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Executives

Allen F. Wise - Chief Executive OfficerShawn M. Guertin - Chief Financial Officer

Drew Asher - Senior Vice President, Corporate Finance

Analysts

Gregory Nersessian - Credit Suisse

Scott Fidel - Deutsche Bank Securities

Thomas Carroll - Stifel Nicolaus & Co.

Matthew Borsch - Goldman Sachs

Joshua Raskin - Barclays Capital

Charles Boorady - Citi

Ana Gupta - Sanford Bernstein

Justin Lake - UBS

Matthew Perry - Wells Fargo Securities

Doug Simpson - Morgan Stanley

Carl McDonald - Oppenheimer & Co.

Coventry Health Care Inc. (CVH) Q2 2009 Earnings Call July 28, 2009 8:00 AM ET

Operator

Good morning and welcome to the Coventry Health Care second 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. Please go ahead, Drew.

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, and Form 10-Q for the quarter ended March 31, 2009, 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. Q2 was a very decent quarter in all fronts from a financial, operational, human resource, and with improved organizational structure in our company. We’re making good progress in most areas just about every month. Progress to me equates to a better foundation, better focused staff, and a longer-term view of our business as opposed to spending all of our time on day to day issues; longer terms in the sense that we’re thinking a lot more about tomorrow than day to day challenges even though, believe me, there is always enough day to day issues.

As we discuss our business today, I think it might be helpful to look back to some of my comments during our Q1 conference call. At that time, I felt that our business was settling down or stabilizing after a challenging 2008 and huge Medicare growth during the 2009 enrollment period. Another quarter of experience has solidified these feelings further.

At our Q1 call we said that there was a high likelihood of exiting our private fee for service business, and in fact, we did. Revenue reduction in 2010 and lack of long-term business prospects feel this decision.

During our last quarter, I also shared my significant concern about serious administrative and operational shortfalls in our Medicare enrollment activities. We used huge resources last quarter from both inside and outside our company, and I’m very pleased to report that we have for all practical purposes successfully addressed a large majority of our operational issues and have successfully reconciled our enrollment file. Our operational performance metrics are demonstrating very substantial improvement and closing approaching CMS guidelines.

Moving my comments from Q1 to Q2 developments, we entered a definitive agreement to sell our Medicaid non-risk administration business to Magellan Health. The decision to sell this business was one of focus and a view that we’re better off using our resources to grow our Medicaid risk business.

On that subject, as most of you know, we were successful and be one of too many secure companies to be awarded a risk contract in the State of Nebraska. The win was a direct result of the huge team effort to get serious about more Medicaid growth. Unfortunately, two of the unsuccessful bidders filed appeals, and we learned very recently that the Department of Welfare in Nebraska has chosen to invalidate the entire RFE process. The invalidation did not have anything to do with our bid and we will continue to evaluate our participation in Nebraska.

We continue to believe that even though revenue can be a challenge with the current stress in many state budgets, Medicaid is a business we can, should, and will grow.

As we previously announced, a significant number of executives who were part of our company in the past have returned. In Q2, we were successful in recruitment of two highly qualified new executives for future leadership. Paul Conlin has joined us to deal with our Medicaid program, and in addition, will develop better resources to assist and manage our current and future aged, blind, and disabled population. We’re also close to reaching an agreement with an individual to fill our vacant Chief Medical Officer spot.

While Shawn Guertin will review our businesses in more detail, I have some brief comments on our 7 principal businesses. First an overview.

In general, our 7 basic businesses provided very decent balance and a good foundation for an uncertain future. We have a good executive team, better organizational structure at the end of Q1 with my direct reports down from a number of 15 to 7 during the quarter. Our health plans and corporate sales activities have been placed under Michael Barr, who has been with our company for 6 years and in the past was responsible for Utah, Nevada, Idaho, and Wyoming. Mike is an actuary by training and during his tenure in our company, has earned the respect of the entire organization. We believe that Mike is uniquely qualified to lead health plan operations at this time.

In a few words, we got solid businesses, good people, good structure, good focus, and very solid financial performance. Management changes are largely complete with people in the right place, all of which results in optimism for the future on my part.

Our businesses, as Shawn will provide specifics just briefly, in the group which includes the individual business, commercial group and individual, our margins are excellent and stable, membership is a bit of a challenge. We need to do better in sales along with improving our cost structure to provide better value for our customers, and over time, we will.

Our individual product is going well, however, we well understand that the future will require a substantially different product. Q3 will see us begin work in earnest on tomorrow’s individual product which will be unlikely to be different from our current efforts in the individual area in almost every respect.

Medicare coordinated care, I would say that the loss ratio is a bit higher than we would like, and Shawn Guertin will discuss our decision for pricing and product design for 2010 a bit later, but here is a reminder that the 5-point plan for 2010 to address the challenges in revenue on the Medicare coordinated care fees and a reminder for what we’re going to do to address these realities.

There were 5 areas; one, we need to get the risk adjusted revenue 100% right; work the plans to reduce unit cost, in all markets we’ve got a dashboard for lack of a better name to identify where our cost structure can be improved in 15 or 16 markets, and we will act on that. Number 3 is to help manage the members better, it’s our chronic care model, and we’re going to expend considerable resources in doing a better job on this front. We did a lot of work to get the plan design and revenue right; and number 5, and more about that, we need to do better in the SG&A area and we will.

Our part D business, we’re halfway through the year, and what I would say is so far so good. Q2 is okay and without surprises. Our growth in this area was huge, there are a lot of moving parts to this product; so, having another quarter consistent with our ’09 plan is highly satisfying.

Medical loss ratio is disappointing for the first 6 months. Revenue in our major plans increases ’09 over ’08 is soft in many of our markets, and I think in some of our markets, our patient management focus hasn’t kept up with this more difficulty environment. The company has added new leadership to the Medicaid area with Paul Conlin and he is in the middle of addressing these issues.

Workers’ comp short stories, same show as last quarter. We liked the business, feel like we have a good management team. The current economy makes revenue growth a bit of a challenge, but we feel there is an opportunity for 150 to 250 basis points of margin expansion over the next 24 months. Business performed well this quarter.

Networks shorter story still, similar to the last quarter, revenue was the same, good management team, good sales results. The business is on plan, and I would say the same for mail handlers and fee books on plan.

A significant effort is going into managing our SG&A area as we have to address both the loss of revenue from our exit of the private fee for service business and in addition make improvements in our cost structure in our 7 basic businesses.

Given the revenue challenge that exist today and that will exist tomorrow, controlling administrative cost is more important than ever, and while managing our admin cost has always been a priority, there’s room for improvement, and in addition, our exit from the private fee for service business presents a significant challenge in that we need as much of the fixed cost allocated to private fee and need to address as much of these costs on the private fee for service as we can. And I think even more important is low cost structure now that you can save your way to prosperity, but we definitely need to be in a position to continually invest where necessary, to develop new products for tomorrow’s world. Essentially, this effort is spending your dollars smarter, and the process is never easy and requires many hard choices.

People costs are largest SG&A expense and we’ve evaluated areas of opportunity in this area over the past 6 months and have begun eliminating certain positions across all business lines. So far this year, we’ve eliminated 500 jobs with 350 of these being enacted late in Q2. There would certainly be other actions taken in the remainder of 2009 and 2010 as we wind down private fee for service and implement other strategic initiatives.

In the non-people categories expanse, we stepped up our efforts to manage SG&A, and for example, we’ve negotiated or in the process of negotiating contracts with our top 25 vendors for both SG&A and capital expenditures, and as you might expect, we’re working on print, telecom, and office space initiatives as well.

Well, no silver bullets in SG&A, but it’s rather an accumulation of making good decisions every day and developing a culture that drives low cost structure, a smarter spending, and I think we’re making good progress.

I think the good news today is that we’re better able to address some of tomorrow’s opportunities and challenges as opposed to yesterday’s agenda as characterized to Q1 when we were talking about enrollment in operational challenges.

I think our businesses are well positioned, have a reasonably diversified earnings stream and a good cash position. We’re making financial progress with a good team and this team realizes that there’s always more to do.

A word about reform; well, I don’t know where it’s going to land but we’re spending our resources and efforts on what we can control and making some early decisions on where to place our bets. We’re going to focus on core competencies and no hobbies. Low cost is going to be essential. We’re beginning to work on what we believe will be tomorrow’s products, there’ll be substantially more resources in patient management, our chronic care model is going to be a priority for every year; I think the exposure is pretty balanced with commercial small group and individual, both our current product and the product that we will be developing in earnest in Q3, Medicaid, our Medicare coordinated care product, workers’ comp, our network rental management business, and our mail handlers and fee book business.

In closing, very briefly, it’s a very decent quarter, and with more thought and resources being directed toward the future.

Shawn Guertin is going to provide our financial report and additional details about our Q2 results and our prospects for the future.

Shawn M. Guertin

Good morning everyone. As you’ve seen this morning, we recording earnings per share excluding the impact of charges related to the pending divestiture of First Hope Services Corporation of $0.50 per diluted share for the second quarter of 2009. While the current environment is certainly not short on challenges, overall, I was quite pleased with the quarter.

Our cash flow generation continues to be outstanding and the performance of the businesses most critical to our success in 2009 was very encouraging. Every bit is important as the quarter itself is what these results portend for the full year 2009 as evidenced by our decision to increase our full year EPS guidance.

One of the critical hurdles for 2009 was the performance of our Medicare business; so I’m going to start off my commentary there.

First, on part D, you will recall that our guidance for the full year 2009 medical loss ratio was in the 84% to 85% range consistent with the 2008 full-year medical loss ratio results. After the first 6 months of this year, the medical loss ratio was very consistent with where we stood last year at the same point in time. I believe that this is a strong indicator that we’re tracking well with our full year guidance expectations, and considering that we’ve grown membership by about 67% since year end, this is a good outcome half way through the year.

While there are still 6 more months to play out with this new membership as well as a dynamic external environment to contend with, I feel better about where we stand today versus a quarter ago.

On Medicare Advantage, we had a very stable quarter as well with the aggregate medical loss ratio coming in at 90.4%, a result consistent with the first quarter result of 90.5%. In addition, we now have the benefit of some more mature claim experience for both the fourth quarter of 2008 as well as the first quarter of 2009, and the signs here are that our claim estimates are holding up well. One indicator of this is that unlike a year ago at the same point, we have experienced favorable reserve development relative to 2008.

Looking forward, we expect the medical loss ratio result in the second half of the year to be consistent with that experienced in the first half of 2009. This is as good a place as any to address one item in the area of claim reserves. Our days in claims payable decreased one day in the quarter, and this is entirely attributable to the private fee for service business. Our health plan days in claims are essentially unchanged from last quarter. This decrease is directly related to significant improvements in the performance of our customer service organization in the second quarter in terms of reducing the level of inventory of private fee for service claims in-house and thus improving overall claim payment time limits.

The other important event in the quarter related to Medicare was the submission of our 2010 bids to CMS. The first big piece of this process is making sure that the base you’re jumping off of is stable and well understood, and our results for the first 6 months of this year are reassuring in this regard. Nevertheless, we lean more in the direction of protecting our margins for 2010 with membership change being more of the open issue. We intend to accomplish this through prudent and conservative assumptions regarding revenue and cost trends as well as exiting smaller unprofitable geographies and products like underperforming special needs plans for example.

Given that we haven’t seen all the specific actions taken by our competitors, it’s still too early in the process to form a specific conclusion regarding 2010 performance, and in particular, membership change, but I believe it’s important for you to understand the philosophy and approach we embraced in the 2010 bid cycle.

I’ll now turn to our commercial group risk business which from a medical loss ratio advantage point was clearly the bright light in the quarter and one of the areas that contributed to our increase in full-year earnings guidance.

As you will recall, we started our pricing push proactively in the first half of 2008. From an operational perspective, pushing price through the system is never as easy as it sounds. Having said that, I couldn’t be more pleased with both the speed and commitment of the company in terms of executing in this very important area.

From a financial perspective, I’m even more pleased to see the results of our pricing action show up in the premium yield increase for the second quarter of 2009. In fact, we continue to see acceleration in the rate of increase and the premium yield this quarter versus last. Despite the fact that benefit buy-downs are elevated above our initial expectations for the year, we are nevertheless achieving our desired premium yield increase. The bottom-line of these two items working in tandem is that we are effectively getting more price increase year-to-date than we had previously modeled to the tune of about 75 basis points. This is a result of both getting more price increase in some places as well as getting our targeted level of price increase a bit sooner in some places; again, a testament to the agility and commitment of our sales, underwriting, and actuarial areas in terms of acting early and staying the course.

From a medical cost perspective, fundamentally medical cost trend in 2009 appears to be developing consistent with our expectations. In regard to industry watch-list items, we experienced a very minor amount of pressure in Q2 related to swine flu and we observed or first real uptake in COBRA enrollment rising from about 1% of our commercial group risk membership at the end of Q1 to around 1.3% at the end of Q2, an increase of approximately 3000 members.

It’s still a little early to have any credible visibility into the medical loss ratio on the new COBRA members versus the existing members, but as previously discussed, this is an item that bears close scrutiny going forward.

The take-away from this discussion of both revenue and medical costs on commercial is that based on the first two quarters of the year, we feel better about the full year commercial group risk MLR, taking our estimate down approximately 50 basis points. This was based on the more favorable outcome on premium yield partially offset by a prudent provision for other back-half pressure items like a growing COBRA population for example. As we discussed last quarter, we would expect the Q3 and Q4 medical loss ratios each to be sequentially higher than the preceding quarter.

Medicaid was a little bit of a good news/bad news tale for the second quarter. The good news is that the macroeconomic conditions straining membership and other business lines are creating a membership tail win here with membership up 10,000 lives, about 2.7% in the quarter. The majority of this growth was from two states, Missouri and West Virginia. The bad news part of the story is that we experienced a medical cost pressure and resulting pressure on the medical loss ratio in the quarter. The cost pressure is most evident in the areas of outpatient facility and physician with particular pressure in emergency room, outpatient surgery, and radiology. In certain markets, some of this pressure can be ascribed to new membership; however, this was not universally true across each and every market.

Having said that, the cost pressures here appear more real than transitory and we’re actively working on solutions. Based on what we’ve observed so far this year, we are assuming that we will experience a medical loss ratio result in the second half of the year similar to what we have observed in the first half of 2009.

Regarding the balance sheet and liquidity, I’m pleased to report that our overall position in this area remains strong and stable. We ended the quarter with approximately $550 million of free cash at the parent. In addition, during the quarter, we paid off a little more than $95 million in debt including $35 million on our revolving credit facility.

Our investment portfolio remains conservatively positioned with approximately $2 billion in cash, cash equivalents, and US Treasury Securities, and continues to be in an overall unrealized gain position. We will continue to be prudent and deliberate in terms of our capital allocation going forward with a reasonable application across acquisition, de-levering, and share repurchase being a likely result over time.

Let me now turn to guidance and start off with housekeeping. As has been our convention regarding pending transactions, we have not adjusted the detailed income statement items for the pending sale of First Hope Services, in other words, it’s still in there for full year 2009. We expect the transaction to close in the third quarter and our plan would be to adjust our detailed guidance for this on our third quarter call. As a reminder, while the detailed income statement amounts will change, we expect the transaction to be neutral to ongoing 2009 earnings per share after the one-time goodwill and transaction related charges.

So, with that in mind, from an overall adjusted earnings perspective, we are increasing our existing EPS range by $0.10 with about half of this coming from an improved outlook on operating earnings. We have updated the operating elements to incorporate an overall higher level of revenue as a result of higher than previously forecast Medicare volumes driven by both part D and private fee for service. This higher Medicare volume is partially offset by lower than expected commercial group risk membership.

In addition to adjusting our aggregate medical loss ratio for the increased proportion of higher loss ratio Medicare business, we have also updated our outlook on all of our medical loss ratios across the board reflecting the emerging 2009 experience including a reduction of 50 basis points in our expectation for the full year commercial group risk medical loss ratio. Despite the overall increase in revenue, we have decreased our full year guidance on SG&A, evidence of our strong belief in and commitment to low cost structure being a key success factor in this business.

In closing, the solid start that we were off to last quarter gained some momentum in the second quarter of 2009. Some of the watch-list items that concerned us at the beginning of the year appeared to be clearing as we certainly feel better about the medical loss ratios on commercial, part D, and Medicare Advantage versus a quarter ago. We continue to experience profitable growth in our individual and workers’ compensation businesses. We continue to operate in an excellent liquidity position.

Our investment portfolio is conservatively positioned and our cash flow generation is excellent. However, there is still happy year to play out and will play out amidst some awfully choppy waters. In addition, there are still some real macro industry challenges out there. For example, the challenges in turning around the commercial group risk membership picture in this macroeconomic environment are daunting. The ability to navigate the Medicare waters in this environment of ever-increasing reimbursement pressure will not be easy either. However, I believe the key to survive and may be even thriving in the face of these challenges in all about low cost. So, I feel very good about our assets, our culture, and our proven commitment to becoming an efficient, effective, and true low cost player in this industry.

Operator, we will now open up the call for questions.

Question-and-Answer Session

Operator

(Operator Instructions). We’ll take our first question from Gregory Nersessian - Credit Suisse.

Gregory Nersessian - Credit Suisse

First question on the Nebraska Medicaid, what happened there and what’s your understanding of how it’s going to play out, are they going to re-bid the whole state, you’re going to have to resubmit your bids, or are they just going to re-score it? Any color there would be helpful.

Allen F. Wise

We’re not certain. What happened is that two of the unsuccessful bidders filed an appeal and we learned last week, I believe, it was very recently; at this time, their decision is to invalidate the whole process; we’re having discussions this week and we’ll send the letters since we weren’t in any way the subject of anyone else’s appeal to see if they can settle it among the other three, but the real answer is, we don’t know. Technically, they were not upheld, they technically took the positions to invalidate the whole process; we don’t know, it’s yet another education about being in the Medicaid business, but we’re following, I’m following through the strong position in the Mid West, strong position in that state, and scored the second highest score on the RFE process of the people applying for the risk contract and have a very solid position there and would like to see where it plays out.

Gregory Nersessian - Credit Suisse

So, if they ask you to re-bid, you’re still interested in that business?

Allen F. Wise

Well, I think yes, but I would like to know what the rules are; I’d like to see if the financial information is the same and to be satisfied that we’re not going to spend the time and effort if we don’t have an even chance. So, the answer is yes, but the devil is in the details.

Gregory Nersessian - Credit Suisse

And second question on the commercial premium yields came in a little bit better than expected, should we interpret that as perhaps the pricing environment is more conducive to pushing those kinds of yields through or is that may be reading too much into it, is it more a function of mix? Any color on your ability to pursue the yield?

Allen F. Wise

Shawn should answer part of that question; no, it wasn’t easy and I think we paid a price in membership for that; it was a highly disciplined process and we have spent an enormous amount of time looking into our underwriting model, looking at renewals, and we paid a real price on not our ability to go get new business necessarily but we paid a real price in the renewal area. Things have changed a bit; it used to be if your renewal was within 500 basis points and they liked your plan and you provided good service, which we do, that people will stay with you, but that’ll change for a 100 basis points in today’s economy; so, it was difficult and has been difficult, and we paid a bigger price than would be ideal in membership.

Shawn M. Guertin

I would agree with what Allen said; I would not sort of read that through to some sort of change in the external environment. I think it speaks more to sort of the speed and commitment that we had to sort of staying the course on this topic and plugging all the leaks that we could see as soon as we could see them. So, probably this is more about just sort of our commitment to it than a broader read.

Gregory Nersessian - Credit Suisse

Okay, just one more, the Medicare part D MLR, the seasonality on that looks a little muted this year relative to last year, did you give guidance for that full year or second half with the MLR you expect on part D?

Shawn M. Guertin

We’re still in the 84% to 85% range on part D for the full year.

Operator

Our next question comes from Scott Fidel - Deutsche Bank Securities.

Scott Fidel - Deutsche Bank Securities

First question, can you give us an update on what your new expectation is for commercial group risk enrollment and for commercial MLR for the year?

Shawn M. Guertin

The commercial MLR is down 50 basis points from previous guidance; it used to be 82.5% to 83%, so we would be 82% to 82.5% now. The commercial group risk in isolation is probably down more like 12%; we do have individual growing, so when you put those two things together, are kind of commercial risk membership which I think is the way other people talk about it sometimes is down 9%.

Scott Fidel - Deutsche Bank Securities

Second question just on investment income, looks like you had a nice balance sequentially up around 60%, could you just talk about factors driving up the investment income and then if there were any capital gains realized in the quarter?

Shawn M. Guertin

The biggest things driving that as you’ll see in the cash flow statement is part of the way that we retired debt as we bought some of our bonds out in the open market, and so, there is about $0.04 of gain in the quarter that is a result of bond buy-back, and that’s really the line where it shows off; that largely explains the difference from quarter to quarter. The level of realized gains is small and it’s consistent from quarter to quarter.

Scott Fidel - Deutsche Bank Securities

And then, I know it’s early here for 2010, but would be interested if you guys wanted to opine a bit on what things are looking like in terms of employer’s early thoughts on product and benefit designs for 2010, and how you think price competition in the industry will start shaping up as we get into the selling season for 2010?

Shawn M. Guertin

I think it’s a little early; I probably wouldn’t comment on it, it’s hard; I think in the middle of what we’re going through now sort of economically; I would say that the pricing environment has been fine, people have been rational, it’s been tough but it’s been fine; I wouldn’t anticipate that really changing for 2010, and may be on the opposite side of that is with everything going on today, there is always pressure on cost management and employers want to see somebody bring book products and capabilities to bear to continue to do a better and better job on total cost management for them.

Scott Fidel - Deutsche Bank Securities

Are you guys building in any additional reserves for the remainder of the year in terms of potential uptake in the severity of swine flu?

Allen F. Wise

What we’ve done is I think there’s probably two meaningful items which is sort of how does this COBRA subsidy and the impact on enrollment and loss ratio play out potentially as well as swine flu; as I mentioned, probably pricing in an absolute is 75 basis points better so that the amount we take in our loss ratio guidance as I mentioned is only 50; so, we’ve built in on a full-year basis 25 basis points of cushion and to follow my math so far would be about 50 basis points in the back half of the year whether that be swine flu or COBRA pressures.

Operator

We’ll take our next question from Thomas Carroll - Stifel Nicolaus & Co.

Thomas Carroll - Stifel Nicolaus & Co.

Two quick questions for you; last quarter you provided a good explanation of how you’re removing SG&A related to your private fee for service business, that you’re eliminating, and I think you said there was $10 million to $20 million of SG&A that’s going to be difficult to eliminate; with another quarter under your belt, I wonder if there is an update to that number or expectation?

Shawn M. Guertin

No, the number is still the same in terms of its aggregate pot, and what that really means is that some of that may be we can get out directly in the Medicare area, but if we don’t get it there, then we have to get it elsewhere across the company, and as Allen mentioned in his comments, we’ve had a very broad-based across the company effort to look at SG&A from every angle; so, I would tell you that I continue to feel confident, maybe a little more confident, that we can certainly manage through the revenue loss and what that means based on another quarter and identifying specific initiatives that we can undertake to get that out.

Thomas Carroll - Stifel Nicolaus & Co.

So, maybe that $10 million to $20 million expectation is about $5 million less perhaps; sounds like it is moving in the right direction?

Shawn M. Guertin

I think we have a plan to solve it all. We think we can solve the whole problem, and some of that we’re executing on now, but I would say the aggregate size of the pie isn’t any bigger; that’s good, and I think we’ve got plans like I said to keep it a neutral item for us, which means eliminating that $10 million to $20 million of expense elsewhere.

Thomas Carroll - Stifel Nicolaus & Co.

Excellent, and then secondly, within your commercial book, do you feel you’re seeing any unusual physician or other provider behavior as a result of the recession; maybe doctors doing more things to get paid for?

Allen F. Wise

They’ve been doing that for a very long time.

Shawn M. Guertin

I think that’s the problem. The answer, sort of, is yes, but I am not sure. To some extent a lot of the things that challenged us last year had that look and feel to it and we continue to see those going on today, and I can’t really prove or disprove that those are more macroeconomically based or not. So, what I would say is that our trend results as we see them emerging in the first half of 2009 on commercial appear consistent with the result that we had in 2008.

Thomas Carroll - Stifel Nicolaus & Co.

In 2008, you commented more about the medical costs being sourced from a unit cost perspective. Has that turned into more of a utilization source in 2009?

Shawn M. Guertin

There were certainly unit cost pressures, but they were things as we have torn them apart that might manifest themselves on the surface as unit cost, but with regard to your point, a simple example was, if I used to show up in the ER with chest pains and I used to get a chest x-ray and now I get an MRI, that looks like unit cost increase because I haven’t done anymore procedures, but it’s a more expensive procedure. To me, that’s not through a unit cost in the classic way we talk about it. So, there are clearly things that have gone on in the system that look like both providing more services or providing more expensive services in lieu of less expensive services, and again, I think that’s going on today and I think it was going on a year ago. In my opinion, it’s very difficult to ultimately cheese out the recessionary effects or the cause and effect of the recessionary environment. I would say in aggregate we do not see accelerating trend in ’09.

Allen F. Wise

It’s a type of question that defies an easy answer. You look at 16 different marketplaces, what we’re doing is taking a micro look on a case-by-case basis, market-by-market basis, service-by-service, and seeing where the norms are being exceeded and developing a plan to address those, but it defies some easy answer.

Operator

We’ll take our next question from Matthew Borsch - Goldman Sachs.

Matthew Borsch - Goldman Sachs

I am just wondering if you can characterize, I know you’ve gotten a question about the commercial pricing environment a couple of times here, but can you draw any distinction to the level of price competition you’re seeing regionally or perhaps between the public and major not-for-profit plans?

Allen F. Wise

I think it has always been on a marketplace-by-marketplace basis; people that price what we believe is rationally in marketplaces, where we know our cost structure is at the very least competitive, has always evolved and without naming competitors, we had a large competitor in Atlanta that was doing things that looked irrational to us for a long time and in fact turned out to be irrational. So, it kind of comes and goes. A given is always Pittsburg, which is always difficult between Highmark and UPMC, it’s been difficult for a long time, but generally speaking, I think that our cost structure is competitive everywhere we’ve elected to be in business. I think we have a good handle on trends and the environment is one step more difficult. One way to characterize it is there is a smaller pool, I would like to characterize this as a smaller pool of fish with more sharks; the small group, the mid-size group pool is diminishing because of decision employers and individuals make about providing coverage at least for today. So, it’s competitive and difficult and when you go from difficult to irrational, it sort of ebbs and flows and comes and goes.

Matthew Borsch - Goldman Sachs

Fair enough; I would just observe from what we’re hearing from the middle market consultants and some brokers generally as compared to a year ago, the pricing discipline in the industry has noticeably improved; is that consistent with your view?

Allen F. Wise

I think the best way to answer that is to say that the discipline that Shawn and his group have applied to getting our margins back to where we think they need to be has caused us to pay a substantial price in some areas. If you think about the 12% hit in our commercial book, you would want to think about that as sort of split evenly; 6% of that is in-group losses where we retain the group that either do the layoffs or employees electing not to continue coverage or insolvencies in the small group area; that accounts for about half of the loss. The other half is a price that I think we paid for our discipline, and I think we can, as I have outlined in my comments, I think that in some of our markets where we can do a better job with the sales/underwriting skill set and discipline there, and I believe that our new leadership managing our health plan activities, Mike Barr, who is an actuary in underwriting by training, who has been with our company for six years, and he and Shawn I think are improving the actual application of our pricing and underwriting model a bit better than we have in the past. I think there is room for us to improve on that front. It’s not an inconsistent story here; it’s about the details, it’s about the quality of the information, the quality of your people, and probably not a dramatic change in general in the last 12 months.

Operator

We’ll take our next question from Joshua Raskin - Barclays Capital.

Joshua Raskin - Barclays Capital

First question on the divestitures/exit businesses, the First Health asset that you sold and then the Private-Fee-For-Service; I was wondering what the contribution was in the first half of the year to the overall results.

Shawn M. Guertin

We typically do not disclose that at that level. Again, on First Health Services, we expect by use of the proceeds from the sales of that in essence is going to be neutral to ongoing 2009 earnings. The Private-Fee business as we’ve talked about, running MLR in the mid 90s, is at best a breakeven business. So, the contribution really of either isn’t really all that material to the total company.

Joshua Raskin - Barclays Capital

I understand the First Health sensitivity of the assets, but you have the Private-Fee-For-Service which sounds like that’s not a big loss in the first half?

Shawn M. Guertin

No, I wouldn’t say big.

Joshua Raskin - Barclays Capital

Second question around the use of the capital; you guys paid down some debt in the second quarter and obviously had other alternatives; exchange bonds, trading the discounts, what have you, but is that still the preferred use of capital; is there a need to get the cash down below that low 30s range now?

Shawn M. Guertin

I wouldn’t say a lot below that, I think our next settling point there is to call the debt-to-cap right around 30. So, part of the activity that we’re undertaking is designed to get us there this year and the activity in the second quarter was largely a piece of that. To some extent you always have to be a little flexible and opportunistic, but as I have thought about this, certainly over the past year, I would really like to have a balanced application of capital, whether that be some to share repurchase at the right time, some to de-levering to satisfy our commitments in that area, and some to build the business for the future in terms of M&A. I don’t feel like I would want us do only one and the exclusion of the others.

Joshua Raskin - Barclays Capital

That debt-to-cap; you guys have been in that 33% on average range for the last couple of year going back, even ’07 and before; is there some sort of pressure, is there a rating agency discussion or is there a thought process that maybe you’ll need to raise some debt to do M&A or whatever in the future; I am just curious, why now, why is the debt-to-capital of 30% a more comfortable range?

Shawn M. Guertin

It has something to do with us as a company feeling like that is a comfortable position for us to sit in a normal time, but as you know, as we have built the company, we would like to be able to see some of the M&A opportunities and that requires us at times to temporarily jump up in the debt-to-cap and de-lever back down. So, I don’t like settling at a higher level and in essence having no powder left if that’s what you want do again; there is no imminent thing here. I like sitting at 30% area, but opportunistically that does afford us the opportunity to move up a little bit if need be.

Joshua Raskin - Barclays Capital

Last question on that; the First Health Services sales, is that a de-leveraging event after the write-down?

Shawn M. Guertin

Not really. The way to neutralize earnings is probably more share repurchase based although it’s possible that de-levering could be a small piece of that, but I would think about that more as share repurchase.

Operator

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

Charles Boorady - Citi

Just following on Josh’s questions on the $550 million of cash that you described as deployable at the parent; that’s more than 15% of your entire market cap, and I am wondering if you could elaborate a little bit more on your plans for the use of that cash and what your debt covenants would allow in terms of share repurchase or potential dividends.

Shawn M. Guertin

Let me go back; I think it’s important for everybody to remember where some of that $550 million came from. Remember that in the dark days of October when money markets were breaking the buck and we had our own earnings issues, we had to do subsidiary infusions; we took $440 million of that off of our revolver. So, in many ways, that’s borrowed money that if things went according to plan, the plan was to pay back at some point. So, it’s not like it’s been sitting there for an extended period of time and nor did it come from earnings. To get to our debt-to-cap targets of around 30% we would need to de-lever and use cash of about $300 million this year and we’ve used $80 million of that so far. So, a substantial amount of that will go to de-levering. The only real financial covenant we have is on our revolving credit facility and that is a modified debt-to-EBITDA covenant of around 3:1. I believe we’re around 2.5:1 right with carrying that revolver draw, but clearly there is a non-zero limit as to what we can do there as well; but again, part of this was to make sure we had the liquidity to fund our operations. Our first priority here is to deliver on our de-levering commitment that we need to make and then as always, it’s both the financial exercise to think about share repurchase as well as the business exercise to assess what’s out there from an M&A perspective to build your business.

Charles Boorady - Citi

Thanks for clarifying that. I have a question on your Medicare business and what your present thoughts are on how that book of business might look going forward specifically around plans for exiting Private-Fee-For-Service markets and the scaling back of investments and building out networks. Can you give us a sense for how you see that book looking next year or beyond?

Shawn M. Guertin

As I alluded to, our plan in 2010 would probably be, we’ve exited a few small geographies and I emphasize smaller, we’ve exited some of the special needs plans that we didn’t think had merit or were performing, and so in my mind as I think about that in the near term, I don’t know what the membership picture looks like without seeing whatever other people have done, but we got a little bit smaller footprint. I would not confuse that though with not investing in this business. I think on the contrary I think a redoubling of our efforts in terms of our patient care models especially in the area of chronic condition management is really something that’s at the forefront of our thinking on this. For that matter making sure that we’ve fully optimized the risk adjusted portion of the revenue is something that we might invest in as well. To take SG&A out of the infrastructure might require some upfront investment. So, while we’re not investing in building a network for the Private-Fee business; I think we view the coordinated care product as a pretty critical piece of our portfolio going forward and would intend to invest in it fully.

Allen F. Wise

I think I’d add to this a few things, little hobbies; we’re going to be in marketplaces where the cost structure is as good or better than anyone else there and those five basic disciplines that it takes to be profitable that we announced in Q1 and again earlier this morning; aren’t just regular things, but things that we’ll work at everyday and take seriously. We’re going to stay in that business, we think, for what we understand about that now, and do the basics better and so you could make a case that membership may due to competition leak a little bit, but not significantly, and that we’re committed to earning our margin in that next year and hopefully revenue will settle when the world realizes that the 4% reduction in revenue that the coordinated care people are going to give out this year is really a tax on the people that can afford it the least. Hopefully, revenue will stabilize, but in the meantime we’re going to execute on those five basics we have identified very well and see what happens.

Charles Boorady - Citi

It looks pretty impressive that you grew Medicare Advantage 37% even while the loss ratio improved 280 basis points year over year and I wonder if you can just elaborate on how you achieved that and maybe was there a durational benefit from having new lives that haven’t fully matured yet, and if so, is that headwind going into next year, and then maybe if you could elaborate on how you were able to improve the loss ratio so much even while growing the book this year.

Shawn M. Guertin

Charles, I think the biggest part of that is, you got to remember last year we actually had $50 million of unfavorable Private Fee development and so in some ways that loss ratio improved and it comes more from just lack of that this year and a proof to an underlying fundamental improvement. When you think about coordinated care, I wouldn’t think about that as the loss ratio being a lot better. I think, to your point, it’s still a nice growth story, I think, that has to do with cost structure, product design, and frankly even some things we did on the distribution side this year that led to that number shift increase.

Charles Boorady - Citi

What is the headwind that you would see, as the book matures loss ratios tend to rise; so as we think about next year, how much pricing actually would you need to keep the loss ratio stable on that new book of business that you brought in?

Allen F. Wise

The headwind is the 4% reduction in revenue 2010 over 2009 and when you add medical trend to that you get something like 10% or 11% that you’re going to have to make up to those five things we talked about; product design and premium sharing of the part of the members and the list that we talked about earlier. So, there’s a decent amount of headwind.

Charles Boorady - Citi

I guess this is even greater than that and that’s why I am asking in light of the new lives that you brought in this year to the extent that as books mature, loss ratios tend to rise.

Allen F. Wise

We’ve been in coordinated care business in Pennsylvania for 12 years, we’ve been in it in St. Louise for 10 years, and we’ve been in Kansas City, sold in every major marketplace; so we have a long history of adding some memberships that are having an older more mature membership and really no surprises.

Shawn M. Guertin

Charles, I think the best way I can answer that is that in the 2010 bids, as I mentioned, we tried to make conservative and prudent assumptions about cost increase and certainly one of the factors we thought about was a combination of product design and the fact that we might have less new business in 2010 versus 2009 and what that might entail, and using those more conservative assumptions, we tried to solve for holding our margins stable. I think we’ve approached the issue cautiously. Again, it’s difficult to opine because it’s not only a function of what you’ve done, it’s a function of how much or how little new business you get next year; I just don’t have a good feel for that until I see the competitive products.

Operator

We’ll take our next question from Ana Gupta - Sanford Bernstein.

Ana Gupta - Sanford Bernstein

My first question is on the individual book of business; can you provide us some more color on where the sources of growth are, is this coming more from the unemployed and all the retirees perhaps or are you actually seeing active both employees and dependents moving out of group coverage?

Shawn M. Guertin

I think it’s probably all of the above and I would say in general when we’ve looked at this in the past it has not been early retirees per se as much as it has been uninsured or maybe people moving out of the group market, and again, it’s largely a new product, it’s only a couple of years old in most of our markets; so the growth is pretty widespread geographically across most of our plans.

Ana Gupta - Sanford Bernstein

Then a mirror image question to that; are you seeing any selection biases in any specific groups; one of your competitors has talked about that and can you elaborate a little more about your underwriting practice, let’s say relative to the Blue who apparently use something called Gatekeeper, and then maybe the other for profits, and is there a reason that you’ve been able to stabilize your book of business at this point?

Shawn M. Guertin

The biggest thing that we’re seeing is there is probably a slight aging going on in the book because it’s really just lack of new hires. You have people falling out and normally the new hires come in at a younger age, and you’re not seeing fundamentally anything biased in the people who are leaving versus staying, but the lack of new hires coming in who normally come in a younger average age, is nudging the average age of that group commercial risk block up. We haven’t really seen any bias that the people leaving or healthier or sicker as you would suspect; it seems pretty close to the book average overall. Other than the slight aging in the population because of that, we haven’t observed anything yet.

Ana Gupta - Sanford Bernstein

On the cost trend, it appears that you’ve stabilized your trend; is your baseline now higher but you’re not seeing any additional coding intensity and on the contracting side do you feel that that’s played itself out and your actions are taking hold and is going to trend that back down?

Shawn M. Guertin

I do agree it’s been stable, we’re not seeing acceleration in some of the issues that we experienced last year. I would not say that everything that we have identified as an action plan is in place yet, and I am optimistic that we can actually still work the number down over time. An example is bringing in the radiology benefit management is something that we haven’t executed on yet; that’s related to our transaction with Magellan. So, I think there are opportunities. We’ve certainly done somethings, but I would agree the environment appears stable in the first half of the year and we’re not seeing acceleration so far this year.

Operator

We’ll take our next question from Justin Lake - UBS.

Justin Lake - UBS

First just on the SG&A, just curious to see if there’s any, you mentioned all the transition on the job front there; the 350 job losses at the end of the quarter. Is there any severance in the numbers here?

Shawn M. Guertin

Yes, that’s just been expensed.

Justin Lake - UBS

That’s just been expensed; can you give us a round number?

Shawn M. Guertin

I know that year-to-date severance expense is about $14 million all in and I want to say it was, if you hold on a second I have the exact number for the quarter, I think it’s $6 million off the top of my head, but let me…

Justin Lake - UBS

Is there more of that built in for the rest of the year?

Shawn M. Guertin

For whatever actions we have in our plan that’s incorporated in our guidance for the year.

Justin Lake - UBS

So, as you come out of the year and you’ve got this run rate, the run rate should be somewhat different I would say; can you give us the decent quarterly expectation of where, after all these SG&A initiatives, do you expect to come out at the end of the year; the current is somewhere in the $565 or $570 range?

Shawn M. Guertin

If you look at our guidance you’ll see that you’d probably be in that range, potentially a little bit up for the third quarter, and then we always have higher spending in the fourth quarter related to Medicare and commercial open enrolment; you can probably just back into the number; I think, it’s in the $580 or $590 range for the fourth quarter.

Justin Lake - UBS

Do you expect to get improvement from there in 2010 as well or do you feel like these are most of the initiatives and they should be done by the end of this year?

Shawn M. Guertin

I don’t want to get into 2010 guidance per se, but there are things on our plans that would carry us and have benefit into 2010 as well.

Justin Lake - UBS

Great. A couple of questions on the MLRs; on the commercial side obviously you’ve done a good job on the net pricing for the year and I think there has been some expectation that more of that improvement was going to occur in 2010, and I am just curious, you still think that the commercial MLR improvement, let’s just call it a 100 basis points, in 2010 would be achievable given that you’re getting a lot more pricing than maybe you had expected early on.

Shawn M. Guertin

I think it certainly is achievable, but that is one of the things we need to play out if we get some of that early this year, obviously in the past we’ve talked about actually 150 basis points that we’re pushing harder than trend. If we get some of that earlier, some of that could be in ’09, but there still should be an opportunity for 2010.

Justin Lake - UBS

Okay, so is it fair to say that this 50 basis points or 75 basis points or are still about 150?

Shawn M. Guertin

Yes, you could think about it that way, but now we’re getting into the danger of this and there’s an awful lot of moving parts, whether it is COBRA and the MedCost trend, and so, I would just caution you to be careful to look at any single factor in isolation, but yes, you can think about the 75 that way.

Justin Lake - UBS

Just a quick numbers question; on the individual membership, can you throw out that number for us for the quarter?

Shawn M. Guertin

It is 138 I think.

Operator

We’ll take our next question from Matthew Perry - Wells Fargo Securities.

Matthew Perry - Wells Fargo Securities

Just a couple of questions Shawn; last quarter I think you’d talked about generating dividends to the parent company of about $150 million in Q2 through Q4 of this year, and it looks like you might have already gotten close to that figure; do you have an updated view on dividends to the parent in the second half of the year?

Shawn M. Guertin

I think we got $89 million in the second quarter, and I think $130 million is our full year estimate right now.

Matthew Perry - Wells Fargo Securities

$130 million for the full year and $90 million through the second quarter; is that right?

Shawn M. Guertin

Correct.

Matthew Perry - Wells Fargo Securities

On the Medicaid business you’re selling net of taxes and transaction costs, what will the proceeds be?

Shawn M. Guertin

Around $100 million probably.

Matthew Perry - Wells Fargo Securities

Okay great. Those are the only questions I have.

Operator

We’ll take our next question from Doug Simpson - Morgan Stanley.

Doug Simpson - Morgan Stanley

Recognizing that there are a lot of moving parts and the debate very much remains in flux, could you just give us a sense of how you would see the competitive landscape shifting in a state like Pennsylvania with a little bit more limited underwriting restrictions relative to New York or New Jersey if we saw a commercial market reforms come to bear; and then maybe just wrapping to your commentary, what are you seeing from competitors; is there an opportunity for increased M&A as some of the smaller competitors think about maybe the potential costs associated with some of these reform ideas that are being thrown around?

Allen F. Wise

Regarding your second question, we are seeing some minor signs of some provider-based businesses and some of the competitors rethinking their options in what could very likely be a difficult environment for the future, and it’s one of the three things that we think about are uses for cash and historically we have been opportunistic when these things come to bear and we will be looking at them. Really hard to guess on a state by state basis what the environment would be like for the future, but I think we have made some early guesses and some early bets where Medicaid is a piece of that. The individual market as we know it today which is primarily a distribution source through brokers with very high commission rates, it’s a heavily underwritten product, with lots of policy defenses, and our belief is that there will be a very good individual market, but it will have little in common with that. You’re going to have to have a distribution source that doesn’t have 20% in frontier commissions or you’re not going to have the same policies defenses, it’s going to be likely underwritten and so, it’s one of our initiatives to start off as we continue to sell our current product to start off with a clean piece of paper and develop what we think tomorrow’s individual product will be, how it’s going to be distributed and issued, and how we’re going to direct people toward an efficient use so that the value proposition for the member is good, how you’re going to live with probably mandate of loss ratios that are inconsistent with today and make the margins. So, just one of the things; part of our SG&A efforts are to improve the bottom line, but part of the SG&A efforts are to develop a small war chest of sorts to invest in the future and we have picked the individual as the first thing we need to start off with a clean piece of paper and it will have more to say about that in another quarter.

Operator

We’ll take our final question from Carl McDonald - Oppenheimer & Co.

Carl McDonald - Oppenheimer & Co.

Could you talk about the rate increase that you got on July 1 for the state of West Virginia account and what impact that’s having on the Medicare book in the second half.

Shawn M. Guertin

I don’t have the specific number in front of me, but it’s a fairly nominal increase. I wouldn’t have thought that if my memory serves me correctly, that it’s the kind of thing that will move it around in the second half of the year. You said Medicaid in West Virginia right?

Carl McDonald - Oppenheimer & Co.

Medicare; Private-Fee-For-Service.

Shawn M. Guertin

Medicare; it was a trend like increase, the group accounts have generally run closer to expectation and the individual block. So, that won’t be very meaningful in the second half.

Carl McDonald - Oppenheimer & Co.

The second question; Allen, just following up on your comments on the individual book; is that something that you see happening if reform happens or do you see the changes coming to the individual business regardless of what goes on from a reform perspective.

Allen F. Wise

It will be a part of reform.

Operator

I would like to turn the call back over to Mr. Wise.

Allen F. Wise

No more closing comments. Thanks a lot for your interest and participation.

Operator

That does conclude our conference. Thank you and have a nice day.

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Source: Coventry Health Care Inc., Q2 2009 Earnings Call Transcript
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