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Executives

Allen Wise - Chief Executive Officer

John Stelben - Interim Chief Financial Officer

Drew Asher - Senior Vice President, Corporate Finance

Analysts

John Rex - JPMorgan

Matthew Borsch - Goldman Sachs

Ana Gupte - Sanford Bernstein

Justin Lake - UBS

Scott Fidel - Deutsche Bank

Kevin Fischbeck - Banc of America, Merill Lynch

Coventry Health Care Inc (CVH) Q1 2010 Earnings Call April 30, 2010 8:30 AM ET

Operator

Good morning and welcome to the Coventry Health Care’s first quarter 2010 earnings conference call. Today’s conference is being recorded, and all participants are in a listen-only mode.

Today’s call will begin with opening remarks by the Chief Executive Officer of Coventry Health Care, Mr. Allen Wise, and after a brief forward-looking statement led 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, 2009, and as maybe updated from time-to-time and Coventry’s quarterly reports on Form 10-Q may materially impact those statements and could cause actual future results to differ materially from those anticipated and discussed. Allen.

Allen Wise

Good morning and thank you for joining us. We’ll follow our normal agenda. I’ll start off by providing some brief comments. John Stelben will provide more details on the financials and that will be followed by some time for some brief questions.

My comments will cover three areas this morning. The first is on Q1, then our outlook for the remainder of 2010, and finally I’ll provide some brief remarks on the post reform future of our company.

With regard to the first quarter, this morning we announced EPS of $0.66. As we look beyond Q1 to the remainder of the year, we are providing full year guidance of $2.35 to $2.50 per share. Q1 was obviously a very strong start to 2010 for our company, and while our management group believes that our business is improving rapidly, the strength of the quarter was a bit unexpected.

I believe that Q1 results can best be explained with two to three comments. First and most important is the sharper focus on business fundamentals over the last 18 months. Our SG&A, our medical unit costs worked towards improving our members’ quality of healthcare, much better integration between our actuarial, underwriting and sales team, our government program execution, and the many areas I have discussed in my prior four quarters of conference calls. Simple stated, we are actually getting better on the basics of our business and we will continue to do so.

I think the second area to describe Q1 results, is that we have some favorable, for lack of a better word, tailwind. There was little impact from the flu; and I think two, it cannot be quantified, severe weather in many of our markets undoubtedly influenced utilization to some extent. And the third factor explaining our results is very positive reserve development.

Under the subject of quarterly highlights, I have a few comments. We closed our preferred health system acquisition in Kansas on February 1. This property has further strengthened our mid west regional presence, and will allow us to improve care for our members with a very high quality delivery system.

We are working and plan on completing a proprietary Medicare advantage product with the Via Christi healthcare system, which we hope we’ll be able to market later this year, with January 1, 2011 effective dates. Within this product we’ll provide excellent coverage and improved care for the Kansas senior population.

Staying with quarterly highlights, we were once again awarded a contract to provide care for Medicaid members in Nebraska, with an effective date of August 1. We completed a very orderly and positive Medicare private fee for service exit. We took a number of successful steps in the last step of 2009, to neutralize the SG&A impact.

We are experiencing positive reserves developments, which at a minimum will create additional statutory capital and ultimately free cash flow. On April 1, we began enrolling Medicaid members in Pennsylvania.

Turning to the outlook for the remainder of 2010, I’d like to address our core businesses. Commercial business, I believe that you’ll see a merchant proved membership progression during the first quarter. Including the close of our strategic preferred health acquisition during the first quarter, we grew commercial risk membership by 83,000 members.

On a same store basis we were down approximately 20,000 members, and although we would certainly prefer to grow the same store membership and plan to do in the future, this is the best Q1 sequential result that our company has reported since Q1 of 2006. Much of this improvement is just plain better execution.

I think during last year, during 2009 where there was substantial membership erosion, that I previously told people and told all of you that half of it was the economy and the diminishing size of the block of business, but atleast half of it was internal. We have addressed the internal issues and our new business sales show that and have exceeded plan. The number of personnel and process improvements that we made during 2009 are beginning to pay off in 2010.

We are still vigilant in pricing to underwriting costs, our costs of goods sold if you will. This is evidenced by our financial metrics in the press release. As all of you know, the key to long term success in this business is managing the cost of goods sold or the medical cost, along with SG&A, on behalf of our employer and individual customers.

While we made improvement in patient care and the underlying cost structure in the past few quarters, we recognize that we have a lot more work to do in this area, and it will remain an area of focus. It’s especially necessary to have this focus as we navigate reform and prepare for the many new requirements there.

Moving from the commercial block to Medicare, the membership in our Medicare advantaged coordinated care plan reached 190,000 members, up from 186,000 at years end. This is 2% better than our flat forecast, but beyond that a very good result considering that we exit from a number of S&P plans and subscale markets which totaled about 13,000 members.

Our medical loss ratio of 85.7 was 120 basis points improvement from the full year in 2009, and while this trend is positive, it was undoubtedly helped by a mild flu season and we recognize there’s a lot of work to be done, heading into the post reform payment environment. In short, we can do better in this business and we will.

I’m pleased to report that new initiatives are underway to improve care coordination for the chronically ill, and are on target to be continually rolled out through the balance of the year. These are initiatives that began in 2009 regarding the frail elderly and they are showing some early promise.

As explained earlier in my comments about Via Christi, we have developed a new model of care. We believe that more innovative reimbursement arrangements that align incentives to improve patient care with better outcomes are increasingly necessary in tomorrow’s environment, and a substantial amount of resources will be directed towards models in that end.

As you all know too, I am sure that we’re preparing our bids on the Medicare front for 2011, and given the recently announced and anticipated fact or revenue raise, and the reform related reductions that began in 2012, we must continue to intensify our focus there. We will continue to make progress on medical costs and contracting efficiencies along with other areas. These obviously include intelligent plan design, best practices for risk-adjusted revenue, SG&A improvement.

Proving the quality of care for members is basic and fundamental for all of our efforts. Overall we are please with Q1 results for this business and we feel that we are doing the right things to prepare for changes in 2011 and 2012. In fact we anticipated the revenue environment, regardless of the reform movement, and spent a lot of time and energy and resources working on this effort beginning in 2009.

With regard to Medicare Part D, we have a solid stable business. We knew that quarter of 1.6 million Part D members are on track with our guidance. Once again I feel this is a good results because of our exit from nine auto assigned regions. From a pharmacy cost perspective, Q1 results are inline or slightly better than our expectations.

Moving to Medicaid, our Medicaid business is demonstrating very significant progress, both in terms of growth and better management of our members. From a growth view we’ve added two new areas of business in Nebraska and Pennsylvania. Our Nebraska as I announced earlier is scheduled to commence in August this year, and should result in 30,000 to 40,000 new members.

As discussed in our last call, we qualify to enter southeastern Pennsylvania and began receiving auto assigned members at the beginning of this month. We are continuing our efforts to finish our medical delivery system in central PA and hope to qualify in that region in the near future. We see opportunities to service this population and will continue to seek new opportunities in this space, especially given the long-term expansion of the population.

With regard to our fee-based businesses, network rental, FEHP and the workers compensation, we are performing at or better than expectations. This business has provided predictable and consistent results. While the soft economy and the employment market has provided some headwinds for our workers compensation business, our strong sales execution and SG&A control has largely offset this headwind.

Let me give you some few comments about the post reform environment. What bout the environment? Well, we understand that regulations here have to be finalized, it will determine much of the future, but nevertheless the less the broad outlines are known and consistent with how we positioned our company during the past year.

Our commercial group business, our $5 billion business is about evenly split, with about 50% of our enrolment below 100 subscribers and about 50% over 100. With a little progress in broker costs, which needed to be addressed regardless of reform, the weighted medical loss ratio average on our book of business should be in the low 80’s. Assuming a reasonable set of regulations, this positions us decently for the new rules and should allow a fair margin, and especially so we can find the 100 basis points of SG&A from a variety of sources.

The Medicare advantage coordinated care product is one that we’ve always believed in. If you follow our company’s history back to the balance budget in the mid to late 90’s, a lot of people in our space abandoned this line of business; we did not and we have always believed it’s the best way to provide care for seniors, and we are dedicated to put the effort and resources at best business practices in this line.

As I previously announced in several calls, we have five ongoing initiatives to improve our results in this product line. We feel like the 2011 race announced early in April are manageable for us, and we are planning for the new payment system that starts getting payees down for 2012.

With regard to post reform, we have focused on Medicaid, again putting additional resources in that in 2009, both in improving our unit cost and caring better for our members.

We understand that revenue will be a challenge as states struggle with their own revenue shortfalls, but low cost, both unit and SG&A along with better care for the member wins. Requirements for success, our skill sets that we have and that’s demonstrated in our recent medical loss rational progress. We are going to work hard to grow membership in Medicaid and this will continue to be a priority in our company.

We are well aware of the many of the challenges in the post-reform environment and in shot we believe tomorrow’s environment will create plenty of challenges, and also opportunities. We believe that organizations that are thoughtful, nimble, creative and have the industry tools and cost structure will succeed.

We feel we are entering the reform environment as a well diversified resource, with a capable manager group and that we are well prepared for the evolving landscape. What about the tools for the future? We should have about a $1 billion in per cash by the middle of next year if we don’t find other opportunities like preferred health.

With regard to tools it’s our senior team. One of our most significant accomplished over the past year has been the formation of a senior management team, who have proven records of success and are exceeding capability in their areas of responsibilities. A lot of these have been announced in the past, but I’ll take them in a minute, and I will remind you of some of the additions that we’ve made to our organization.

Staying with tools for the future to lower cost structure, its important to compete in the past and it’s going to be critical in the future, and where we have delivery systems we think that our cost structure will generally be second to no one. A diversified, well positioned business and the nimbus and know-how to adapt is the fourth tool for the future, and I think that in general that we have the tools and resources to run a better company in tomorrows environment.

I want to stay on our management group a bit, and a few comments and their commitments to the company I believe is appropriate. We’ve had a lot of experienced individuals. All have demonstrated records of success. People have proven their skills well previously, and more importantly during the last 15 months. In the end it’s really about the quality of our management team in our business.

In our operations and IT area, Harv DeMovick has been with the company for many years retuned a year ago and is committed to stay with our company through 2011. Our Medicare advantage in Part D is headed by Nancy Cocozza. She was with our company in the past, the best of what she does and is a building block that we need to do more of this business.

Paul Conlin joined us this year. His responsibility is Medicaid. He’s added to our foundation for the future; has demonstrated early success both in unit cost and with new business during the last six months.

Mick Bahr has been with our company for eight years and is part of our Altius and western operation and headed that up. Mike’s a underwriter and actuary, and he assumed the responsibility for all of our health plans about six months ago, and is uniquely qualified, to add a new group and individual business at the correct cost structure and revenue.

Dr. Patricia Mueller, our senior medical officer joint us last year and is leading the efforts for better patient care. Matt Isles is our new addition in government policy and brings insights in the policy area that our company simply hasn’t had in the past. I can continue the list but my point is that the best management team is basic to tomorrow’s success and we’ve got a very solid team. As our company has always done previously, the search for additional talent will continue.

My own commitment is at a minimum though 2011 and I’ve stated earlier that the search for best people will not end, and I need to add that this will include a through and very thoughtful search for my successor.

Closing though. Well there is a lot left to play out in 2010, but our management group feels very good about the year. Lot of work to be done to prepare for 2011 and beyond, but I’m excited and positive about our progress. In my own view there is a very high likelihood of future consolidation in our business in the not too distant future, and we feel very positive about our ability to participate in that consolidation process. In the end, change almost always brings opportunity.

With that, that concludes my comments. John Stelben is going to provide a financial report and then we’ll open the call for questions. John.

John Stelben

Good mornings. As Allen said, we are pleased to report EPS for the first quarter of $0.66. This is a strong result embedded in our plan for the quarter. In addition as you have seen in the earnings release, we are increasing our full year guidance to a range of $2.35 to $2.50, up from the previous guidance range of 210 to 225.

First I am going to provide some highlights on the quarterly performance and then turn to the increase in guidance for the full year. At a macro level as Allan mentioned, we had some tailwind as we look back on the quarter.

First, our Medicare advantage private key product line, which we exited January 1, produced $0.17 in the quarter, due primarily to prior period reserve development. While we set reserves with an expectation of favorable development, recall that we did not incorporate any private key run our earnings in our previous guidance. So this $0.17 is an upside to 2010 expectations.

In our commercial risk business, membership was a little out of expectations due primarily to small group sales activity, which is ahead of Q1 2009 results. This is really the result of better sales execution, coupled with products that demonstrate better value. Our preferred health acquisition came online February 1 and that was a little over 100,000 commercial risk members.

Premium yields our inline with expectations and are up 5.3% over the prior year quarter. The commercial group medical loss ratio of 80.2% is slightly better than expected, primarily due to lower than expected impact from flu. We previously guided to about 15 basis points of additional flue pressure on the 2010 full year group loss ratio, but it was front end loaded in Q1, and none of it really materialized during the quarter.

It maybe fair to say weather had some impact, but that’s pretty hard to quantify and it would be prudent to assume that elective procedures will get rescheduled at some future point. COBRA membership levels ticked up slightly to 1.8% from about 1.7% of total commercial group membership, which is consisted with our expectation that COBRA would climb to 2% during 2010.

Our view of fundamental challenges continued stability in the 8.5% to 9% range. While our Q1 result was slightly better than expected, one quarter does not make a trend and while we are implementing unit cost in utilization of prudent initiatives across all our businesses, it is still too early to count the impact as I think about 2010. Our preferred health acquisition as Allan mention is performing as expected, both operationally and financially.

Moving on to Medicare, the coordinated care results in Q1 are inline with our expectations for the quarter and the comments we made on the Q4 ’09 earnings call. Membership is up slightly above where we ended ’09 which is a very positive result given the 15,000 member blocks of business we exited coming into the year. Medicare Part D results as well were inline with our plan, and I’d like to provide a little more prospective on the loss ratio.

You will note in the last couple of years that Q1 loss ratios were generally in the range of 100%, higher than the 95.3% we reported this quarter. In 2010 we introduced deductibles on about 70% of the members, who had no deductible in 2009. The introduction of deductibles will alter the historical slope of earnings, but not the annual result. Given all the changes we made coming into 2010 with pricing and product design, we are very pleased with our membership results, and are on track for our full year Part D loss ratio guidance of mid 80’s.

Medicaid produced a very good Q1 loss ratio of 84%, to lead a better management of patient care, especially in-patient care and lower than expected flu. This result is several hundred basis points better than the annual loss ratio guidance. While we are very pleased with the results and the changeable progress we are making in patient management, we do see some late headwind that I will address later in my comments on guidance.

Turning to the balance sheet and cash flows, total cash in investments stand at $3.85 billion. Our investment portfolio is in a net unrealized gain position of $66 million at March 31, virtually unchanged from year-end. GAAP cash flow from operations for the quarter was a negative $187 million. This result includes a $297 million outflow for the run out of the private fee product line. As a reminder, we have cash and short-term liquid securities in our statutory entities matching private declines liability.

Adjusting for the private key run out in Q1, adjusted cash flow from operations would have been $110 million or over 150% of net income. More importantly, free deployable cash at the parent was $450 million versus $510 million at year-end, the main driver of the difference between the funds used for the preferred health acquisition net of some other ins and outs. Our normal statutory dividend process to parents starts in the second quarter.

Days in claims payable displayed in the press release exclude private key for service for all periods presented. The increase in DCP of 4.7 days over the prior quarter is due primarily to seasonal timing, timing of Part D subsidies and a small increase in claims inventory. Debt to cap ratio now stands at 29.5%, driven by the addition of Q1 earnings. We did not repay any debt in the quarter.

Turning to updated 2010 guidance, we are forecasting EPS in the range of 235 to 250. As a reminder, this includes the $0.17 of earnings generated by private gain in the first quarter, but does not assume any further private fee impact for the remainder of the year.

In summary, we are adding our view of Q1 out performance to the prior full year guidance, while essentially maintaining our prior aggregate view of Q2 through Q4, while recognizing some new facts we now know about. For simplicity, our work through the guidance changes using the mid point of the range for both prior and revised guidance.

The mid point of prior guidance was $2.17 and the mid point of revised is $2.42 an increase of $0.25. As I just explained $0.17 of this increase was related to private fee, which leaves about $0.08 for our seven core businesses. Now, let me provide a few highlights on that.

Starting with commercial risk, we still expect same store membership to be down for the year in the low single digit. When we include the addition of 100,000 preferred help commercial risk members total growth should be in the range of 4.5% to 5%. While our Q1 small group sales performance is better than expected, it is still early and the macro economic issue still exists. That being said we are very pleased with the same store sales results, and believe that volume will be slightly more favorable in the range than our previous expectation.

Forecasted commercial group risk MLR, including preferred health is expected to be in the range of 82% to 82.5%. This is a 25 basis point reduction from previous guidance, driven largely by the benign flue season. It also incorporates our fundamental view of forward trend stable. Together we believe these two items account for about $0.08 of the increased guidance. For Medicare CCP our view of guidance is unchanged. We continue to expect the0 Medicare Advantages loss ratio to be in the mid 80s.

Part D has also performed consisted with our expectations so far in 2010. As a result, our annual view of this business is unchanged from prior guidance. Membership is in the $1.6 million range and our loss ratio in the mid 80s. For Medicaid, from an earnings standpoint our annual view of this business is unchanged from prior guidance. While we had better expected Q1 results and we see improvement in patient management, we see raised headwinds in the second half of the year.

In our Missouri based health care US subsidiary, which accounts for almost half our Medicaid membership, we will be receiving a rate increase just under 1% in July, and this is around two points lower than expected. While our Medicaid team has multiple networking utilization initiatives underway to mitigate trend, we don’t count things until we can physically count them. I would not be surprised given state revenue challenges of other rate actions in other space, and I have nothing definitive at this point and time.

Our guidance has been adjusted to incorporate the addition of the Southeast PA and Nebraska market. We are underway in Southeast PA with auto-assignments beginning in April, and as Allen said, in Nebraska the contract begins August 1, with an expectation to reach 30,000 to 40,000 members by year-end. We expect a mutual impact over our earnings in 2010 for these new Medicaid markets. Our fee-based businesses will be up about $0.02 based on stronger than expected revenues.

On SG&A, midpoint of the 2010 guidance is $1.96 billion. The new midpoint is up about $20 million to recognize volume related SG&A for our better commercial membership and the addition of the southeast PA, Nebraska Medicaid businesses. Note that at the midpoint of SG&A guidance, the percent of revenue is 17.3% down slightly from the 17.5% previous guidance. Given we have not repurchased any shares year-to-date, we have adjusted the share count in our 2010 guidance to reflect deployment in the back half of the year.

So, let me just re-summarize those points. Private fee Q1 earnings of $0.17 growth grew for the full year. Commercial group risk out performance, both our improved unit loss ratio as well as higher expected volume drives about 8%, $0.08 of the increase.

Medicare CCP and Part D are unchanged from an earnings perspective. Medicaid earnings are unchanged for the year. Q1 out performance will be offset by lower than expected rating increases in Missouri. Fee-based businesses will be up about $0.02 based on stronger than expected revenues, and lastly our more conservative view of share repurchase has an impact of negative $0.02.

On free cash and capital, as stated earlier, we have $450 million of deployable cash on hand, and expect to generate over $250 million of free cash from our seven core businesses in 2010. In addition, we expect to dividend out the capital supporting the private fee product line, which during Q1 results would be approximately $275 million.

We will seek to partially dividend this up in late 2010, with the remainder in the first half of 2011. Assuming no additional deployment of cash, we could end 2010 with $700 million to $800 million of deployable capital. In adding to that the remainder of the private fee dividend in 2011, we could have total deployable capital of approximately $1 billion by mid 2011. Our priorities for deployable cash are the same as always, growing the business through acquisition followed by opportunistic share repurchase and delevering.

To conclude, Q1 was a strong but early result. We see changeable progress and better sales execution, and in managing all of our expenses better. While we all know the challenges ahead, we continue to focus on improving our overall cost structure. A low cost structure will be the key differentiator in succeeding in the reform world, really as it had always been in this business.

Allen, do you have anything else to add?

Allen Wise

No, lets open the call up for questions please.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from John Rex - JPMorgan.

John Rex – JPMorgan

So I appreciate your comments on thinking about reform and the minimum MCR’s for 2011. So just going a little deeper on that, you mentioned making some progress on commission structures as you look out to 2011. If you could tell what you are doing now for that, and what you would anticipate -- how much you would need to do in terms of progress or commission structure, maybe focusing first on some of that and then a couple of questions on your individual book also.

Allen Wise

John, unfortunately we are not doing much now. A year ago, there was a plan in place but we haven’t made much progress on it. We will make progress and we are redoubling our efforts towards that, but its sort of a slippery slope.

If you get out too far in front of all that and don’t do it in a reasonable and thoughtful way, and consistent with the competition, you are going to lose some of your profitable book, but regardless of reform, the amount of commissions have continued to creep in the commercial arena, with a decreasing block of business out there and people increasingly eager to preserve market share. So its just going in the wrong direction and that has to change.

We have not made much progress and will be redoubling our efforts to go with the people that are most helpful to us and to their clients. That’s something that is consistent with the realties of tomorrow and we just haven’t done very well, and its some thing that we probably would not pre-announce and it will vary obviously market by market. So its an area that the whole sector needs to do better on, and we haven’t done much.

John Rex – JPMorgan

I guess in just thinking, if we can get to the low 80s you are talking about, with the progress in broker costs, do broker costs have to essentially cut in half to do that? I mean that is the kind of the right range to think about for a small group at least?

Allen Wise

I don’t know about half, but if you talk about 100 basis points of SG&A, some of which would be broker efforts and some the continuing efforts that we have internally to manage our own cost, and just do a better job. The weighted average of our book of business is somewhere in the low 80s now, and so I think we are making a 100 basis points of improvement, that we are not so far off from where we are now.

John Rex – JPMorgan

Okay, and then on you’re individual book, so we see about maybe just under $300 million in individual premium revenue. I wondering if that’s kind of still accurate, and then we would see that at a 71% loss ratio, this is thinking about ’09 statutory filings actually. So, how about on the key, just because of the gap from where that sits today, would suggest almost as much impact as a small group could reserve.

Allen Wise

Well, individual is about 3% of our revenue and miniscule part of our profits and once again John regardless of reform, I think that I have explained before that one of our initiatives beginning last year, is to start with a clean piece of paper on the individual product that would give a better value equation for our customers, and that would incorporate a different distribution system.

So its a small part of our company and I would say something that needs attention first, and one of these days soon we will be announcing a new addition to our company in product development with this person; one or two things that the person is going to do in the company, but we have been working on that. We are working on from an IT perspective, a clean piece of paper and a different distribution system, because what we have today doesn’t work for tomorrow.

John Rex – JPMorgan

I’m just summarizing, your view being for 2011, at this point you don’t necessarily expect any drag from the implementation there with MCR’s. You think about your commercial book overall, is that the correct way to walk away with that thought?

Allen Wise

No, its kind of a leap of faith. I think the things we began a year ago in terms of our internal cost, in terms of a better delivery system, there is a huge difference in some markets between the quality and efficiency and outcome and the cost of some of the delivery business.

So the efforts that we started to give a better value equation for our membership and everything started a long time ago, and the new reg as I understand, or the new law about the regs as I understand them and a look at the distribution of our business, sort of 5050; 50% falling in that minimum of 80, and 50% in the minimum of 85, I’m not complacent or anything, I just don’t see any tremendous hurdles that we can’t deal with.

We have to get more cost out of the place. I told you a year ago we are going to get cost out of the place and now you can count it, and we will get more cost out of the place.

Operator

Your next question comes from Matthew Borsch - Goldman Sachs.

Matthew Borsch - Goldman Sachs

I would like to just ask on a non-reform question. You alluded to some pricing action in the market, maybe by competitors. I’m wondering, have you actually seen an uptick in price competition in the commercial risk area or is that just a continuation from what you’ve seen last year and any further geographic or other color you can give us and that will be great.

Allen Wise

No, I don’t think I said price. What I said was for broker commission, our sector as a group. What I said six months ago or something, when I was addressing our loss of commercial membership in 2009. I said that half of it was a condition of the economy. We kept a group, but there were layoffs, our people couldn’t afford the product anymore or Chapter 11s on their small group of business, and half of it was self-induced that we introduced some new underwriting actions in the end of 2007 and 2008.

When we got a new team, there was a certain amount of dysfunctionality in the communication between actuarial underwriting and our sales team. When we looked to the mirror and corrected our own decisions, we are having much more success in the market place, and if anything, I would say the pricing environment, the competitive environment is a bit better than it was a year ago.

Matthew Borsch - Goldman Sachs

Okay great, and actually this is on reform. As you referred to the individual product is about 33% of revenue and contributing miniscule amounts to the earnings, can we take it from miniscule that its substantially less than 3% from an earnings contribution on that

Allen Wise

If you add 3% of our revenue, then the margin is under 5%, its just not a big deal.

Operator

Your next question comes from Ana Gupte - Sanford Bernstein.

Ana Gupte - Sanford Bernstein

I was wondering if you could give us some color on the recent rate pressures in Massachusetts, Maine, and California, and your perspective on states that you are participating in. Will this slightly become an agent in terms of the regulatory or legislative pressures on small group rates?

Allen Wise

In terms of group, down to any business in any of those states and I kind of know what I read about that, I don’t see anything today in any of our markets that suggest that there are any movements like what we are seeing in those three areas.

Ana Gupte - Sanford Bernstein

When the state regulatory commissioners are deciding rates, would they restrict or consider restricting the dividending of cash to the parent and thereby they can keep pressure on the rates while still keeping you adequately reserved. Do you see any sort of conversations or trends in that direction?

Allen Wise

No.

Ana Gupte - Sanford Bernstein

Then, finally on the small group and individual, the restricted underwritings that you are seeing right now coming into being prior to reform restricted underwriting in terms of its medical condition, recession and so on, are you seeing any impact on that in 2011 margins?

Allen Wise

On the recession front, we have been looking at that several quarters now. That would be under 500 recessions a year in our company, maybe under 400, so the impact is not great.

Our legal and regulatory people are reviewing now whether or not for the remainder of the year that we would want to go to a third party to also review the recessions, but we have a pretty arduous process within our company. 100% of the recessions go to a legal team who review the facts, the information and so we don’t do that many right now. Only in extreme cases of beyond misrepresentation of fraud, so not a huge impact.

The question has always been with anything less than universal coverage, what kind of product you are going to be able to have if you can’t do any underwriting, and we just have to wait and see what the details and see where are the niche is there.

If we can’t do that in a business, likely we don’t that in the product, but I think a of what’s coming is going to come out in the regs and may vary by state and the devil is going to be in the details. So the real answer is in the short term, no not any impact, longer-term we’ll have to see.

Ana Gupte – Sanford Bernstein

And on the baby end of the market are you seeing any changes in the way these employers or responding to reform. Are they more likely to subsidize in light of tax credit or are they sort of pulling back from getting into this phase?

Allen Wise

I don’t know, except what we’ve talk about in Q1, in our smaller mid-sized group; whether its more of the markets improving slightly or its because of our own efforts our quotes up. We are running more business than we have in a while and I can’t at this stage really know how much of that, because we got a better team with better focus out there or if the environment is improving slightly.

Operator

Your next question comes from Justin Lake - UBS.

Justin Lake – UBS

Allen you talked about the expectation for significant consolidation in the industry post reform. I am just curious to get your view on the, how important are the attribution with regards to the scale of local level versus having just international scale?

Allen Wise

Well, the comments of our consolidation is educated guests or may be a guess, but we all acknowledge that the things we did yesterday aren’t enough for tomorrow. The revenue environment is going to be more difficult and you just have to be better with what you do and I think if you are in the business and don’t have best business practices, best information, best people, best focus and a reasonable cost structure, you aren’t going to be able to compete.

So I would be surprised if there weren’t other opportunities like the preferred healthcare of Kansas where people focus on doing what their primary business is, and so we’ll see where that comes out a year from now. If you look at the balance sheets and margins, it’s going to get more difficult, so I don’t see how you avoid consolidation in all the lines of businesses; certainly Medicare Advantage, certainly some of the small private Medicate plans and some of the commercial plans and we’ll see.

Justin Lake – UBS

Okay, and just as you are seeing that shift happen, you mentioned the acquisition you did there. Do you see that happening in a way where there is going to be opportunities to be the best, smaller markets where you don’t feel like you have scale or to be purchased; thinking of making acquisitions like this, or do you think it’s just going to be happening naturally for competitive pressures?

Allen Wise

I think the latter. We are a regional company, a multi regional company. We are not national, not going to be national and can’t be. Where we have health plans, where we have HMO type networks, our cost structure has always been competitive with the best, and let’s say competitive means within 500 basis points of the best, and that hasn’t changed.

I think that we have to be better in selecting maybe something. Networks are not as broad as they once where, in return for picking a delivery system with good outcomes and high quality care for the members, which always means usually a better-cost structure. I think that within the places that we do business there will be a narrower products.

The one that we are working on with Via Christi on Medicare Advantage, and the Central Kansas area will be a product for the Via Christi system only. They have a huge amount of resources including 26 primary care physicians that are employees of the system and I think that will just allow us to get better benefits, better resources to help those physicians manage the care better, and I think that is going to happen on the commercial side as well.

Just the problem with our product is no one can afford it, and I’m talking about our sector, our investment, so we are going to have to do a better job on the cost front. So I think its going to get tougher for everybody, and if you don’t have best business practices and a good balance sheet, and the information and the insights it takes to manage the patients; that people are going to opt out, but we’ll see. I have no evidence of that at this stage, but maybe in a quarter or two.

Justin Lake – UBS

So you don’t see the need to take that $1 billion that you talked about and keep that as a [warchest] to go out there and buy smaller plans. You think most of what you’ll be doing is more organic; is that fair to say?

Allen Wise

No, this company has always been opportunistic. If we find a property that fits our criteria, which is, do we understand the business, is it fairly priced, and third thing is do we know how to make it better; is our cost structure better in having one IT system, can we do better, we would always do that.

Its accretive, it helps our presence in the marketplace, and we did that for a long time, but consolidation kind of stopped and I believe that its likely on all those fronts we talked about, the Medicare advantage and registered with a small private Medicaid plans, but sort of into commercial I think that that will return.

One of the reasons that we didn’t do any share repurchases in Q1 is just to your point. I want to keep our powder dry and I think that buying businesses that we understand and no one make it better, and can make a fairer margin is good use of capital.

Operator

Your next question comes from Scott Fidel - Deutsche Bank.

Scott Fidel – Deutsche Bank

Just to address it first; if your 2010 guidance at this point has any healthcare reform related expenses, and just things like some of the early implementation of some of the market reforms or higher taxes shared with some of the reforms, bill changes, just if you could summarize that?

Allen Wise

Sure Scott. Yes it does, and those impacts we don’t believe are material to this year, but our guidance does account for them.

Scott Fidel – Deutsche Bank

Okay, and then do you have any estimate on how much membership that you can add in Pennsylvania Medicaid this year?

Allen Wise

Yes, that we added about 2000 orders signed in the month of April, and I think for the year that number is probably about 10,000.

Scott Fidel – Deutsche Bank

And then just one last question John, just if you have an update on the cost components and John if there is any change in view on any of them.

John Stelben

Sure. As I said earlier, its really stable, so I will just rip through the components. Now in-patient, that’s running in the range of high single digits. Really unique cost driven. Out patient, low double digits split but tilted a little more towards unit cost. On our physician I would say its mid single digits split. In an OpEx, it’s mid to high single digit again split. So again, a stable view of what we just discussed before.

Operator

Your final question comes from Kevin Fischbeck - Banc of America, Merill Lynch

Kevin Fischbeck – Banc of America, Merill Lynch

I guess I wanted to go back to the comments you made there on the acquisition front. Really it sounds like you think consolidation is inevitable. Are you seeing anything from just smaller plans embracing that view? Are you seeing proximity from them approaching you; any update there?

Allen Wise

You have to keep my comments in proper perspective; one closed deal in the quarter doesn’t make a trend. We see a thought process out there in several fronts where people are at least bringing new subjects to the table in their organizations. Obviously, if I had anything definitive there, I would announce it, but keep my comments in perspective. One, its my view, there is what I would characterize as some slight evidence in terms of people that we know that are sort of thinking about it, but that’s all.

As things get more difficult, as the revenue is harder to come by, I don’t see, if you don’t have best practices and a strong balance sheet and its not your primary business, I don’t see how you survive, certainly not thrive, I don’t see how anything else happens, but we will see. It’s my guess.

Kevin Fischbeck – Banc of America, Merill Lynch

Okay. So it sounds like, just about that last comment, you are talking more about kind of like the Christi type deals in companies that aren’t. Its part of their business, but not a focus of their business, and looking to sell that off rather than have a fixed plan.

Allen Wise

I think that’s right.

Kevin Fischbeck – Banc of America, Merill Lynch

I didn’t hear anything in particular about the Medicaid acquisition. Have you thought about growing that plan?

Allen Wise

Not beyond what I said. When I returned early in 2009, the second day I was here, I traveled to Nebraska, because an RFE was in process, and my view was that the government already represents over 50% of the healthcare spend. My view is that we needed to redouble our efforts in the Medicaid area. We have, and have successfully landed two pieces of new opportunity there, and so we would get Medicaid payers just the same way we would in commercial and continue to seek new business.

I think with the skill set we have; we’ve been in the business for 15 years. We just, I think got a little bit distracted with several other large acquisitions and we kind of returned to our rits, and so, we are very bullish, and we understand the challenges and we understand the right revenue, but it is an area of focus for the company. We are going to do our best by whatever means to grow revenue there. Whatever means meaning, either obtaining new business or if an acquisition opportunity would present itself, we would certainly look at it.

Kevin Fischbeck – Banc of America, Merill Lynch

Okay. That’s really helpful. This is just to clarify, on the Medicare advantage, the 85, that excludes the development right.

Allen Wise

That is the pure CCP loss ratio.

Operator

And that does conclude our question-and-answer session. I would now turn the conference back over to Mr. Allen Wise for any closing or additional remarks.

Allen Wise

That concludes our comments today and thank you very much for joining us.

Operator

And that does conclude our conference call. Thank you for your participation.

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Source: Coventry Health Care Inc. Q1 2010 Earnings Call Transcript
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