Coventry Health Care Inc., Q3 2009 Earnings Call Transcript

Coventry Health Care Inc. (CVH)

Q3 2009 Earnings Call

October 30, 2009 8:30 am ET

Executives

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

Drew Asher - Senior Vice President, Corporate Finance

Analysts

Joshua Raskin - Barclays Capital

Scott Fidel - Deutsche Bank Securities

Ana Gupta - Sanford Bernstein

John Rex - J.P. Morgan

Justin Lake - UBS

Christine Arnold - Cowen and Company

Matthew Borsch – Goldman Sachs

Matt Perry – Wells Fargo

Presentation

Operator

Good morning and welcome to the Coventry Health Care third 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 June 30, 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. Thank you for joining us, and thank you for your interest in our company. We just completed an excellent quarter with all seven of our core businesses performing at or better than our earlier expectations. If you remember our Q1 and Q2 conference calls, my discussion about our company explained a need for better focus on our core businesses, the need for additional management talent, the need to address serious deficiencies in our government programs in both finance and our administrative process along with beginning substantial SG&A reduction efforts. Being accurate and credible about representations will make a better company, and it means everything to me, and I am pleased that these areas and others in our company have improved substantially. This progress is reflected in both our financial results and our comfort level in understanding where these businesses are today, and even more important, what needs to be done for tomorrow.

During Q3 we finalized the sale of our Medicaid administrative business to Magellan Health, and we signed a definitive agreement to purchase Preferred Health Systems from the Via Christi Health System in Kansas. Both events reflect our efforts to focus on our core competencies. I am both pleased and optimistic about the long-term Via Christi relationship and our combined potential to reduce healthcare costs in the mid west. It is interesting that after the Via Christi agreement was announced some individual on a blog expressed the view suggesting that we didn’t have control of our existing business and therefore should not have purchased the plan. I found that interesting because nothing could be less factual. Our core businesses are under excellent control. Making health plan acquisitions and improving these businesses over time is something we know how to do and have done successfully for over a decade.

Our seven core businesses are stable and are performing well and we know exactly what to do with this new health plan. We’re hopeful that the acquisition will close some time in the next 90 days. Although it is too early to declare victory for 2009 it is instructed to look back over the past nine months to understand the changes that we have made, some major, some subtle, and the things we have accomplished at Coventry to set us up for future success.

First, I am very pleased that we have delivered financial stability and predictability over the past few quarters. It’s a critically important element in our business. We originally told you we would earn $1.70 to $1.90 per share and last quarter we raised that to $1.85 to $1.95. Now as you can see on the press release, we’re guiding to a mid point of $2.02. We have told you that we would have unrelenting focus on our seven core businesses and we have. We made swift management decisions early in the year and removed much of the internal clutter necessary to get the necessary focus. As I stated earlier, we executed a non-core business to Magellan which closed in Q3. We also exit a small number of non-performing distractions that we inherited over time. Our Via Christi acquisition also mentioned earlier allows us to build our core health plan business in a very key geographical area for us.

This organization is crystal clear on our objectives and our areas of focus. In the area of Medicare, as you will recall, we decided not to spend $50 million in an attempt to build out a partial private fee for service network and exited this product for 2010. We have a plan which we have already begun to execute to eliminate all SG&A for this business in Q1 and Q2 of 2010.

Given what the federal government has done with reimbursement, staying on the Medicare subject here, we focused on setting the appropriate level of benefits in our core Medicare Advantage HMO and PPO products for 2010. Despite the necessary benefit adjustments due to 2010 reimbursement levels, we are generally satisfied with their product decision relative to our peers. On Part D, we believe we were prudent with our pricing as evidenced by the reduction in auto-assign region in 2010. We feel good about our market positioning in both the low income and retail products.

Staying with Medicare and Medicaid here, we continue to work on improving the coordinated care model, to deliver value to both the federal government and to Medicare beneficiaries. In our Medicare operations we worked through the spring and summer to clean up our Medicare enrolment process that was very stressed due to the historic explosive growth in the 2009 enrolment period. We made enormous progress in this area and received high marks in the CMS enrolment readiness audit. We’re absolutely committed to vest business practices in this area of the company and we will continue to improve and execute in that area.

We invested in our Medicaid business in the area of hiring new leadership and adding new personnel to staff this business for future growth. We paid down $194 million in debt in the quarter with more to come while maintaining a liquid and flexible balance sheet which boards well in these challenging times. Well enough history but there is much more to do. We’re working hard on stemming the macro-pressure on our commercial risk membership. While some of this is driven by the economy, we can do better on sales, we can do better on retention, and we will. As we reported last quarter, we now have one leader, Mike Barr, for health plans, and Mike is a proven executive with sales, underwriting, and actuarial skills from one of our more successful markets. Mike is making good progress laying the foundation for future success in these local markets.

We’re seeking ways to grow our seven core businesses, primarily through organic initiatives where possible, and the example I gave in Medicaid is investing now for future opportunities is one of those. Our chronic care patient models are really just beginning and we understand the results in this area will be difficult, and like a lot of things worthwhile, we’re committed to providing the time and resources to provide better and more cost effective care for our members.

In this company we have a never ending focus on our cost structure; we’re going to drive to be the low-cost operator in our business, and in this area of SG&A, we made progress on the specific initiatives I laid out last quarter as you can see by tracking SG&A results. But we can do more and we will.

The foundation of companies like ours always are people and on the human resource front, Dr. Patricia Muller joined us as our Chief Medical Officer and has begun her work to provide high quality and more cost effective care for our members during the last quarter. We have also reached agreement with Matt Isles who will be our new Vice President of Public Affairs and Policy and will be joining us on December 7^th.

A word about some items on our short and mid-term worry list. By that I am talking about possible pressure on our commercial health loss ratio because of COBRA, a serious flu season, and pressure on our risk flu or possible pressure on our risk flu due to layoffs of younger employees and younger employees dropping coverage. We think about these items daily and as a result I believe we have established appropriate reserves in all three areas for anything less than a pandemic flu event.

Shawn Guertin is now going to provide detailed financials and when Shawn concludes his report, I have one more item to discuss today which I will do in my closing comments.

Shawn M. Guertin

Thank you Allen and good morning everyone. As you have seen this morning we reported earnings per share excluding the impact of charges related to our completed divestiture of First Health Services Corporation of $0.66 for the third quarter of 2009. I continue to be quite pleased with the performance of our businesses in one of the more challenging external environments in recent memory. Our key medical loss ratios are in line with or better than expectations. Cash flow generation continues to be outstanding and days in claims payable was up slightly for the quarter. All of this culminated in a quarter where we exceeded our internal expectations and for the second quarter in a row have increased our EPS guidance for calendar year 2009.

Before I launch into the details of the quarter, I want to make sure I set the table upfront regarding the charges and accounting treatment related to our completed divestiture of First Health Services which closed on July 31^st. You will recall from last quarter that we expected a one-time largely non-cash charge related to this transaction of $0.55 to $0.60 in total. The complexities of the accounting literature dictated that we take $0.38 in the second quarter, and as you can see, the remainder $0.18 was taken in the third quarter bringing the total charge to $0.56, a result at the lower end of our estimated range. When you look at the discontinued operations line in the income statement, you will not see this exact amount as that line is actually the combination of two items; the one-time charge I just referenced offset by the operating earnings for the time period for which we owned the business. For the quarter, these operating earnings represent a $0.02 loss and on a year-to-date basis represent a $0.06 gain. Thus, you can see the year-to-date result from discontinued operations as a loss of $0.50 which is the sum of the $0.56 charge and $0.06 of operating earnings for our ownership period. Consistent with our prior guidance on this topic as well as our plans for application of the proceeds, our adjusted EPS results and guidance as described in the press release, ignore only the one-time charge element of discontinued operations; $0.18 for the third quarter and $0.56 for the full year.

With that out of the way, let me now turn to our core businesses. While all of our businesses performed quite well in Q3, the results on our Medicare business were particularly strong in the third quarter. On Part D, we continue to grow in the third quarter adding more than 80,000 new members. From a membership perspective, we have grown this business by approximately 75% so far this year. As you know this has been an area where we’ve been monitoring financial performance very closely all year, and I am pleased to report that the third quarter medical loss ratio continues to track very well with expectations. On a year-to-date basis, the MLR now stands at 91.9% in 2009 versus 91.5% through nine months of last year. So, through nine months we continue to be tracking well with our full-year expectation of a mid 80s MLR result for this business. Again, when you consider having grown memberships 75% year-to-date, this would truly be an outstanding result.

The Medicare Advantage business also performed well in the third quarter. Our medical loss ratio in the third quarter came in at 89.4%, better than where it has been running so far this year and better than our internal expectations. This favorable result was driven by the private fee for service business. In fact, as you saw on the press release, the private fee for service medical loss ratio improvement in the third quarter as compared to the first half of 2009 contributed approximately $0.07 per diluted share in the third quarter, notwithstanding the fact that we will be exiting this product line in 2010, this is a good result given the growth we experienced this year and its implications for the profitability and capital levels of our regulated subsidiaries.

Looking forward to the fourth quarter of 2009 while it is certainly possible these favorable results could recur, we’re not assuming that they will in our updated full-year 2009 earnings guidance. Whether it is in an early erosion of membership or an increasing claim utilization before the product terminates, I believe that caution is in order here as you consider the multiple factors that could be present in the fourth quarter of this year.

While in the neighborhood of government programs I did want to offer a brief comment on Medicaid. The positive membership dynamic we discussed last quarter continued in the third quarter as we experienced net growth of approximately 6000 members bringing our year-to-date growth to 20,000 members, an increase of about 5% since year end. Even more pleasing was the loss ratio for the quarter which came in at 86.1%, an improvement from the levels we had seen in the first half of 2009. However, we did observe an increase in flu related costs in the month of September and therefore have a more cautious outlook on the medical loss ratio for the fourth quarter.

Let me now turn to our commercial group risk business. Overall, while we continue to experience volume pressure in the form of declining membership, the medical loss ratio result for the third quarter was excellent and very consistent with our expectations. You will recall that following the second quarter, our outlook in this area for the full year improved by 50 basis points producing a full-year mid-point expectation of 82.25%. Following our third quarter I am happy to reaffirm our guidance in this area. These strong results are a byproduct of our success on the pricing front that we discussed last quarter as well as medical cost trends developing consistent with our expectations. Our commitment and results on the pricing front continued to be strong as evidenced by the steadily increasing rate of premium yield change since the fourth quarter of 2008. In fact, the year-over-year change in premium yield exceeded 6% for the third quarter of this year.

On the medical cost front, you will recall that when we updated our full year view last quarter, we incorporated an element to account for the potential impact to the MLR of increased COBRA membership and to some degree increased cost due to H1N1, the latter being a little more difficult to predict than the former. Looking at the second quarter and emerging third quarter results, providing for these items appears appropriate. Our full-year guidance for the commercial MLR would allow for an MLR in the fourth quarter of up to 84.4%, an increase of 230 basis points from Q3. I believe this properly accounts for the seasonally higher Q4 MLR expectation due to deductible satisfaction makes provision for increasing levels of COBRA enrolment in Q4 and still leave some additional headroom for increased cost levels due to potentially rising levels of H1N1 in the fourth quarter.

I would like to touch on one other income statement related item for the quarter. You noticed that the tax rate for the third quarter stands at 33%. There is nothing particularly extraordinary going on here other than the fact that the third quarter is when many statutes of limitations expire for prior tax years. Current account treatments dictate that you recognize these events in the quarter they occur as opposed to smoothing them out over the year. This is a fairly typical phenomenon for us, and thus, third quarter is typically the quarter that we experience the lowest quarterly tax rate. Having said that, our outlook for the full year tax rate is improved versus a quarter ago, driven mainly by an improved outlook on the state tax rate. We now see the full year tax rate coming in around 36.25% and this improved tax rate is worth about $0.03 on a full year basis.

Before I move off the third quarter, I would like to update you on our capital position and balance sheet. The short story here is the strength and stability that we’ve demonstrated all year has continued through the third quarter. On the asset side, our investment portfolio continues to operate in a net unrealized gain position. As I stated in my opening remarks, our cash generation continues to be outstanding. We closed the quarter with $570 million of free cash at corporate following a quarter where we reduced our long-term debt by $98 million, mainly through paying down some of our revolver. You will recall that in order to neutralize the forward EPS impact of the First Health Services divestiture, we needed to do some share repurchases and we began this process at the end of the quarter repurchasing 1.5 million shares.

In the fourth quarter we will continue to de-lever in order to satisfy our commitment of a year-end debt-to-capital ratio approaching 30% which would require debt repayment in the neighborhood of $100 million. Going forward, our capital plan will continue to look at a balanced application of our capital across three broad areas; share repurchase, de-levering, and small to mid-size M&As similar to our recent announcement of our pending acquisition of Preferred Health Systems in Wichita. As you’ve seen we’ve increased our full-year 2009 EPS guidance to $2.01 to $2.03 excluding the impact of the one-time $0.56 charge related to the First Health Services divestiture. This would imply an EPS for the fourth quarter of $0.55 to $0.57. While we’re not in the business of providing quarterly EPS guidance since this range is lower than what we reported for Q3, I thought a bridge between the quarters would be useful. This is a bit of a simplification as there are always many moving parts, but the easiest way to think about the first step in the bridge is to take the $0.66 for Q3 and remove the $0.03 for the improved tax rate outlook and remove the $0.07 of contribution from the private fee for service business which, for reasons stated earlier, were not banking on recurring for the fourth quarter. This math produces $0.56 as an adjusted jump-off point.

For the fourth quarter, we are in aggregate, expecting a similar result. Although we’re projecting the Part D loss ratio to improve, the increased earnings from this are expected to be offset by the seasonal increase in the commercial MLR up to the 84% range I mentioned earlier, and as you’ve seen in past years, higher Q4 SG&A spending as we prepare for the commercial and Medicare open enrolment seasons.

In terms of our plans regarding our 2010 earnings guidance, our current intention is to provide that on our Q4 earnings call in February followed by an Investor Day in New York on March 4^th. We have always taken our guidance commitments and all of these seriously, and while our businesses are performing well and are stable, particularly as it pertains to medical loss ratio performance, I would certainly like to have a better read on commercial and Medicare membership levels, not to mention the various factors at work in the external environment.

In closing, the consistent results and momentum we demonstrated in the first two quarters of 2009 continued into the third quarter. Some of the 2009 watch list items now appear to be behind us as we have produced stable medical loss ratio results on commercial, Part D, and Medicare Advantage. We continue to operate in an excellent liquidity position; our investment portfolio is conservatively positioned, and our cash flow generation is excellent. While the challenges around the growth dynamic are certainly daunting, there are still some legs in our historical small to mid-size M&A growth strategy as evidenced by our pending acquisition of Preferred Health Systems. However, we all know that the waters are still choppy out there.

In closing, I would echo what I said last quarter. I believe the best course to chart through these choppy waters is one that is truly focused on efficient and effective healthcare cost management and one that continues to deliver on low cost; an approach that is ingrained in our culture and has been the mainstay at Coventry for a long time.

Before we open up the call to questions, I’m going to turn it back over to Allen Wise for some final remarks.

Allen F. Wise

Thank you, Shawn. I do have one final item that I’d like to update all of you on. After nearly 12 years with our company, the last 5 is the chief financial officer, Shawn Guertin will be resigning from the company effective at the end of this year. Shawn told me when I returned to Coventry as CEO in January 2009 that the prior year 2008 had been very difficult and had taken its toll on him and his family. At that time, nevertheless he said it was important for him personally and for the company that he remain until the ship was righted, so to speak, and the company had the proper foundation for the future. But at this time, we have mutually agreed that this is the best for him and his family to take a much needed break, and while from a company standpoint, I believe we would be better off if Shawn remained in his position, I have to respect what’s best for him and his family, and I understand his priorities.

In order to ensure a smooth transition, John Stelben will be assuming the role as interim CFO while we work on evaluating to assume the role on a permanent basis. Many of you know John from his long 10 years at Coventry and I am pleased we have someone with John’s background and a very wide variety of assignments and accomplishments at our company. John joined Coventry in 1994 as controller of our Missouri Health Plan. In 1998, John became Vice President of Business Development in our corporate office where at various times he was responsible for investor relations, tax, treasury, and credit markets, along with the budget process. More recently John served as the Chief Financial Officer of our Workers’ Comp business for two years.

I am also pleased to tell you that the company will continue to benefit from Shawn’s talent, experience, and perspective as he will remain associated with the company in a consulting capacity for at least 18 months.

Also of note is that our entire finance area has a great deal of depth and experience beyond John. We have a world class controller in John Ruhlmann who has held that position since 1999. We have a very deep and skilled actuarial area headed by Tim Myers who has held that position for the past 6 years. The underwriting area will move from the CFO responsibility to Mike Barr who heads our health plans, and we’ve discussed Mike previously. Mike is an actuary. He has a breadth of experience in actuary and underwriting, so I believe we’re very well covered on that front.

One last comment on the subject of our company’s future and related to my previous comments, my own employment contract which was set to expire at the end of 2010 has been extended for one year. The board and I have been working on a succession plan and we agreed of having a 2-year runway so to speak to complete the process and ensure that we have the time needed for a smooth and successful transition in shareholders’ best interest.

With that operator, that concludes my comments, and we can now open the call for questions.

Question-and-Answer Session

Operator

(Operator Instructions). We will take our first question from Joshua Raskin - Barclays Capital.

Joshua Raskin - Barclays Capital

Shawn, Good luck and congrats on the next stage; two questions, first, you mentioned a little bit of a flu in the Medicaid business and maybe an expectation for 4Q, can you break out what the actual dollar amounts were and by segment would be even more helpful?

Shawn M. Guertin

I’m going to give you sort of a loss ratio impact and if you don’t have the revenue you can figure out the dollars; it was actually very minor overall in the third quarter, in fact, the levels in July and August were minimal and we saw a fairly dramatic uptake in September, and so let me give you some numbers to frame that; so, the actual quarterly impact, July, August, September was virtually non-existent on Medicare, was probably worth about 10 basis points on commercial and about 30 basis points on Medicaid; now, I hope this doesn’t confuse you, if you just looked at September, if you had had three Septembers, commercial would have probably been double about 20 bps, and then Medicaid would have been more like 70 bps; so, just to be clear, the first set of numbers is what we actually saw. While we’re on this topic, I want to talk to you about how we though about this and why I think we have at least head-room for something nothing short of an epidemic or a pandemic rather. What we did in the fourth quarter is actually a look at that September level and we actually sort of modeled out 4 times that September level for the whole fourth quarter as we worked through our estimates; so, we probably have something approaching 100 basis points in our commercial estimate and we probably have something approaching 300 basis points on Medicaid.

Joshua Raskin - Barclays Capital

So, nothing in Medicare though?

Shawn M. Guertin

No, when I go back to why we didn’t assume that the Medicare favorability would recur, that was in the back of my head; we haven’t had any experienced that this is going to be an issue yet on Medicare, again it did seem that prudence was in order though to at least give yourself some head-room if it did start to show up in Medicare as well.

Allen F. Wise

It’s hard to say for sure, Josh, but I talked to some internists in the middle of the country whose opinion was that it wasn’t showing up much in the senior population and the guess is that there is some type of limited immunity there over the decades of their life, but the internal medicine people that I talked to this week weren’t seeing that in the seniors to any degree at all.

Joshua Raskin - Barclays Capital

Just one quick followup, I think you mentioned the change in your PDP regions and the impacts you’re going to have, give an updated sort of expectation in terms of PDP lives for 2010, and maybe while you’re on the subject, what do you think about the MA side, obviously ex-private fee for service?

Allen F. Wise

On PDP, the answer is that I think we’re certainly comfortable with our pricing posture given how this year has developed, we feel good about that. I think our competitive position in the market is where we thought it would be, and we priced the cost and the result of that might be that we lose some auto-assigned regions, and so, I would say that if you just look in isolation at the auto-assigns, I think there’s a lot of estimates out there on the street, those are probably pretty accurate; the one thing that might be missing from that thinking is through those programs, we do have some SPAP, the State Pharmacy Assistant Program members who also come in through that and so that there could be up to another 60,000 members in the auto-assign regions, from what you’ve seen on the street estimates, that could also fall out now; I don’t know yet because we’re just not deep enough into the selling season is how much of this will be offs, what the performance of the mainstream products will be which you know was really strong this year, and while I feel like we’ve taken appropriate conservatism in our pricing next year, I still like our product offerings and our price position out there in the market; so, that’s the story that remains to play out for next year.

Joshua Raskin - Barclays Capital

So, no range for the PDP lives?

Allen F. Wise

I just don’t have enough of a view point on the selling season yet.

Shawn M. Guertin

We’ll have soon enough.

Operator

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

Scott Fidel - Deutsche Bank Securities

Shawn, good luck on your next step; first question, Allen, if you can give us some updated views on your thoughts on health reform, how that could impact the business just given the substantial changes that they are proposing for the individual and small-group market?

Allen F. Wise

I wouldn’t be concerned, the only answer is, don’t know where it’s going to land, and personally I wouldn’t be concerned about it; we’ve competed with the Blues for a long time, I’m not overwhelmingly concerned; what is of a lot of concern is the softening mandate for universal coverage combined with lack of ability to exclude pre-existing conditions and to underwrite the individual and small-group business. I think like everything, the devil is going to be in the details and if you take the worst case there which is the mandate for universal care continues to soften and the ability to exclude pre-existing conditions or to underwrite the business, that would probably vary by state, that will be in the details, and our view there is that we’re keeping all of power we can draw in terms to develop products, file them quickly, and execute well when the final facts are known, but it’s really difficult, Scott, when you don’t know exactly where it’s going to land.

Scott Fidel - Deutsche Bank Securities

Just as a followup to that, Shawn, do you have the enrollment data for what percentage of your commercial business are in small group with less than 50 lives and individual?

Shawn M. Guertin

These are percentages of our risk business, so we got obviously more self-funded business, so just the 1.4, 1.5 million kind of risk numbers we typically have; about 11% of that business is individual today and about 36% is less than 50; so, the total is 46% or 47%.

Scott Fidel - Deutsche Bank Securities

Then just a followup on cost trends just relative to what you’ve seen in the industry this year with provider claims and the issues in upcoding debate, just interested in the third quarter relative to the second quarter, any incremental change there, would you say it is sort of the same, has gotten worse, or better?

Allen F. Wise

I would say it’s still in the area of stable; again, the phenomena of upcoding and the push phenomena is something we still see in our results, but it was something we began to see in our results last year, and so, I would say that I can’t say that it has markedly abated, so it’s pretty stable. When you look at it again as we’ve sort of touched on the things that stick out when you dig into med costs right now really are sort of the COBRA and the flu impacts, and again, that was something we had made provision for, but I would at a fundamental level, ignoring those two transitory items, our view on cost trends in ’09 is one of stability still.

Scott Fidel - Deutsche Bank Securities

Just a quick followup on the COBRA updated estimate percentage of members in COBRA in 3Q relative to 2Q?

Allen F. Wise

Yes, you’ll recall, we ended Q2 at 1.3 and we’re around 1.6 in that area at the end of Q3, and you’ll recall we started the year right around 1% which is a little bit lower jump-off point than other people. In our forecasting, we have forecasted that trajectory will continue through the end of the year, and we should land right around 2% by December of this year.

Operator

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

Ana Gupta - Sanford Bernstein

Another followup on that cost trend question; so, it seems like the cost trend is stable this year but there’s a remarkable improvement from I think you were low double digits last year and it’s probably like a mid single digit range this year, and I was wondering if this is because of more stringent underwriting has helped you and you’ve been able to get some of the sicker people off your book or is it more about a mix shift to individual, or finally, is it really your underlying cost trend where these small claims would stop loss, etc., now they’re built into the cost base and as you’re saying it’s not abated but its not accelerating?

Allen F. Wise

Let me go back to the beginning because these numbers can get confusing because different people talk about trends with and without benefit buy-down, but we were talking about a 9% trend for most of ’08 and sort of apples to apples we had talked about stability coming into this year; now, nominally because benefit buy-downs have picked up, that 9% probably does get driven down, but at a fundamental level when you adjust for that, we’re still seeing a stable result this year. I wouldn’t say that we’ve gotten sort of an undue mix either way; now, if you wanted to then sort of fully complete the picture clearly, COBRA and flu will be transitory items over the long-haul, and then probably push the trend sort of right back up to around the 9% range when you put everything in, but when you tease those things out and you look at homogenous data, you would come to the conclusion that we’re more or less have been in the last three quarters in an environment of stability as opposed to sort of markedly up or markedly down.

Ana Gupta - Sanford Bernstein

So, the cost trend is still running at about the high single if you look at it apples to apples?

Shawn M. Guertin

Just to keep the math simple, if benefit buy-downs probably picked up 100 basis points that would drag you down to 8 and then COBRA and flu are probably pushing you back up if you want to count them in into the upper 8 range.

Allen F. Wise

I think you have to go back to my earlier comments about fanatical focus on our business; most of our business is network based and the unit cost area there is we have some control over and there is renewed focus in the company to practice the basics of our business and to contract more carefully and look market by market and see where the trends are out of whack and understand how they got that way and to develop a plan to improve those. It’s been a lot of work this year on that front and there will be more next year.

Shawn M. Guertin

I’m glad Allen brought that up because I don’t want anybody to sort of misconstrue my remarks with sort of complacency with that result; actually on the contrary just things like you saw with First Health Services and our relationship with Magellan to use the radiology benefit management services and oncology management services whether it is the day-to-day contracting, there is sort of a plethora of activity to make this answer sort of better for the long-haul, so again, don’t misinterpret the fact that it’s stable, that is something that we’re just sort of acceptant of.

Ana Gupta - Sanford Bernstein

Actually a followup was just on that; you’ve hired a couple of very talented executives from Aetna, and on the medical management side, should we now be thinking about some more allocation on your SG&A line toward any build out of capabilities on health IT, medical management, how are you thinking about that on a go-forward basis?

Allen F. Wise

On the subject of chronic care model, the sickest 5% of our patients, whether that’s the ABD Medicaid population or our senior population, we have begun a comprehensive effort to do that better, started with sort of evaluating the 300 companies that are in some little piece of that business and offering services, trying to understand who does that best, what we’re going to need to do, so I think there will be an investment on that front, that investment is 150 people over time, we’ve got a lot to learn about this, I understand it’s going to be very difficult but we are committed to your point to committing some resources whether that’s human resources or whether that’s IT resources to do that, to care for the patients in a higher quality, more cost effective way.

Shawn M. Guertin

Again, I want to make sure that the context of that as ultimately the answers to be determined as Allen mentioned, but as he mentioned in his remarks and as you’ve heard us say before, the lack of complacency on med cost is maybe even stronger on SG&A, and so we have broad-based SG&A efforts, and so we’re looking at different ways we can sort of save money in places and some of that money to your point will probably be re-deployed to medical management and sort of the net value of that still needs to be determined, but we’ve got a lot of other things going on in SG&A which should help us pay for some of this as well.

Operator

We will take our next question from John Rex - J.P. Morgan.

John Rex - J.P. Morgan

Was wondering if you could update us first of all on your long term outlook, so you’re focusing down on the seven core businesses, what should we be thinking about in terms of the pre-tax margins that you can run out of those businesses over the long-term; I think you had like a 4-year period, ’04 through ’07 where you were running 10% to 12% pre-tax margins on your core businesses, so, what should the reconfigured Coventry be able to do longer term?

Allen F. Wise

It’s hard to speculate especially with everything that’s out there today, John; I mean it’s really a discussion that you sort of have to go through product by product. I do think, for example, in the area of Medicare as we’ve talked about, our ability to manage cost in that product would still seem like there is a future for that product that generates a fair margin, and I sort of feel that way today as we sit there about commercial; again, the long-term question brings in a lot of the external things that are happening today, so, it’s very very difficult for me to sort of speculate on that, but I think when you sort of think about what we have sort of talked about historically as fair margins, those still seem achievable on most if not all of our products.

John Rex - J.P. Morgan

So, how would you look, I mean you’re 3% to 4% today, your running at third, I mean we’re just trying to get kind of broad side of the barn here in terms of it, is this is now a 5% margin company going forward, do you think it is kind of 7?

Shawn M. Guertin

I think that’s a little misleading because you probably have $3 billion annualized of private fee, that’s really not making much money; you know we have talked about historically insured product margins, pre-tax being in the mid single digits, and there’s play in that number, but again when you look at longer-term modeling, when you have so many different variables, again that still seems certainly not certainty but still seems feasible.

John Rex - J.P. Morgan

Can you talk about the drag, just kind of want to make sure we understand the drag in the first half of 2010, because as the PFFS revenues roll off and then you’ll just have some G&A cut, there’s going to be a claims run out, all this, can you size kind of the dollars drag that we should be thinking about in the first half until all that can be shut down?

Shawn M. Guertin

I think on private fee and isolation, I would not think about this as being a major earnings drag as Allen mentioned, it’s more or less sort of operating around break-even; we did a little bit better this quarter and we do have plans to eliminate the expense and typical accounting actually is you do make provision for a loss adjustment expense reserve to pay out your claims, it is a fully insured product; so, I think the earnings drag is minimal. What you will see though which will be very transparent next year is the cash flow from operations. This is an IBNR that’s probably in the $400 to $500 million range and you will see that get paid out largely in the first half of next year, and so in the cash flow from operations you’ll see that. I want to be really clear here, that is not a strain on corporate cash, that’s money that is down in a regulated sub today already; so, while the cash flow from operations will show that, it’s not sort of an impediment in our ability to generate free cash at corporate.

John Rex - J.P. Morgan

So, the cash that is running the back-off you don’t think is significant in terms of keeping that going for the first half? I’m not talking about the med costs, I understand those would be accrued, but I’m talking about more just the claims paying function has to persist until everything is rolled off.

Shawn M. Guertin

There are real costs there, but we are actually accruing that shut-down expense and the run-out expense if you will this year.

John Rex - J.P. Morgan

Okay, I appreciate the fact that you won’t be able to guide for 2010 for a while, but just take us through the idea on whether or not Coventry should be able to see operating earnings growth next year, whether you expect it to be a down year, just again the broad directional sense that you have as you look at the business right now, ex-flu impact and I understand that’s really hard to forecast.

Shawn M. Guertin

I think the way we look at it is we understand that there are headwins for next year, headwins on the revenue side, from the government programs both Medicare Advantage and Medicaid, we understand that our industry has kind of prices herself out of business and in the commercial there is pressure on membership because people cannot afford the coverage any longer. We think for 2010, the initiatives that we have here on unit costs, on chronic care management, on SG&A mitigates the headwin and we understand that it won’t be an easy year but we think we understand how to neutralize the headwins, and a lot of our efforts now looks like after 2010, but I don’t see any dramatic change for the coming year.

John Rex - J.P. Morgan

So, Allen, you would be kind of surprised to see kind of less than flat operating earnings for 2010, is that how I read that comment?

Allen F. Wise

That’s close; we’re still working on the final stages of the 2010 budget; I can’t tell you what I don’t know but we understand the macro-environment, we understand the challenges, we understand the headwins, and we have been working all year on the things that seems to neutralize that, and I think effectively that our leadership in our health plans under Mike Barr to go through the health plans and the ones that are off-budget, he knows to the penny why they’re off budget and he’s got a program to address those things; so, I feel good that we’re doing everything necessary to neutralize the headwins, I think we’ll be okay for 2010, and that’s is as close as I can come.

Operator

We will take our next question from Justin Lake - UBS.

Justin Lake - UBS

Just wanted to follow up on the question around some of headwins, tailwins next year; first of all on the SG&A side, you gave us some color on the second quarter call around some of the initiatives but without putting any kind of numbers out there, can you give us some idea, broadly, how much SG&A you think you need in this business from a dollar standpoint in order to meet those goals for 2010?

Shawn M. Guertin

I don’t want to get into the piecemeal discussion, it is just preliminary; we have a lot going on, we talked about the medical management initiatives, we have talked about the private fee side of this, and as I mentioned, the big variable really in my thinking about 2010 right now is volumes, and volumes drive SG&A, and so, it’s very difficult to sort of speculate in absolute dollar terms until I have some sort of construct of that, but the one thing I can tell you is that it is something that is of primary, sort of top five list focus around each and every day, and is getting a lot of attention to sort of make the place as efficient as possible.

Justin Lake - UBS

And may be just on the commercial pricing side, I think you talked about pricing your book about 150 basis points ahead of your thoughts on cost trends, is that correct?

Shawn M. Guertin

That’s correct, that’s how we came into this year.

Justin Lake - UBS

Can you give us an idea how much you think you have achieved this year, it feels like from your commentary review, you’re probably a little bit ahead of pace there?

Shawn M. Guertin

We are, and you can do the math on the yield, but last quarter we thought we had out-performed by like 75 bps our expectation, and that’s probably a little bit more in the neighborhood of 100 bps or so with the third quarter results; some of that 50 basis points of that is already incorporated in the improved guidance, but the balance of that at least right now has been taken by the provision that we’re making for Q4 especially around flu and COBRA.

Justin Lake – UBS

So, if you think about the ’09 run-rate for the full year, how much is the 150 you think you got this year?

Shawn M. Guertin

Well, let me be careful here, we needed to price 150 ahead because we had a little bit of timing mismatch; so, I would say we’ve gotten every bit of what we intended. Now, the 150 was never going to translate all the way to the bottom-line, if you follow me, because with the timing mismatch, so let’s go back through this, 50 has fallen through to the bottom-line already in our guidance and some of that excess has been again sort of pushed aside and held the COBRA and flu related expense mainly in the fourth quarter.

Justin Lake - UBS

And then just a couple of quick numbers questions; one, from a delevering standpoint, can you give us an idea of how much of debt paid on between now and next year?

Shawn M. Guertin

Could be determined next year; we haven’t formalized a plan, we have $100 million more roughly to do in the fourth quarter of this year.

Justin Lake - UBS

Lastly, you talked about your thought on Medicare Advantage, PFFS being break-even, obviously you’ve got a $0.07 benefit this quarter, I’m just trying to think about that, that obviously go away next year from a comparison standpoint but then you have the divestiture which appears to have been losing money.

Shawn M. Guertin

Because of some transaction related things, lost money in the quarter, but on a year-to-date basis, it was a $0.06 gain; now, you’ll recall that we intended through application of proceeds from the divestiture to sort of neutralize the forward EPS impact of that.

Justin Lake - UBS

So, really the only headwin in the next year is that $0.07 from PFFS, but you won’t have that for 2010?

Shawn M. Guertin

Yes.

Justin Lake - UBS

Perfect.

Operator

Our next question comes from Christine Arnold - Cowen And Company.

Christine Arnold - Cowen and Company

A couple questions; Medicare did really well, private fee for service Medicaid also did really well, was there any prior period development helping the results for the quarter that we should be extracting?

Shawn M. Guertin

There is always prior period developmental wise, but generally prior period develop in all quarters, but there is nothing atypical this quarter compared to prior quarters.

Christine Arnold - Cowen and Company

And then, as I look at your private fee for service kind of guidance for SG&A, you’re kind of looking at just a 6% SG&A load which feels kind of small for business that’s grown this rapidly with broker commissions and that kind of stuff, is it possible to extract kind of more than you guided for there, I’m just trying to get a sense for kind of gives and takes on that SG&A?

Shawn M. Guertin

No, you got to remember there is a good good chunk, maybe a third of that is group business which is commission-less and these single-digit expense ratios are not atypical in Medicare products, it’s just sort of the math obviously of the premium yield in the SG&A; so, that 6%, 7% is sort of a zone that we’ve always looked at, sort of allocated expenses around private fee for service and we update that every month and look at that, and that’s still valid.

Christine Arnold – Cowen and Company

Then you have a separate PDP formulary for the low income seniors, and there was some sense or fear that that would go away. Were you able to retain that separate formulary?

Shawn M. Guertin

Yes. I don’t know Christine we have had different conversations. There has been a push to limit the product offerings which is one discussion, and that push has been very discrete from CMS about reducing the number of product offerings, but that’s not per se translatable to formulary offerings.

Christine Arnold – Cowen and Company

So your cost structure will remain consistent on the seniors?

Shawn M. Guertin

Yes.

Operator

The next question comes from the line of Matthew Borsch with Goldman Sachs.

Matthew Borsch – Goldman Sachs

I’m wondering if you could comment on what you’re seeing in terms of pricing trends from competitors, and are there any regional variations there that you can talk to?

Allen F. Wise

No, not really. It changes by quarter and changes by marketplace, but I don’t see any departure from there. A comment about our own policy: I think given 2008 when Shawn instituted price increases, he had to make certain that if we guessed wrong, we guessed wrong, but I would characterize those price increases as being done a bit with a meat axe meaning that in some market places, we may have overshot, and I think that with Mike Bahr and his actuarial background with underwriter reporting to him and everything and with the data that we have now, it’s going to be characterized more with a scalpel, so we’re going to get the sweet spot to maintain our margin and do something about some of the renewal business that we lost last year, and I think we have an ability to improve that, and the information and the data that we have marketplace by marketplace and the initiatives we have on the unit cost structure, just going to get us to the spot where we have been some years in the past where we executed better than our competitors in a lot of these marketplaces, but it hasn’t changed. It’s been down to reserves; it gets super tough. When that’s over, it eases up, and we don’t see anything of an irrational or different manner going on out there. Some of our problems are self-imposed. We missed the mark on some renewals in 2009. They were stronger than they needed to be in some cases. We lost some good business, so we’re doing what we have always done. We’re refining how we manage these market places and get more experienced, better people, and we’re going to do a better job next year.

Matthew Borsch – Goldman Sachs

Can you give us a sense of directional view on your network base Medicare Advantage product in terms of? Are you expecting that enrollment will be able to grow in 2010 with the product repositioning that you’ve done, and with that, do you think you can maintain stable margins or do you have to take some margin deterioration as part of that product?

Allen F. Wise

Those are two separate questions with regard to the margin. Shawn and his group and the Medicare group here follow those products very carefully, and if you remember when those needed to be filed in the spring, we knew lot less about our business then than we do now, so I think in terms of the 5 points that I outlined in the last couple of conferences to address the revenue challenges out there, much of which is product design and everything, our very best estimate there is that we’re going to maintain margin. With regard to membership, we would be guessing, and we’re guessing that it might leak a little bit but not of any substance, but I hate in these calls to guess, and that’s what we are doing on that front. We just don’t know, but we think that we’re positioned pretty well in comparison to the competition. We think it’s in a steady state, but we’ll know soon. We’re guessing now.

Shawn M. Guertin

Let me just give you a little more color on that. I admit upfront this can be a little bit biased because we know about one side of the equation, which are places that we exited. We really made the predominant focus of our bid margin preservation, and with the stability and the loss ratio this year, I think that’s good affirmation that we are tracking well with that. On the CCP side, part of that margin preservation strategy was looking at some areas that were unprofitable. I think some of the SNFs were most notable exceptions, and so I believe in areas that we’ve explicitly exited, that’s about 13,000 members. So you take our base, we know we are exiting 13 and you shouldn’t end your thought process there. Now you got to think about the regular selling season and what we can do after that, and in general, I think I was actually probably more fearful about product positioning before I saw the public stuff that has come out, and I think it’s decent out there, so I think again like Part D, it’s all going to come down to the success of the selling season.

Operator

The next question comes from the line of Greg Nersessian with Credit Suisse.

Greg Nersessian – Credit Suisse

Allen, I wanted to ask you about the individual business. I think you had mentioned on the last call that you were doing some rethinking there about your product alignment going forward and how you’re going to approach that business. Obviously in some of these reform proposals, that business gets impacted pretty dramatically, so I was wondering what you’re thinking in terms of going forward, your participation in that business, how it might change, how your product might change and whether it’s worth the investment to keep growing that ahead of reform?

Allen F. Wise

I’ll answer that in two different ways. The first one is being till the US congress finishes their work and we see where that’s settles, it’s impossible to know. I’ll tell you what that product should look like and what I hoped it will look like a quarter ago. I was hoping that there would be universal care so that you’d stop worrying about preexisting conditions and underwriting. Let’s start with where the product is today and what concerns me about the product and what it should be like tomorrow. Today, it’s heavily commissioned on the broker side. It’s very costly to underwrite, to administer from underwriting and a claim standpoint, so what you get is a product even in our network based areas with a 60% loss ratio or something to make a modest margin of 5 points or something like that, which is not a great value equation for the customer. What I think the product should look like and what I wanted it to look like in some places of near universal care or something like that where it was a web-based directly sold product with very low administrative cost. So, forget the underwriting process and the difficult claim adjudication process where you’re investigating for preexisting conditions and in a case of material nondisclosures doing the rescission process, and eliminate all of that and have an 85% loss ratio product where you still make 6 or 7 points and have a very good value equation for the consumer.

If there is an absence of universal care or something closer to it, then the question gets murkier, but we’re thinking about it and talking to outside development people about what this product would look like as a web-based offering and to get it down to where the cost associated with the product now which really don’t equate to proper value proposition for the customers and turning that around, but until the US Congress finishes their work, it’s really kind of hard to figure out exactly where you are going to find the sweet spot there, but I had hoped three months ago that there would be a mandate for universal coverage and that we could proceed the way that I just explained.

Greg Nersessian – Credit Suisse

It sounds like Shawn’s decision has been in the works for sometime. Just wondering when your search started, if it started already, and maybe why you didn’t have somebody in place considering that it’s been a while since you have known that he was planning on leaving before the January 1^st transition thing.

Allen F. Wise

No. I didn’t know he was planning on leaving at all. I know that there were discussions. I was a director in 2008, and it was a very difficult time for Shawn. My hope as the Chief Executive Officer here is that he understands this business better than just about anyone I know, and he has an ability to articulate simple answers to complicated questions better, and my hope was that he would recover from the difficult year and that he would remain. His decision was very recent, and very recent being a few weeks—like 2 or 3 weeks. I then went through the process. I had five possibilities, and myself, Shawn, and the board picked the one that would be the most stabilizing to the company. John has been here longer than any of us and has been in every area of the company and along with the stability that we have in the other areas, this company won’t miss a beat while we look at internal and external candidates, but the answer to the question is it was a very recent decision and not something that I have know about for a long time.

Operator

The next question comes from the line of Matt Perry with Wells Fargo.

Matt Perry – Wells Fargo

It’s a question for Shawn. I understand the price push that you pushed through in the commercial business this year has benefited the MLR. Would you expect any incremental further benefit from the price push in 2010? I guess I’m a little confused on that issue.

Shawn M. Guertin

In a vacuum, the answer is yes. We continue to leave the pricing hotter than trend. Now you have to inject reality, and again we’re not giving guidance, bbut things that I start to think about is, these transitory issues around COBRA and flu, how long do they persist into next year and/or do they worsen, so that’s probably the most discrete factor, and then I think the second thing is and the answer to your question is what is your view on fundamental trends excluding those transitory items. If trend remained flat, which is the assumption in my vacuum equation, then you would get some gain. One of the things that’s obviously going to be a big driver of the commercial business next year is how long and the severity and duration of these transitory factors as to how do they play out next year.

Matt Perry – Wells Fargo

Did you guys disclose a price on the Preferred Health acquisition?

Shawn M. Guertin

No.

Matt Perry – Wells Fargo

Would you, or would you see in the cash flow statement eventually?

Shawn M. Guertin

Eventually, it will be in the cash flow statement.

Allen F. Wise

Thanks a lot for your interest and thanks for joining us.

Operator

We would also like to thank everyone for their participation. That does conclude today’s conference.

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