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Magellan Health Services Inc. (NASDAQ:MGLN)

Q1 2014 Earnings Conference Call

April 29, 2014 11:00 ET

Executives

Renie Shapiro - Senior Vice President, Corporate Finance

Barry Smith - Chairman and Chief Executive Officer

Jon Rubin - Chief Financial Officer

Analysts

Joshua Raskin - Barclays

Carl McDonald - Citigroup

Dave Styblo - Jefferies

Ana Gupte - Leerink Partners

Michael Baker - Raymond James

Scott Fidel - Deutsche Bank

Matthew Borsch - Goldman Sachs

Operator

Good morning. Welcome and thank you for standing by for the First Quarter 2014 Earnings Call. At this time, all participants are in a listen-only mode. (Operator Instructions) Today’s conference is being recorded. If you have any objections, you may disconnect at this time.

I will now turn your meeting over to your host Ms. Renie Shapiro. Ma’am, you may proceed.

Renie Shapiro - Senior Vice President, Corporate Finance

Good morning and thank you for joining us today. This is Renie Shapiro, Senior Vice President of Corporate Finance for Magellan Health Services. With me today are Magellan’s Chairman and CEO, Barry Smith; and our CFO, Jon Rubin. They will discuss the financial and operational results of our first quarter ended March 31, 2014.

Certain statements that will be made during this conference call are forward-looking statements contemplated under the Private Securities Litigation Reform Act of 1995. Forward-looking statements are subject to known and unknown uncertainties and risks, which could cause actual results to differ materially from those discussed. These forward-looking statements are qualified in their entirety by the complete discussion of risks set forth under the caption, Risk Factors, in Magellan’s quarterly report on Form 10-Q for the three months ended March 31, 2014 and in the current quarter’s Form 10-Q which will be filed in the SEC later today and will be subsequently be available on our website.

In addition, please note that in this call, we refer to segment profit. Segment profit is disclosed and defined in our Annual Report on Form 10-K and is equal to net revenues less the sum of cost of care, cost of goods sold, direct service costs and other operating expenses and includes income from unconsolidated subsidiaries, but excludes segment profit or loss from non-controlling interests held by other parties, as well as stock compensation expense. Segment profit information referred to in this call maybe considered a non-GAAP financial measure. Included in the tables issued with this morning’s press release is the reconciliation from segment profit to the line item income before income taxes. We encourage you to review such reconciliation for an understanding of how segment profit compares to that GAAP measure.

I will now turn the call over to our Chairman and CEO, Barry Smith.

Barry Smith - Chairman and Chief Executive Officer

Good morning, Renie and thank you all for joining us today. During the first quarter of 2014, Magellan took several steps to advance our strategic initiatives. We have recently announced that we entered into an agreement for pharmacy acquisition and are just a short time away from going live with our Magellan Complete Care, Florida SMI Specialty Plan. As you can see we are taking the necessary steps to execute on our plan and continue our progress towards achieving our long-term growth objectives.

As you read in our press release this morning for the first quarter of 2014, we produced net income of $25.7 million, diluted EPS of $0.92, and segment profit of $76.5 million. So far this year through last Friday, April 25, we have repurchased approximately 470,000 shares for a total cost of $27.3 million at an average price of $58.06 and to-date have completed approximately 48% of the current $300 million authorization. We ended the quarter with $291.8 million of unrestricted cash and investments. I am pleased with our strong results this quarter, particularly in our managed healthcare and specialty solutions businesses.

Jon Rubin will provide additional details on our results and an update of our full year guidance, but first let me discuss the progress we have made on our pharmacy management and Magellan Complete Care initiatives. It’s been a very busy quarter for our pharmacy management business, with Partners Rx now a part of our re-branded and reorganized pharmacy business we have hit the ground running in 2014. We have experienced strong sale success in the Medicaid managed care and employer markets during the first quarter.

Most importantly, the CDMI acquisition that was recently announced will further enhance our scale and capabilities as we strengthen our total drug offering managing any drug under any benefit at any site of service. The acquisition of CDMI will allow us to offer proven best-in-class clinical programs and outreached services to help manage chronic conditions such as asthma and chronic pain as well as provide offerings that addresses drug compliance and adherence. In addition, it will enhance both our traditional and specialty rebate management capabilities and will bring us additional customer relationships. This will create opportunities for us to cross-sell our PBM capabilities into CDMI’s existing MCO client base.

We expect the acquisition of CDMI to close tomorrow April 30. The best purchase price of $205 million will include $125 million to be funded in cash and $80 million to be reinvested in Magellan restricted common stock by the principal owners and by certain key management of CDMI. In addition to the base purchase price, there is a contingent payment of up to $65 million dependent on achieving certain rebate retention targets in 2015. There are also up to $100 million of earn-outs to be earned through 2016 based upon achieving certain gross profit performance targets and the potential conversion of CDMI customers to a full service PBM client. We expect CDMI will generate approximately $28 million of revenue and approximately $23 million of segment profit for the remainder of 2014. CDMI brings a strong leadership team adding further capabilities, customer relationships and expertise. It will be integrated over time into our pharmacy organization.

Jon will provide further details on this acquisition later in the call. I am confident that we will reach our goal to grow pharmacy revenues to at least $2.5 billion by 2018. Given our existing business, sales momentum to-date and the CDMI acquisition, we are well-positioned to achieve approximately $1 billion in pharmacy revenues in 2014 with the robust sales and acquisition pipeline in place. Further, this acquisition demonstrates our continued execution on our strategy to create a robust pharmaceutical operation that will drive future profitable growth.

Magellan Complete Care is moving forward in Florida, New York and Iowa as we position ourselves to expand our footprint into other geographies. In Florida, we continue to prepare for the implementation of our Medicaid specialty plan for individuals with serious mental illness, or SMI. We estimate that there are at least 100,000 individuals with SMI in the eight regions we were awarded, with an average healthcare spend of approximately $15,000 to $20,000 per year. The state is on track to migrate all regions to Medicaid managed care plans on a staggered basis for May 1 to August 1. However, the process of moving to mandatory managed care is extremely complex and the state continues to modify its systems to support an SMI Specialty Plan. As a result, our SMI Specialty Plan will not receive any initial auto assignment for the first four regions scheduled for May and June.

Once we are approved to go live, individuals in these first four regions who were auto assigned to general Medicaid plans will be notified by the Agency for Healthcare Administration, or AHCA, that they will have the opportunity to change from their existing plan to our SMI Specialty Plan. Beginning in July, all individuals in the remaining four regions who have been identified as having SMI will be auto assigned to our plan and will have opportunity – the opportunity for 90 days to opt out and choose another managed care plan. Approximately, 55% of the SMI population in our service area resides in these four regions.

As we get ready to implement our SMI specialty plan, we are beginning to hire and train approximately 200 employees across the State of Florida. We also continued to enhance our technology platform, which provides sophisticated reporting, predictive modeling and proprietary medical management algorithms. In addition, we are working with state to finalizing engagement strategies for individuals with SMI their families, providers and advocacy groups and our strengthening relationships in the community. We remain confident in our assumption that we will achieve penetration of at least 20% in the first year of implementation with the potential for significant additional penetration over time. We are working closely with AHCA to finalize all remaining details including rates. The state’s collaboration and support in bringing this groundbreaking concept to life has been outstanding and we applaud their position as innovators and leaders in improving the lives of individuals with SMI.

In New York AlphaCare continues to add members to its Medicaid managed long-term care or MLTC plan, launched in June of 2013 and its Medicare plans which launched on January 1, 2014. In addition, the state’s Fully Integrated Dual Advantage or FIDA demonstration program which integrates Medicaid and Medicare benefits is now scheduled to begin with voluntary enrollment on October 1, 2014. Auto assignment and the ability to opt out of Medicare will begin on January 1, 2015. MLTC members have been mandatorily enrolled in Medicaid plans like AlphaCare since last year.

As we prepare for the start of the FIDA program, we are focused on augmenting AlphaCare score operations and processes as well its marketing strategy to ensure effective community outreach and visibility. We are also building out the management team at AlphaCare and recently hired a Chief Executive Officer with extensive experience leading large Medicaid and Medicare health plans. Our 65% in AlphaCare has accelerated our entrance into New York – into the New York marketplace and expanded our Medicare and long-term care management capabilities, which can be leveraged in other geographic areas. In Iowa Phase 1 of our integrated health homes program also known as behavioral led health homes launched last July and on April 1 we began rolling out Phase 2 in 28 surrounding counties. The third and final phase covering rural counties will begin on July the 1.

This program which is available to adults with SMI and children with serious emotional disturbance or SED provide access to coordination of physical and behavioral healthcare. The initial data obtained on these two populations indicates positive outcomes from care coordination such as reduced time children are missing school and adults are out of work. The results of our Iowa IHH program will increase our significant data set and will provide further insight as we launch similar programs in other states. Our objective is to work with the state of Iowa to create an SMI specialty plan similar to our plan in Florida to be up and running when the first phase of this IHH program has been completed in June of 2015.

We continue to be aggressive in our pursuit of new markets and capabilities for other populations. We are pursuing HMO licenses in several states as we discussed the possibility of providing integrated care management for their special populations. Nebraska is expected to issue an RFP this summer for the management for their Medicaid long-term care population as well as their general Medicaid population. We plan to enter new markets and serve additional populations through acquisitions or by building out internal capabilities.

We are excited about our accomplishment to-date and look forward to growing this business. We remain confident in reaching our goal and managing no less than $2.5 billion of total healthcare spend for targeted populations in approximately five to seven states by 2017. Before I turn the time over to Jon I would like to update you on a few upcoming changes with the acquisition of Partners Rx, we now have a growing presence in Arizona which also happens to be where I live.

After much consideration we have decided to open a small executive office here and we will be transferring the company’s headquarters to Scottsdale over the next few months. While we will continue to maintain our business operations in many of their current locations, we will establish Scottsdale as our corporate headquarters with a few of our key corporate leaders residing there. We will continue to have a presence including an office and staff in Connecticut. As a result of this change some of our executives will move to Scottsdale and others will remain in their current location.

Jon Rubin and I have agreed that one of the key officers who should be located in the company’s Arizona headquarters is the Chief Financial Officer. After careful consideration Jon and his family have decided that he will not relocate to Scottsdale, as a result, we have agreed that Jon will be leaving Magellan. Jon has agreed to continue on for up to a year and if necessary to help recruit and orient our new CFO. He will be 100% engaged as CFO for the duration of this transition and nothing will change until we have identified and oriented a new Arizona-based CFO. Jon has been with Magellan for almost six years, and during that time has made numerous and valuable contributions to our company and over the last 16 months to me personally. I am grateful for all he has done and I am not surprised that his desire and commitment to provide great leadership in assisting in this transition. We will manage this change in a way that minimizes disruption and distraction and ensures that we remain stable and focused on our trajectory of profitable growth.

I will now turn the time over to Jon to discuss our results and an update on our guidance for the year. Jon?

Jon Rubin - Chief Financial Officer

Great. Thanks Barry and good morning everyone. Net income for the first quarter of 2014 was $25.7 million or $0.92 per share on a diluted basis. For the first quarter of 2013 net income was $28.1 million or $1.01 per share on a diluted basis. The decrease in net income between periods was mainly attributable to higher depreciation and amortization due to asset additions after the prior year quarter and acquisition activity and a higher effective tax rate as a result of non-deductibility of the health insurance fees, offset by higher segment profit.

Our segment profit for the first quarter of 2014 was $76.5 million compared to $69.2 million for the first quarter of 2013, primarily due to strong results in our commercial and public sector segments. Revenue in the first quarter of 2014 was $966.5 million, which was $144.7 million higher than the first quarter of 2013. The revenue increase resulted primarily from the inclusion of Partners Rx revenue in the current year quarter, new business and rate increases partially offset by loss of revenues associated with terminated contracts.

Regarding AHCA taxes or the health insurance fee, we now estimate that our full year expense will be approximately $20 million. Negotiations are ongoing with our customers for contract amendments which will enable us to recover the health insurance fees as well as the impact to our federal income taxes for the non-deductibility of these fees. We currently have one executed contract and are in various stages of finalizing amendments for other customers. We are now confident that the majority of the impact to us from the health insurer fees will be addressed via contract amendments. The timing of revenue recognition during 2014, however, will depend upon the timing of execution of these contract amendments. For the first quarter, we have recognized $5 million of expense and $3 million of revenue related to the health insurance fee. Including the impact of non-deductibility of these taxes, the negative impact on our first quarter EPS was $0.17 per share. We now expect the full year impact of the health insurance fee to be immaterial.

I will now review each of the segments results and growth opportunities beginning with commercial. Segment profit for commercial behavioral health was $37.6 million, an increase of $4.3 million over the first quarter of 2013. The increase is mainly due to new business and net increased membership from existing customers partially offset by terminated contracts. We have experienced the modest increase in health plan exchange membership during the latter part of the quarter. Overall, exchange membership is still lower than expected for a number of health plans as they work through their enrollment challenges.

During the quarter we have also seen expansion in our military and family life counseling program and are now expecting annualized revenues from this contract in excess of $100 million. We have renewed all significant health plan customers whose contracts were up for renewals in 2014. From a pipeline perspective, we continue to work on health plan, military and employer opportunities for the latter part of 2014 as well as pursue opportunities for 2015.

Segment profit for public sector was $34.1 million, an increase of $8.2 million from the prior year quarter. This increase was mainly due to the timing of incentive revenue and rate increases in excess of care trends partially offset by the excess of health insurer fees over revenue recognized to-date. On April 1, we transitioned the Maricopa contract to the new vendor. We are continuing to proceed with our appeal in the Superior Court and are waiting for scheduling of a hearing on this matter.

We ended this contract on a positive note executing on all performance targets and ensuring that our members had consistency and continuity of care. The State of Iowa has notified us of its decision to extend our contract for the one year optional period. This contract will now run through June 30, 2015. Regarding the public sector pipeline, the States of Maryland, Texas, California, and Georgia have all released RFPs for behavioral health services, while other RFPs including New Jersey and Greater Arizona are expected to be released later in 2014.

In our specialty solution segment, first quarter 2014 segment profit was $17.1 million, a decrease of $2.2 million from the first quarter of 2013. This decrease was mainly due to anticipated rate reductions on renewals, which were partially offset by the impact of new business and net increased membership from existing customers. We continue to see growth from both new products and from Medicaid expansion within our health plan customers. We recently signed a new risk contract with a national Medicaid MCO that includes both RBM and cardiac services across five markets.

Implementation of these markets will be phased in from April 1 through August 1 and the contract expected to have annualized revenues of approximately $50 million. We are also pleased to see expansion from existing customers with new exchange membership in our various programs. In addition to new sales, our products suite expansion continues to resonate in the marketplace, most notably, our musculoskeletal program focused on spine surgery and interventional pain management continues to generate significant interest. Our pipeline also continues to include risk RBM and cardiac opportunities.

First quarter segment profit for the pharmacy management segment was $15.3 million, a decrease of $0.6 million from the first quarter of 2013. This decrease is primarily due to terminated contracts partially offset by new business and the inclusion of Partners Rx in the current year results. We experienced strong organic growth in the pharmacy business. In addition to the $65 million life MCO with revenues of $40 million that we mentioned on the last call, we recently signed a new PBM contract with the Medicaid MCO with approximately 60,000 members. We expect this contract to go live in the second quarter of 2014 and produced annualized revenues of approximately $60 million. During the first quarter, we also added approximately $80 million employer lives. And in April 1, we successfully implemented the contract with the Medicaid MCO that we discussed on our guidance call in December.

Our pharmacy pipeline contained multiple state fee-for-service PBA opportunities and we anticipate additional state RFPs in the latter part of the year. Our pipeline for employer opportunities is robust as well. We continue to focus on the employer managed care specialty and government markets. And as Barry talked about it earlier, CDMI will further enhance our pharmacy capabilities and position the company for continued growth.

Regarding other financial results, corporate costs excluding stock compensation expense were $2.3 million greater than the first quarter of 2013. This increase includes cost associated with acquisition activity in the current year period. Excluding stock compensation expense, total direct service and operating expenses as a percentage of revenue, were 16.6% in the current year quarter, which is slightly higher than the ratio for the prior year quarter mainly due to health insurer fees recorded in the current year. The effective income tax rate for the quarter ended March 31, 2014 was 51.2% compared to 40.5% for the prior year quarter. The increase in the effective tax rate was mainly due to the impact of the non-deductibility of health insurer fees.

Turning to cash flow and balance sheet highlights, our cash flow from operations for the three months ended March 31, 2014 was $82.8 million compared to cash flow from operations of $45.9 million for the prior year quarter. Cash flow for the current year period and the prior year period includes the positive impact of a shift of restricted cash into restricted investments in the amounts of $28.2 million and $5 million respectively, which are reflected as a source of cash from operations and the use of cash from investing activities.

Absent these transfers, cash flow from operations for the current year totaled $54.6 million compared to $40.9 million for the prior year period. The increase in cash flow between years is attributable to the increase in segment profit of $7.3 million and the net favorable impact of working capital changes of $6.4 million. The other working capital changes were mainly due to a decrease in working capital for the pharmacy management segment partially offset by additional restricted cash requirements for the company’s regulated entities.

As of March 31, 2014, the company’s unrestricted cash and investments totaled $291.8 million, which represents an increase of $30.4 million from the balance of December 31, 2013. Approximately $59.6 million of the total unrestricted cash and investments at March 31, 2014 related to excess capital and undistributed earnings held at regulated entities. The company’s restricted cash and investments at March 31, 2014 of $442.9 million, reflects an increase of $56.1 million from the balance at year end. Of this increase $12.6 million is due to the net increase in restricted cash requirements for expansions in public sector business and the remainder relates to increase in restricted funds, which are offset by changes in other balance sheet accounts and which does not result in the use of cash. Restricted cash and investments include approximately $60 million related to required capital for the terminated contract with Maricopa County. We expect these funds to become un-restricted later in the year.

As Barry noted, CDMI is expected to generate revenues during the last eight months of 2014of $28 million and segment profit of $23 million. This acquisition will have a significant tax benefit to Magellan that is estimated to be approximately $80 million, assuming a base purchase price of $205 million and which will be recognized over 15 years.

The tax benefit will increase if there are additional earn-out payments. The purchase price includes $80 million of restricted stock that has service and performance requirements and which will result in stock compensation expense of approximately $20 million during the remainder of 2014. Depreciation and amortization are estimated to be $9.5 million for 2014. In the current year, the CDMI acquisition is expected to be dilutive to EPS by approximately $0.14 per share due to the non-cash stock compensation expense and amortization of acquisition intangibles. Excluding the impact of these non-cash items on EPS, the CDMI acquisition is expected to be accretive by approximately $0.50 per share in 2014.

Relative to 2014, we are updating our guidance to reflect the impact of the CDMI acquisition as well as share repurchase activity. Our 2014 full year expectations of revenue of $3.6 billion to $3.8 billion, net income of $53 million to $69 million and segment profit of $238 million to $258 million. We are increasing our guidance for cash flow from operations to a range of $204 million to $226 million. We continue to expect a full year effective tax rate of approximately 49%. Taking into account, the impact of share repurchase activity through April 25, 2014, but not considering any potential future share repurchases, our guidance range for fully diluted EPS is estimated to be $1.89 to $2.46 based on 28.1 million average fully diluted shares.

Included in our projected EPS estimates, the dilution of approximately $0.64 per share related to the non-cash items associated with the CDMI acquisition, specifically the amortization of intangibles and the stock compensation expense resulting from restricted stock purchases by the sellers. Included in our original guidance was a target for new business revenue of $450 million to be recognized in 2014. We have now sold sufficient business to exceed our original target and anticipate recognizing new business revenue of approximately $520 million in 2014.

In closing and following up on Barry’s earlier remarks, I expect to still be here at Magellan for some time to affect a thoughtful and smooth transition and I will be fully engaged as CFO during that period. At the same time, I want to take this opportunity to convey how extremely proud I am to have been part of the Magellan team over the past almost six years and of our collective accomplishments. And while Barry and I agree that this direction is best for both the company and my family, I will have very mixed feelings leaving Magellan, given the outstanding people that I have had the opportunity to work with here and a great position that we are in as a company to achieve future success.

Barry and I are now available to answer questions and I will turn the call back over to the operator. Operator?

Question-and-Answer Session

Operator

Thank you, sir. (Operator Instructions) Our first question is from Joshua Raskin with Barclays. Your line is open.

Joshua Raskin - Barclays

Great, thanks. Good morning. Just want to make sure I understood the Florida change here. So I think you said that the April and May 45,000 or so of those individuals coming in I think it was April and May and did I understand that Magellan will not be able to enroll any of those lives. And then the 55,000 after that starting in June 1, we will get auto assigned with that 90 day opted out is that the way to think about it?

Barry Smith

Yes, Joshua good afternoon and the short answer is yes. In May the earlier prior to July 1 enrolments will not be auto assigned, but starting on July 1 they will. We expect on July 1 55,000 which are the more dense counties in the Southern Florida in those regions those will be auto assigned. Now for those that go earlier in May and April those individuals will receive letters from AHCA and will be a marketing element to it that will invite those individuals to participate in our plan. So we expect to see some enrollment, but we can’t say yet what level of enrollment we will see from that – those initiatives. We do think that we are going to see significant enrollment from the July 1 auto assigns. And as we said in the script earlier today, they have 90 days to opt out of the plan. We have indicated earlier that we expect at least 20,000 lives to enroll this initial wave the first year and we are very confident of that number and so the issue is just how many more can we expect during the course of the year. And how many of these non-auto assigned will actually opt into our plan during the first 90 days they ago live.

Joshua Raskin - Barclays

Right. So just so I understand the 45,000 in April and May they are going to get a letter from Florida’s AHCA and then you can market through them for theoretic yields, you know who those people are. What if they don’t or what if they don’t enroll in a plan if they don’t like what happens to them?

Barry Smith

Well, they could be in a general Medicaid plan and remain in that plan if they wish. The benefit level and the level of attention for this population isn’t at the same level as it would be with us. And so we think there is a significant incentive for them to join our plan. And many of them don’t forget since we have been involved in the State of Florida for many, many years, managing the SMI population. We are a relatively well known entity to many of these individuals

Joshua Raskin - Barclays

Right. So and then I will pick their stay in the traditional people service Medicaid and then but on July 1 they don’t get auto enrolled at any point, right?

Barry Smith

That’s correct.

Joshua Raskin - Barclays

Okay. Okay, got you. So that makes sense. And then just a second question around the M&A and your thoughts and perspective around your targeted financial hurdles, etcetera. Could you talk about Barry, your perspectives on what you think are the most important metrics in terms of acquisition sizes, is it returns, is it accretion and then maybe just some specific comments around future acquisitions and whether you would expect them to potentially be dilutive to begin?

Barry Smith

Well we look at this on a GAAP basis, because of the stock of the sellers are taking a majority. We think that’s s a good thing. We want to make certain theories that are in line with ours and so we like that structure a lot. Obviously from a GAAP perspective it shows up that $80 million of the charge. But again don’t read – don’t forget that this is a restricted stock and with certain performance parameters, which we like to see as part of the structure. So we chosen to do these deals. If you don’t consider that comp expense this is a very accretive deal, great cash flow and brings us great capability. So we clearly would prefer to have to be accretive both on a have to be accretive both on a GAAP basis notwithstanding the stock compensation. But again we would like to have those aligned incentives with the sellers. So we think that’s an important element of the structure.

Relative to the measures going forward, we do think that these acquisitions do need to be accretive. And we’ll not do deals which are not fundamentally accretive to the business. We also consider the capabilities of the acquisition. So for example in the case of CDMI, we have got great clinical leadership and clinical programs. The rebate business is not that kind of rebates without the clinical tools and capabilities, I think we will be – we challenged in the future, you have to deliver value and tie your rebates to the clinical services delivered.

CDMI has extensive clinical programs and is very strong in the marketplace and has a pretty amazing large client so that our clients we would love to have it full service PBM clients. So they bring that to us because of their clinical capabilities. We also had a very strong rebate element which we like in terms of the cash flow and profitability. And thirdly, as I have mentioned a little bit earlier this cross-selling and ability to strengthen our specialty business and our traditional rebate business is very appealing.

So CDMI, George Petrovas who heads our CDMI actually is a part of deal Magellan family. We acquired ICORE as you recall in 2007 if I recall correctly. And George Petrovas was the key leadership member of that team at ICORE. So we know George, we know of his capabilities and the team both Bob Field and I are thrilled to have George’s team back with us here at Magellan. So CDMI is a good example of clinical capability, strengthened the rebate both traditional and specialty rebate business as well as the cross-sell opportunity. There are other areas that we would love to look at such as mail service we mentioned in the past. We also think that PDP programs are important, an important element going forward. So we will look at other acquisitions that bring us capabilities but which also are accretive and build the management team.

Joshua Raskin - Barclays

Got you. The shares – the preferred shares you are issuing that $80 million is that going to be those preferred or are those included in the weighted average diluted share count, then going forward, is there a stock issuance it didn't look like – in the guidance in terms of shares outstanding?

Barry Smith

Yes, I mean it’s not material Josh but they are included.

Joshua Raskin - Barclays

Okay, so it’s not a 1.5 million shares or so is that just may be offset by some repurchases etcetera?

Barry Smith

Yes and you also have to take into account the way that the common stock equivalents are determined, so I mean – so in total in terms of the impact on the outstanding shares it doesn’t – it surrounding, it doesn’t move at – and during the current period.

Joshua Raskin - Barclays

Okay, got you. Thanks and congratulations Jon by the way on the transition.

Barry Smith

Thank you. And I really appreciate it Josh.

Jon Rubin

And Josh this is a quick follow up the – from a GAAP standpoint its $0.14 diluted but its positive accretive by $0.50 on non-GAAP including the tough session expense. I think given the same opportunity to make sure that the incentives are aligned. We probably look at doing a very similar kind of a structure although if we didn’t need to we wouldn’t.

Barry Smith

Yes and I think Josh just to underscore that I mean that you probably understand that’s with the base purchase price of $205 million the way it worked is that again $80 million was reinvested by the sellers in common stock. And that in the sense because of the performance and other requirements gets recorded as stock compensation. So in effect you can think that as part of the purchase price but again as Barry said the GAAP accounting leads to non-cash expense.

Joshua Raskin - Barclays

Okay, understood. Thank you.

Jon Rubin

Great thanks Josh.

Operator

Our next question is from Carl McDonald with Citigroup. Your line is open is open sir.

Carl McDonald - Citigroup

Great, thank you. So two follow-ups to Josh’s question, just on the last one point the management of CDMI is going to get $205 million in cash then we take $80 million of that and buy stock or they get issued $80 million in stock?

Barry Smith

No it’s the former Carl. They are getting the cash and then turning around and purchasing the restricted shares.

Carl McDonald - Citigroup

Got it, okay. And then just going back to the Florida, situation the April-May individuals they are getting auto assigned to a managed care plan its just not going to be you, is that correct interpretation?

Jon Rubin

That’s correct Carl.

Carl McDonald - Citigroup

Okay. And can you just walk through what the change revolved around there?

Barry Smith

Well, really is an issue of systems, capability and development and they simply weren’t able to go live of auto assignment with the SMI population in April and May. So, it was nothing more than that. We hope that we will be able to capture a good portion of those individuals come July 1 after we go live.

Carl McDonald - Citigroup

Okay. And then just more – just in terms of the earnings just walk through how first quarter turned out relative to your expectations and consensus introduced by a decent amount, no change to the underlying guidance, so as a situation where first quarter just turned out to be in line with your expectations, we were low or is it – now is there are some sort of a cushion in the guidance or some kind of an offset to adjust for the upside in 1Q?

Barry Smith

Carl, I will try to walk through those. As you know, I mean, we don’t publish specific guidance for the quarter. So, we don’t really have sort of an official expectation, but if you look at it big picture, yes, I would say we came in a little bit stronger first quarter. We had a little bit of favorability in what we call out of period items, around $3.5 million, the majority of that being favorable reserve development, but on balance I would say that, we view it as a strong quarter, but certainly in line with what we were thinking big picture as we were – as we were thinking about up full year.

As you look at pluses and minuses, again I look at it is as we are the out of period items, a little bit of a plus first quarter. As we talked about also in our script, we are now feeling increasingly confident about getting the reimbursement of the full amount of the health insurer fee and the associated non-deductibility impact. On the other hand, as Barry said, we are still really sorting through our expectation around Florida and what the membership will be full year. We are very confident that we will at least set the 20% threshold that we had guided as a minimum. But there is some upside and that could create some additional staffing and upfront cost that we need to consider as we think about the full guidance. So, all-in, we still believe that the original guidance we had out there adjusted as we did for the CDMI acquisition is still our best estimate.

Carl McDonald - Citigroup

Great. And I appreciate it. Thank you.

Barry Smith

Right. Thanks Carl.

Operator

Our next question is from Dave Styblo with Jefferies. Your line is open, sir.

Dave Styblo - Jefferies

Sure. Good morning. Thanks for taking the questions. Just to stay on the first quarter results here for a second. Can you guys allocate where that $3.5 million came from? I guess I am just looking in the commercial and public sector seemed really, really strong, so I suspect maybe some of it comes from there, but if you could elaborate if it’s part of out of period development and then I think you had mentioned perhaps some rate increases wasn’t sure where that might have fallen? So, if you could help flush out those two segments and their strong results? That would be helpful.

Jon Rubin

Yes, I would say that if you look at the prior year development, first of all, it was really split roughly $3.5 million two-thirds in public sector and a third in radiology. So, those were the two segments that really had the most impact from the out-of-period items. We did also have in commercial some other favorability in retro membership and customer settlements that was in the $2.5 million range. So, there was some benefit in all three segments as we look at the out-of-period items then a little bit of an unfavorable expense item in corporate. So that kind of gets you to the $3.5 million of out of period.

Dave Styblo - Jefferies

Okay. Just to be clear that $3.5 million that’s then there was another $2.5 million of favorable items in commercial, right?

Jon Rubin

Right, and again offset by some unfavorable expense items in corporate.

Dave Styblo - Jefferies

Got it. And then maybe I missed this or didn’t quite understand it, but are you effectively also increasing your expectations for recouping the industry fee for this year?

Jon Rubin

Yes. If you recall, when we gave our original guidance, we have said that we expected to recover the majority, but not all of the combination of the health insurer fee and the associated non-deductibility, which is – comes through in the tax provision. We now are confident that we – and I think we described the delta in round numbers is around $10 million. We are now confident that we will get the vast majority of it and we expect that delta not to be very immaterial.

Dave Styblo - Jefferies

Okay. So, strong first quarter, better recoupment of the industry fee, their trajectory sounds pretty good as we are launching off here. I guess the question asked earlier, is it – it just sounds like there is more conservatism and guidance at this point just trying to figure out how quarter pans out or is there something incremental that we are just not considering at this point?

Jon Rubin

No, I’d say in terms of new news in the quarter, I would say, again a little bit of favorability first quarter with the out-of-period items favorability relative to the AHCA health insurer fee recovery. And I would say uncertainty in Florida around membership levels and what the associated startup expenses will be. So as we look at – and again remember, we have a range out there, it’s not a point estimate. When we assessed it and looked at various scenarios, we still believe the range we have out there is appropriate without just discussing where we might be in that range.

Dave Styblo - Jefferies

Okay. And then just lastly on CDMI, obviously dilutive this year, can you guys talk a little bit about where that entity is in terms of its growth cycle, how is it growing, is it more expanding existing relationships, a lot of Greenfield opportunities? I think I get the cross-sell opportunity into their customer base, it sounds like they have got 30 key customers maybe. If you guys could help provide some parameters about how deep the membership is? That would be helpful so that we understand just the cross-sell potential there. But not only that, how do we think about accretion going forward, I know obviously you are not giving guidance for ‘15, but should this become an accretive situation next year after we get through transaction costs and getting things going this year?

Barry Smith

Yes. I will start off with the kind of the CDMI opportunity. We feel very strong about the ability of George and his team to sell and to expand markets. They have grown very rapidly both in terms of the depth within their client relationships, but also new client relationships. So we think that we can grow both ways with George’s relationships and selling capabilities. It’s interesting, there is $100 million upside to George in going through the next several years, if he could grow and convert – help us convert existing base into full PBM capabilities. Now, in order to achieve that number, he would have to – that would mean $3 billion to $4 billion for Magellan. So – and we think that there is and I am not saying that’s what George will do, I am just suggesting that there is significant upside through the cross-sell opportunity for CDMI. So, we are very excited about that and their potential for growth.

Jon Rubin

Yes. Following up on the second part of your question, relative to accretion or dilution I mean we’re not at this point prepare to give specific estimates for 2015 but what I will say is again remember that the reason on a GAAP basis that this appears dilutive is because of the fact that again a portion of the purchase price that $80 million that the sellers reinvest in respected common stock under GAAP gets recorded as an expense when you could very much view that from an economic standpoint is being part of the purchase price which is why we talked about it both on a non-cash and a cash basis the impact on EPS that expensing of the stock in stock compensation is a 42-month period that that gets expensed over. So, you can really look at that almost as a separate kind of impact and clearly if you look at things on more of a fundamental economic or non cash basis this is accretive from the outside, on a GAAP basis we’ll certainly be very accretive again once the expensing of that stock comp is complete.

Dave Styblo - Jefferies

Okay, thanks.

Barry Smith

You bet.

Operator

Our next question is from Ana Gupte with Leerink Partners. Your line is open ma’am.

Ana Gupte - Leerink Partners

Yes, thanks. Good morning. So you talked I just wanted to broaden the discussion a bit on some of the trends that you’re seeing I think one of things you said was the health plans that you are providing services for are beginning to recruit exchange membership and there has been some buzz about exchange Rx indicators, I think it was Express and perhaps even Prime that talked about specialty another consumption being higher than the normal population, I just wanted to get your thoughts about how that looks and do you think that this has been priced appropriately by managed care. And as you are contracting with these health plans, is there any kind of shared risk arrangements that they or you are contemplating on a go forward basis?

Jon Rubin

Let me take that, I mean I can’t really comment on how things are being priced by managed care, I mean you have to ask the managed care plans but from our perspective, while it’s early to tell what the actual utilization is, we feel confident that the pricing of our services where we are sub capitated does reflect what we believe is the best estimate of the incremental utilization. So we did factor that into the pricing. We still believe that based on what we know that’s appropriate but I will caveat it by saying, it’s still early in the process, the exchange membership itself is still ramping up. And obviously the claims development is we are just starting to see but no specific signs at this point that would elucidate any material concern.

Barry Smith

And we just don’t as far as these – and in terms of these new blockbuster drugs like this Sovaldi for example (lithio). These drugs have expanded dramatically. It’s got a lot of press. In our population our commercial PBM business for example it goes from 0.8% of total spend to 2.1% so you are seeing some significant rise. We today don’t really have significant risk relative with those because we don’t as Jon said risk or capitated arrangements for these drugs. We will have some exposure within MCC but again we have a fairly aggressive prior authorization management structure that we are putting in place to manage the cost of these drugs. But these new blockbluster drugs which are really up-ticking the trend of total drug spend, I think are going to be a concerned for the entire industry on how they price and how they think about these new drugs.

Ana Gupte - Leerink Partners

To follow up on that, then on Sovaldi, I think on complete care you are probably at risk on the kind of Medicaid-ish, seriously mentally ill or dual like population for the other side of the business where you have got the TPA arrangements, on balance net for this quarter did Sovaldi act as a tailwind or a headwind if you will, because I know you have full service PBM membership but then you probably do this on a fee based arrangement in other areas right. And I would imagine that there is a bit of tailwind Centena 54 had talked about a carrier being a tailwind for them on pharmacy.

Barry Smith

Yes, I think that's true, clearly we make margin on drug spend and so the higher the drug spend the more margin any PBM would make. So if you don’t have risk on these blockbluster drugs that are coming out, you do get some tick up or benefit from that. So that is true. And it depends on the MCO involved what kind of effect it has. And the populations we are looking at in Florida, we said they were between third and twenty – 20% and 30% of the drug spend is within this population of total premium dollar here and these new blockbluster drugs could two, three points of that total spend. So it’s not the main driver but it is a significant driver trend. And I think that with drugs like Sovaldi, this and others that are clearly clinically superior to their alternatives. There is no real step there that you can put in place, you can’t say if you were not going to include it in the drug plan because the effective medication there does happen to be a higher copay attached to these medications just because they are so expensive. So there will be some natural limiters to people but we don’t see great exposure and potentially some tailwinds or some uptick from a profitability standpoint as they come through our plan. And when it relates to the Medicaid pharmacy business that we run, great opportunity, additional new contracts coming out over this next year really is not material to us because these are administrative services contracts and we don’t include that drug spend in terms of our costs and neither in our revenue. So we really don’t have any effect positive or negative in those Medicaid pharmacy plans but that may have been more of an answer than you wanted.

Ana Gupte - Leerink Partners

No, that’s helpful, that’s helpful. So, it sounds like more of a tailwind to me than I had been particularly given the Medicaid adoption of breakthrough therapies has been a lot slower than Medicare in commercial like I guess it’s what I’m hearing…?

Barry Smith

That’s exactly right Ana, I think you’ve got that right on target.

Ana Gupte - Leerink Partners

One last question, was weather a tailwind at all for you in this quarter just on behavioral health or anything else?

Barry Smith

No, not really a factor either way. I kind of smile when I hear a lot of that in the marketplace about various companies being affected. I assume that can be true but it’s certainly not true in our world.

Ana Gupte - Leerink Partners

Okay, thank you. Thanks for taking my questions.

Barry Smith

You bet. Thank you, Ana.

Operator

Our next question is from Michael Baker with Raymond James. Your line is open.

Michael Baker - Raymond James

Yes, thanks. On the PBM, you mentioned wins in the state and employer side, just wondering how it’s come along on the managed care side as you pursue those opportunities?

Barry Smith

Yes, we’ve seen some good progress in the managed care world, Medicaid and managed care particularly. I think we’ve already announced the PBM contract is going to be going live in the significant revenue with that contract and other PBM contracts going live in the second quarter. So, we’ve got a lot of good activity going on and we’re seeing, I was just Bob Field yesterday who is the CEO of our Magellan Rx business and he says that he is seeing a lot of activity. A bit even more positive than we probably anticipate in terms of timing in both the employer side as well as the Medicaid MCO side and we’re seeing some also some good traction on the commercial side but largely the Medicaid MCO side. These plans are under pressure and they’re looking for more sophisticated solutions and clinical programs which we can deliver. We also have the great benefit really understanding cold the Medicaid pharmacy world. So it allows us to bring our expertise to these plans that are struggling with drug cost.

Michael Baker - Raymond James

And then in terms of the employer side in those winds what are some of the key differentiators you’re highlighting vis-à-vis some of the larger players in the marketplace?

Barry Smith

Well, I think to a great degree it’s the level of understanding of their drug spent where we get very specific and we have a lot of clinical understanding and a lot of understanding of utilization patterns and trends. And we provide that data real time in many cases to these employers and TPAs. We’re very responsive as a provider as a PBM and our solutions in terms of implementation are, we could implement in a far more rapid way. So we’re very responsive, I think the reporting that we have is far more detailed, providing greater insight and intelligence into their drug spend and how to manage those drugs. And what we’re seeing with pricing is that there is the traditional way that brokers would have priced these drugs with their new pricing mechanism out there where they are able to evaluate how bidders like us are bidding. We are a transparent model. We tell and communicate with our clients exactly what we’re making and how we’re making it and we deserve a good profit for doing what we do but that’s not traditionally been the case for larger PBM. There is a lot of bundling and packaging. So employers and health plans aren’t quite certain what they are buying or what they are paying for and we are very different in that regard.

Michael Baker - Raymond James

And then finally just to get a sense of the dynamic what is the CDMI management team asking from you what they need in order to enhance their close rates on cross-sell opportunities?

Barry Smith

One of the great…

Michael Baker - Raymond James

From a functionality standpoint?

Barry Smith

Sorry, last part of your question.

Michael Baker - Raymond James

Yes, I was just wondering if there is anything from functionality standpoint because I know you mentioned there is still some pieces that you are looking to kind of bring in over time, I was just wondering if any of those are being highlight by them to enhance close rates?

Barry Smith

Yes, one of the great benefits of this deal from CDMI perspective is that they needed the credibility of an entity with the financial stability security from Magellan. We have very sophisticated technology and systems. We are full service PBM. We are adding on incremental capabilities but CDMI didn’t have that capability so they de facto could not sell a full PBM solution to a large client. So to them, what we have today is a great benefit and solution to help them sell into their marketplace. We both collectively still would like to enhance our Part D capabilities as well as mail service capabilities. We do buy both on the open market which we can’t do, but we give away a better margin to do that. We’d like to have that internally held so that we can offer a full solution, but CDMI again is highly complemented the product line by our general PBM capabilities that we have.

Michael Baker - Raymond James

Thanks, Barry and thanks Jon as well.

Barry Smith

You bet. Thank you, Michael.

Jon Rubin

Thank you.

Operator

Our next question is from Scott Fidel with Deutsche Bank. Your line is open.

Scott Fidel - Deutsche Bank

Thanks, and first of all Jon best wishes on your next move as you leave the company. And first question just on CDMI, can you maybe just talk about the gross margin profile a bit, it looks like just based off of the guidance that you gave for revenues and segment profits that it’s running around the 80% range and just wanted to confirm that if that’s the type of gross margins that the company is trending out or if there is any usual factors that are benefiting the margins this year?

Jon Rubin

No, no Scott there is nothing unusual benefiting the margins. Remember, when we record revenue we are recording revenue on a net basis. So, so think about rebates and there is sort of a gross rebate and there is a portion that we’re able to retain either percentage of rebate or an administrative fee. So in a sense, the margins look high, because the revenues being recorded on a net basis and expenses to mange the programs on a relative basis, relative to that net revenue are reasonably low.

Scott Fidel - Deutsche Bank

Sure. And any insight you can give us into what the gross revenues look like, so we can maybe get a better comp to some of the other peers that report on a gross as compared to net basis?

Jon Rubin

Yes, we are not reporting that Scott. So, again we think the relevant number is the net one, and for multiple reasons including competitive ones don’t want to give that ratio.

Barry Smith

I will say Scott though relative to total margins, if you take a look at the PBM industry in general you are looking at margins traditionally in other words they are tamped down with some of the acquisition M&A activity that happened, but between 4% to 5%. And we’ve always said that we want to be competitive and that we would come up from the bottom 2.5%, 3% up. So having the capabilities and the profitability of what CDMI does is important in the total mix in terms of margin calculation in future. So it’s a really important component. It is too bad the whole, our whole book of business was in 80% but it is not.

Scott Fidel - Deutsche Bank

No doubt. Then just second question, just, any update on cost trends just across any of the segments and just interested in commercial with the margins here having pushed back up towards 20% you mentioned there was a modest out of period benefit but it definitely looks like there has been margin expansion that’s been progressing. So, at this point should we assume that you’ve now annualized off of some of the bump in utilization that you saw when some of the ACA components have gone into effecting you saw some initial utilization does that seem to have leveled off at this point?

Barry Smith

Yes. I think that’s more the driver here. It’s not trends I mean trends have continued in terms of the cost of care trends at a similar level to what we’ve seen over the last year or two but as you noted, we did see some uptick in trends that were one time in nature as a result of some of the ACA provisions particularly as you remember the inclusion of young adults in the healthcare plans of our customers. We’ve now seen that level off to we’ve kind of reached the threshold level on that. So, we’re back to more what I’d described as normalized trends as we go forward which again combined with pricing we're able to achieve this year did give us a modest uptick in margin.

Scott Fidel - Deutsche Bank

Okay, thanks.

Operator

(Operator Instructions) Our last question at this time is from Matthew Borsch with Goldman Sachs. Your line is open.

Matthew Borsch - Goldman Sachs

Yes, hi thank you. Most of the questions were addressed but just a couple of clarifications here when you talked about the expensive hepatitis C drugs ranging from I think you said 0.8% to 2.1% of total pharmacy spending I think is correct me if I’m wrong there and then I think you pointed to Florida accounts as having as much as 20% to one-third of their total medical spending devoted to pharmacy. Did I get those facts right?

Barry Smith

Yes. Let me clarify, it’s a good point to make sure we clarify. From quarter one of 2000 – from the last quarter to quarter one 2013 to quarter one of 2014 the HC drug spend went from 0.8% to 2.1%. So you see in the introduction and the impact of Sovaldi, Alico and really these drugs are typically not administered by themselves. There is usually a complex of drugs that are offered to increase the safety and to decrease the side effects of these drugs. We often here about Sovaldi, being $84,000 for a course of treatment, it’s important to take the entire course of treatment if it’s going to be effective. But typically it’s more than that, it’s typically between $97,000 roughly and $135,000 with a complex of drugs that are taken with it. So these drugs collectively increased the total spend from 0.8% of total drugs spend first quarter of 2013 to over 2% in the first quarter of 2014.

Now, relative to the Florida drugs spend we've always looked at the SMI population very closely, because it’s what we work with and we initially thought that the total spend for that population to be roughly a third and we've seen that from the data historically of the total premium dollar. So in some plans with different populations – special part of these populations that can be really 20% rather than the 33% or so of the total revenue dollar, so but this for special populations and in our particular case we are looking at the SMI population. We have said I think in numerous presentations that we expected that to be roughly a third of the premium dollar, it may be less than that with the proper kind of drug management that we will put in place there in Florida.

Matthew Borsch - Goldman Sachs

Got it. And do you have visibility or at lease some visibility on where different Medicaid programs are in terms of allowing – covering I should say that the new Hep C drug regimens?

Barry Smith

Well, with the challenge that most programs have is that these drugs are simply very effective which is a great thing for ethically, it’s a great thing, they are just really expensive and so there really is no prior authorization rational if a patient meets the criteria and I will speak about that just a moment, meets the criteria not to allow these drugs to be taken. Now, there are certain social behavioral issues in terms of drug use and alcohol abuse that could have impact here, so the states will likely try to put in certain requirements for monitoring. They certainly require a certain hepatologist and other specialist who would be involved in prescribing of these medications but by and large these drugs will be allowed to be dispensed and the states will have exposure to the cost of these drugs. There are certain genome types, types five and six for example of the Hep C virus, these drugs are not effective for. And so that’s a qualifier for example, you don’t want to have that testing done to make sure you wouldn’t make the investment in that drug therapy. If there are certain measurements of effectiveness, you might have them on of a 12-week regimen, you might only go a month for example and then take the blood test to see if the drugs being effective. If it’s not being effective and there are certain clinical indicators it bet isn’t being effective, you would not continue the expensive therapy. But bottom line if the patient meets the criteria clinically, we believe that they will be offered and that there will be exposure in the state Medicaid pharmacy programs.

Matthew Borsch - Goldman Sachs

But I am just curious do you have visibility on when is that occurring?

Barry Smith

Right now.

Matthew Borsch - Goldman Sachs

Right now, so the states are really moving?

Barry Smith

Yes. All these blockbuster drugs get a lot of attention because they are such a significant portion of the drug spend. And so virtually all of these programs are looking at and implementing when possible prior authorization and ongoing management techniques to make sure that the drug is used in an appropriate way. So these are ongoing through both in the Medicaid pharmacy program for the states, it’s also true in the commercial and MCO populations.

Matthew Borsch - Goldman Sachs

Okay, alright, that’s all I had for now. Thank you.

Barry Smith

You bet. Thank you, Matt.

Operator

Gentlemen, we have no further questions at this time. So, I am going to turn the conference back over to our leader, Mr. Smith. Sir, you may proceed.

Barry Smith - Chairman and Chief Executive Officer

Thank you, operator and thank you all for joining us today. We look forward to speaking with you in July when we discuss our second quarter results. Good day.

Operator

That does conclude today’s conference call. We thank you all for participating. You may now disconnect and have a great rest of your day.

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