of a third of that as something that you’ll have to cover with growth in other areas?

Allen F. Wise

That’s way too big; in fact, the way I tried to give you that, Christine, is these are sort of directly aligned costs to the product, and so they would be highly variable, and at the most, I would assume sort of 10% fixed, but I even think that would be stretching it a little bit; and again, keep in mind, out of the number 150, 160, half of that’s brokers and premium taxes for example; so, that’s a 100% variable.

Christine Arnold - Cowen & Co.

So, are the other costs in this 150 to 160 that are fixed or is 10% of 150, 160 kind of the total we should see?

Allen F. Wise

Yes, there’s a little bit of that, there’s always sort of the shared services element of the business, whether that’s things like telecom and other things like that; so, that’s the stuff that we got to work at getting out, but again, I think when you think about how this product came up, we somewhat built it a little bit to stay on our platform, but it was very sort of definable. I think there’s a kind of $20 million nut there that we got to get after, but I’m confident we can do that.

Christine Arnold - Cowen & Co.

And the $20 million in addition to the $15 million?

Allen F. Wise

No, I think that’s probably the total nut.

Christine Arnold - Cowen & Co.

Okay, that’s not bad at all. And then, how do you think about, you said that the network rental business you guys are going to work to grow, but I didn’t hear a lot about the ASO book, is that included kind of in this network rental or is ASO something you’re reevaluating, how are you thinking about kind of that self-insured book of business both on the First Health side and on the Coventry side?

Allen F. Wise

I think what I would say about that is it wasn’t included in my 7 core businesses or my area of emphasis. We’ll do some ASO business if that helps us in the marketplace, helps us with brokers or helps us with a provider, but it’s not a focus for the company. There are companies that do that very well, and my view is we’re much better off than our core competency which is the small and mid-size insured; the margins are better, we’re more competitive, we do that better than many of the people that we compete with. The ASO business is one that we’ll do a bid with and one that I like. On the national PPO business, the truth is we just haven’t been successful; that was a couple hundred million dollar business 4 years ago and it’s 30 now, so it’s just not core competency, we haven’t been successful, and so, a lot of our review the last quarter is about what do we do best and a belief that whatever businesses, wherever we place our bets, place our resources for the future, it better be in areas where we do it the very best and have an advantage, and I would say the national PPO business is one that we will not put any real effort toward, and whatever ASO business we do would be in our marketplaces for the reasons that I expressed.

Christine Arnold - Cowen & Co.

Okay, and then final question, fresh on these plans, is that what you’re talking about kind of moving more into Medicare Advantage when you talk about the chronically ill?

Allen F. Wise

The Medicare Advantage is not specific to that; we’re going to be in the broad-based network business that we have been. Talking about the ABD population, it was in reference to our efforts to do much better in Medicaid, and I think the same commitment we have to caring for the chronically ill and these are people with overwhelming problems, physical problems, may be lifestyle problems, financial problems, not getting support in their houses, people that have a hard time really getting the right amount of care in a medical delivery system; I think that this is faced really in the home or on the spot to help and aid even with custodial issues, and in the ABD population, there’s the same special needs; I think that moving forward, that we’ll be in an area where we put in a lot of resources but not to the exclusion of the broader base network-based population that we have 175,000 members in.

Operator

We’ll take our next question from Scott Fidel - Deutsche Bank Securities.

Scott Fidel - Deutsche Bank Securities

First question, if you can provide an update on how the FEHBA and Vista businesses performed in the quarter from a margin perspective, just trying to get a sense of whether you saw the margins there settle down a bit or still seeing some volatility there?

Shawn M. Guertin

Actually, our commercial business is right on track through the first quarter, so we couldn’t be happier with how that’s going at this stage, but all in all, given that we’re tracking well, I think FEHBA has been okay. There are some decisions to make plan by plan that in the next 60 days we’ll be making about our positioning for 2010, but so far so good on both fronts.

Scott Fidel - Deutsche Bank Securities

Then just on the Medicaid business, it looks like the MLR bumped up around 390 basis points year-over-year, just interested if there were any particular markets that drove that up and what you’re thinking around the Medicaid MLR for the full year?

Shawn M. Guertin

That number is pretty consistent with our full year guidance number. That’s always a number that has bounced from quarter to quarter on us a little bit, but that’s always a story about Missouri and Michigan, and a lot of that candidly is just sort of oscillation from quarter to quarter that’s going on, so, we’re tracking pretty well. Our full year guidance is in the upper 80s, that’s where we started; so, that result is pretty much in line with that.

Scott Fidel - Deutsche Bank Securities

Thinking about the network-based MA business for 2010, Allen, you highlighted sort of the 5-part plan that you’re thinking about with that business to sort of recapture up from the tough MA rates, how are you thinking about margins I guess for 2010; I know it’s early here, but do you think those different initiatives can drive a stable margin for the network based MA business or do you think there will still be some pressure given the down rates?

Allen F. Wise

Our goal for the 5-point plan there is to maintain the margin we have, and to do that and minimize the effect, we have to do with the plan design and premium in contribution; the goal is to keep the margin.

Scott Fidel - Deutsche Bank Securities

And then just one last question, thinking about the different businesses that you highlighted with the strategic review, how much or if it at all did the ongoing health performance discussions in Washington influence your thoughts around which businesses to focus on or not, and as that debate develops this year, do you think that could start to influence some of those thought processes you’re making around which businesses to focus on longer term?

Allen F. Wise

Yes, a little bit above. Overall, there are businesses that we have that may be suffered a little bit and the explosive growth that we had in the Medicare business and with the acquisitions we made over the year, so it was really timely to dissect those businesses and see what they’re actually contributing net-net to the bottom-line. You can’t help but think and guess about the future and think about the role of individual business, individual choice, can’t help but think about the 50 million uninsured and make some educated guesses about what’s presently in Medicaid plans or a version of Medicaid, which will be individual and what kind of pressure there will be on employers to either provide a contribution or provide some group coverage, and I think a lot of that’s consistent with longer term thinking, even in the dark days after the budget cuts of 96, or whatever it was, 97; and always wanted to stay in the network-based Medicare business because I believe it’s the best way to deliver care for a demographic group that’s exploding, so it’s a little bit of both tidying up that we have and making certain that those businesses are very well run businesses so that they are a transportation for the future; so, it’s a little bit above.

Scott Fidel - Deutsche Bank Securities

One last quick numbers question, on the MA-PSFS, the 318,000 lives, do you have the break-out of that between the individual versus the group PSFS?

Shawn M. Guertin

The group is about 100,000 today.

Operator

We’ll go next to Anna Gupta - Sanford and Bernstein.

Anna Gupta - Sanford and Bernstein

My question is about the commercial cost trends, so the first question I had is, is the recession providing a tail end for you and seasonality in the first quarter, and could we expect cost trends to continue at the level they’ve been right now or could they get worse as you move through the year?

Shawn M. Guertin

I just think it’s hard for me to divine that out of the first quarter, Anna, whether the recession is having that kind of impact, again, I think it’s very clear we’re not experiencing acceleration; I think your point is arguable that there’s been some favorable impacts so far, but it’s hard for me to say that. I think the things that worry me more are in the camp of just uncertainty. I think when you lose 5% or 10% of your risk membership, you worry a little bit about what that brings with it; I worry a little bit just because I don’t know what the uptake is going to be on this new COBRA subsidy; I think those are things that could potentially create cost pressure, and honestly I think that’s a key part of my thinking on why we sort of stuck to our guidance at this stage on the commercial MLR.

Anna Gupta - Sanford and Bernstein

Okay, and then just a followup on the unit cost side, so it’s obviously a very key leverage point for you; what percentage of your contracts are coming up for renewal, just trying to get a sense of that, at what point would you be able to change the negative spread between yield and trend to positive and are hospitals willing to negotiate with you, are they improving fee schedules, and then MS-DRG thing that played out and has it gone away at this point?

Shawn M. Guertin

I don’t know the exact specific number for 2009, but we typically enter into 3 to 5-year arrangements with providers and we do try to actually spread these out so that they don’t come up; I would estimate it somewhere between 20% to 33% kind of coming up in any year; that whole discussion is like it always is, it’s never easy, and you’re always pushing to sort of do better and close what you see are the loop holes; they’re obviously trying to do the same thing for their revenues, so I think we can be successful, but as I have described before, it’s a little bit of hand to hand combat and it takes a long time to work through.

Anna Gupta - Sanford and Bernstein

One final quick one, so you’re doing very well in individual and you have a 30K outlook on guidance, what would you attribute that to, is it you pricing structure, is it more of your agency model, what makes you gain share or is it just the whole segment is growing as people are moving out of group to individual?

Shawn M. Guertin

I think it’s both; I think it’s the counter-balance to what we see going on economically. I think there’s some natural lift there, but again, the individual businesses in and of itself to some extent as I mentioned is one where if you are a new entrant with cost structure and that’s important, you have a nice price position both from the fact that you sort of re-underwrite. Some of the legacy people in this market do not have sort of competitive network cost structure, and I think it’s all those factors that are working to sort of produce the outcome that we have here.

Operator

We’ll go next to Matthew Perry - Wachovia Capital Markets.

Matthew Perry - Wachovia Capital Markets

A couple of questions; first on capital at the parent company, you grew that to $500 million for first quarter and now your 2009 guidance has changed so that you don’t contemplate share buy-backs in that guidance, so based on that new guidance, where do you think this number would be at the end of the year, and then kind of related to that, how much capital are you holding in excess of what you’re thinking you need to pay claims in the private fee for service business and how much might you be able to pull back up to the parent if you exit that business?

Shawn M. Guertin

With your first one, you’ll recall that we ended the year with $440 million of free cash; our outlook is that we had $200 million deployable that could go towards share repurchase, it could got to de-levering, or to go to another purpose; so, that’s pretty much the same, so I would pick 640, 650 for a round number is where free cash would go year end before we deployed anything. If you think about a $2.8 billion private fee book, there’s probably about 10% of premium roughly that is tied up in our regulated subs that support that business, so that’s not an insignificant number of $280 million, and the $64,000 question there really ultimately is one of timing. We will have obviously all of that business when we do our year end statements and our year end RBC work at the end of this year and you’re probably looking at 2010 before you could sort of reap the benefits of that in terms of dividending any of that out and may be even into 2011 depending on how that process goes.

Matthew Perry - Wachovia Capital Markets

And then, here’s a big picture question, this company generated $3 to $4 in EPS for 3 straight years on a much lower revenue base and at that time was also generating ROEs of the high teens or in excess of 20 and similar return on invested capital, wondering either where the sustainable earnings could be or what you think of as a sustainable kind of ROE or return on invested capital?

Shawn M. Guertin

It’s a difficult question to answer with sort of all of the things going on with healthcare reform and Medicare. I mean, I sit back and sort of say much of what we’re talking about in terms of price push, medical cost management, SG&A reduction is all designed to point us in a direction to get us back at that point, but as we talked about, there are other things that are hanging around out there on Medicare and on commercial that are just uncertainties. I certainly think the number, as I mentioned back in January, is certainly higher than the number that we’re still guiding to today, but I really don’t know specifically some of the historic numbers and when that realization might happen.

Matthew Perry - Wachovia Capital Markets

And then just last question, you talked about increased focus or effort in the Medicaid business, would that possibly contemplate acquisitions or is it something you tried to build internally?

Allen F. Wise

It’s probably both; step one is we have new leadership, we have a new plan to put the resources in place that it takes to be out in front of these decisions far enough to compete as the best people in this business; we have typically managed that through our local office with some oversight and we’re going to build a team here with the resources that it takes. If there are small plans along the way or if there are opportunities, we would invest in it for the future, but primarily at this point, it’s to do what we’re doing a lot better and see if we can win some cases and we understand that’s a long hard pull.

Operator

We’ll go next to Michael Baker - Raymond James.

Michael Baker - Raymond James

I was wondering if you could update us on how the worker comp claims volumes are trending and also give us a sense of what SG&A saves might be targeted for that business?

Allen F. Wise

Well, it’s all a fee-based business, so actually the workers’ comp business, the more bills there are, the more claims there are, the better that we do. The challenge on the revenue side is in today’s employment market that the incentive is down and so the volumes there are going the wrong direction. In terms of margin expansion, that was a company, let’s call it $730 million in revenue and a huge plan contribution, but the SG&A allocations weren’t very accurate; so we appointed a new CEO, we have made that more of an autonomous business. They had about 1300 customer service people in 4 or 5 locations, and we’re really in a business different than any of our core businesses; so, we uncharacteristically unplug those service organization and place them under management’s control rather than centralize; they’re going to use our IT but they’re on a hey-as-you-go basis; so they’re more careful about their priorities, and all through the organization, on networks, they can use ours, they can use someone else’s, whichever is more efficient for them, and so we have given the management group the resources of a large company in terms of IT and some of our favorable network locations but made them more autonomous, and their earnings and their bonus depends on EBITDA targets, and so, I think now that they have better control of their expenses or rather more accountable for their expenses, they’re making better business judgments and I’m confident that there’s a 300 basis point margin opportunity there over the next 24 months.

Michael Baker - Raymond James

Okay, and then I appreciate your earlier commentary on the PBM side, was just wondering when you plan to make a decision on the commercial PBM vendor side of things.

Allen F. Wise

We have and that will be going the same direction.

Shawn M. Guertin

We are very pleased with our experience so far and think that it will bring benefits to managing those patients as well.

Operator

Our last question will be from John Rex - J.P. Morgan.

John Rex - J.P. Morgan

Just a couple of quick ones on the kind of longer term, so first on two of your core businesses, when I think about commercial risk and to kind of asses the current state of the market in the next couple of years or so, would you say as you look at it today versus where this was a few years ago, would you say it’s unrealistic to think about getting to the kind of high 70s loss ratios that you were showing in this business for several years?

Shawn M. Guertin

Again, John, I don’t think that’s impossible, I certainly couldn’t rule it out; I just, like I said in the confines of the sort of theoretical discussion, sustainability of those margins over the long haul is sort of the question what we always kick about, but again, as we talked about, if we sort of continue to push what we’re pricing today the same way that we priced in a theoretical construct, it’s possible, it’s obviously not something we’re guiding to this year.

Allen F. Wise

I think the way you can look at that is a part of what we’re experiencing is market conditions, but a part of what we’re experiencing also is not a great execution in some of our markets, so, talk about focus and being all over things every day, we have re-thought some of our mid-size underwriting activity; we will have 5 targets from a unit cost reduction in each of our markets and we will be working that every week until we make some progress; so I think the way to look at it is we certainly are going to improve on the rapid deterioration last year and whether that ends up at 80 or 81, who knows, but we can make some improvements.

John Rex - J.P. Morgan

And then when you think about your network-based MA business and looking ahead, so are you kind of prepared for an ultimate move to parity reimbursement; in your network-based markets, what percent of your membership would fall in the markets where you can currently run part A, part B equivalent costs of say 80% of government program cost? I’m trying to think about kind of get into a 5% pre-tax margin and allowing for some extra-benefit for the senior to track demand and some G&A load.

Shawn M. Guertin

I just want to directly answer you question, but actually as a followup, we look at that exact calculation and if I excluded this which is even better, I think the equivalent that we did on providing part A and part B was about 83% in all of our existing markets.

John Rex - J.P. Morgan

In your network markets, right?

Shawn M. Guertin

And that’s prior to any improvements that Allen was talking about earlier.

John Rex - J.P. Morgan

And do you have a sense as to what kind of extra benefit you think you need to offer senior to have to make that decision to either switch into or stay into an MA product versus the distribution of product, do you think it’s kind of roughly about a 10% benefit?

Shawn M. Guertin

That’s exactly what we’re going through now obviously as part of the decision making, but some people think that could be as low as 5 and other people are more in your camp, but that to some extent is market by market as well.

Allen F. Wise

Thank you, this concludes our call.

Operator

Once again, thank you for your participation. This does conclude today’s conference call.

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Source: Coventry Health Care, Inc., Q1 2009 Earnings Call Transcript
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