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Magellan Health Services, Inc. (NASDAQ:MGLN)

Q2 2014 Results Earnings Conference Call

July 25, 2014, 11:00 AM ET

Executives

Renie Shapiro - Senior Vice President, Corporate Finance

Barry Smith - Chairman and CEO

Jon Rubin - CFO

Analysts

Joshua Raskin – Barclays

Scott Fidel - Deutsche Bank

Carl McDonald - Citigroup

Ana Gupte - Leerink Partners

Operator

Welcome and thank you for standing by for the Second 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.

Now I will turn the meeting over to Renie Shapiro Silver. You may begin.

Renie Shapiro

Good morning and thank you for joining us today. This is Renie Shapiro Silver, Senior Vice President of Corporate Finance for Magellan Health. 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 second quarter ended June 30, 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 annual report on Form 10-K for the year ended December 31, 2013 and in the current quarter’s Form 10-Q, which will be filed with the SEC on or shortly after today Friday, July 25, 2014, and will subsequently be available on our website.

In addition, please note that in this call, we refer to segment profit adjusted net income and adjusted EPS, which are disclosed and defined in our quarterly report on Form 10-Q. Segment profit 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 from loss from non-controlling interests held by other parties, as well as stock compensation expense.

Adjusted net income and adjusted EPS reflects certain adjustments made for acquisitions completed after January 1, 2013, to exclude non-cash stock compensation expense resulting from restricted stock purchases by sellers as well as amortization of identified acquisition intangibles.

Segment profit, adjusted net income and adjusted EPS referred to in this call maybe considered non-GAAP financial measures. Included in the tables issued with this morning’s press release are reconciliation from these non-GAAP measures to the corresponding GAAP measures. We encourage you to review such reconciliations for an understanding of how they compare to those GAAP measures.

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

Barry Smith

Good morning, Renie and thank you all for joining us today. The second quarter of 2014 was a busy one in which we made great progress on several fronts. We've now going live with our Magellan Complete Care, Florida SMI Specialty Plan and we closed on the acquisition of CDMI.

We put a new credit facility in place to ensure we have the flexibility to aggressively pursue our growth strategy. In June we held our first Investor Day in more than 10 years and provided details of our long term goals and a specific roadmap to deliver growth and enhanced shareholder value.

Finally, we announced a new corporate name, which reflects the evolution of our business into a health management company. With respect to our financial milestones for the second quarter of 2014, we produced adjusted net income of $11 million, adjusted EPS of $0.39 and segment profit of $45 million. Second quarter net income was $5 million and EPS was $0.18.

For the six months year-to-date period, we produced adjusted net income of $38.3 million, adjusted EPS of $1.37 and segment profit of $121.5 million. For the six month period, we had net income of $30.7 million and EPS of $1.10.

Year-to-date through Monday, July 21st, we repurchased approximately 1.4 million shares for a total cost of $81.3 million at an average price of $59.75 and to date have completed approximately 66% of the current 300 million authorization. We ended the quarter with $194.7 million of unrestricted cash and investments.

Results for the second quarter reflects strong performance in our pharmacy segment, solid results in commercial and specialty solutions and challenges in the public sector as a result of higher than expected cost of care and behavioral health and investments in MCC. We have plans in place to address the cost of care issues over the balance of the year.

Today’s announcement of a new $500 million credit facility is important for several reasons. The five-year facility includes a $250 million term loan and a $250 million revolver and letter or credit facility. Capitalizing on the current favorable credit markets we've obtained modest long-term debt and additional capacity for future investments.

This new facility provides the framework to grow our business while efficiently deploying capital to maximize shareholder return. Jon Rubin will provide additional details on our results and an update on our full year guidance. But first let me discuss recent progress on our Magellan Complete Care and pharmacy management initiatives.

It's an exciting time for Magellan Complete Care as we're making great strides in Florida and preparing for the future of New York and additional markets.

Magellan Complete Care of Florida went live in our first two awarded regions on July 1. This is a tremendous milestone for our organization. This launch represents the country's first and only Medicaid specialty plan focused on the total care of individuals living with serious mental illness or SMI.

Our infrastructure is complete and our operations and systems are functioning well. I applaud our team's huge effort in designing and developing this operating platform, which can be leveraged as MCC expands into other states.

We received auto assignment of members in the first two regions about four weeks ago and in one week we'll receive the next tranche of auto assignment for two additional regions.

Approximately 55% of the SMI population in our service area resides at these four regions. Our immediate focus is to gain knowledge of individual's current health status and to analyze the comorbid nature of this population in order to stratify risk and take early action to improve outcomes and lower costs.

We have established a command center to locate and onboard new members and engage them within their communities. After on-boarding we work with the members, the doctors, counselors, family and caregivers to build individual care plans for recovery and address any barriers to care.

We are also focused on maximizing retention rates of these individuals as they have the ability to opt out of our plan in the first 90 days. To date all the information we have received from ACA and through our own outrage is in line with our expectations for these regions. We will certainly learn more as we move forward.

We previously discussed that MCC of Florida would not receive any initial auto assignment for the four regions that moved to Mandatory Managed Care in May and June.

However, the State recently notified us that individuals with SMI in these regions, who did not select a plan and were previously auto assigned to a general Medicaid plan, will now be auto assigned to our SMI plan on September 1st. We are very pleased with this news and have begun planning for a potential incremental growth that this presents.

There are approximately 45,000 individuals with SMI in those regions out of whom did not choose a plan and were auto assigned to a general Medicaid plan. So it’s too early to predict the opt-out rate for these individuals once they are assigned to MCC of Florida since they have been in another general plan for almost six months before the switch.

Over the past few months MCC of Florida has grown to nearly 300 employees, many bringing their expertise for more behavioral health businesses in Florida and other areas throughout the country. In addition, providers are excited about the work we’re doing and continue to partner with us. And we’ve expanded our Florida network to more than 16,000 providers across the state.

Our original assumption was that we would achieve penetration of at least 20,000 members in the first year of implementation. With the latest information by an enrollment methodology, we now anticipate enrollment of between 30,000 and 50,000 members by the end of the year. We will update the membership assumptions next quarter when we have more clarity on the opt-out rate for auto assigned members.

We’ve previously estimated the average healthcare spend of individuals with SMI in Florida to be approximately $15,000 to $20,000 per year. We now expect final rates to be approximately $10,000 to $15,000 per year as a result of two factors impacting cost of care.

First, the state has decided to pay a portion of the inpatient rate on compensated care directly to hospitals for all of the Medicaid population. This portion of the inpatient rate was considered in our estimated capitation rates prior to go live and our capitation rates now have been reduced accordingly.

Second, we now expect the mix of enrollment to have lower morbidity than our original assumptions and will vary by region. Based on the net effect of higher membership and lower average healthcare spend, we now anticipate our annualized revenue will exceed our initial expectations. In addition, this does not impact our model of care or long-term percentage margins which are anticipated to be in the low to mid single-digits.

In New York AlphaCare continues to add members to its Medicaid managed long-term care or MLTC plan and its Medicare plans. The state has announced further delays in its Fully Integrated Dual Advantage, or FIDA demonstration program which is now scheduled to begin voluntary enrollment on January 1, 2015. Auto assignment and the ability to opt out of Medicare benefit will begin on April 1, 2015.

In addition to our focus on driving membership in New York, we’ve made several organizational and operational improvements in AlphaCare. We continue to leverage our data analytics capability to further refine clinical programs and the model of care in this emerging market. We are excited that AlphaCare has built a platform for MLTC and Medicare that we believe will serve as the foundation for robust future growth.

We continue to pursue new market opportunities and have now received HMO licenses in both Iowa and Louisiana. We have pending license applications in several other states including Pennsylvania and Nebraska, and we discussed the possibility of providing integrated management for the special populations.

As a result of the work we are doing in Florida we are receiving many increases from other state Medicaid directors on the details of our model of care and approach. This has been a very busy quarter for pharmacy management -- our pharmacy management business. On April 30 we closed on the acquisition CDMI, which has now been fully integrated into our existing pharmacy organization.

We are developing a rollout strategy to our existing customers for the unique clinical services provided by CDMI. In addition, we are finalizing a best of breed strategy for rebate contracts with pharmaceutical companies.

In the employers market we continue to experience solid sales during the second quarter. We’re already seeing the benefit of our acquisition of Partners Rx on our sales pipeline with employer opportunities roughly tripling in the ten months since the acquisition including more opportunities and increased average care size.

Our strong sales momentum to-date as well as the acquisition of CDMI positions us to achieve over $1 billion pharmacy revenues in 2014. Our organic pharmacy growth supplemented by acquisitions move us forward towards our goal of creating a powerhouse service oriented PBM.

Now let me turn the call over to Jon for a detailed discussion on our results. Jon?

Jon Rubin

Great. And thanks Barry, and good morning, everyone. Net income and earnings per share for the quarter -- second quarter of 2014 were $5 million and $0.18 per share respectively. This compares to net income of $31.5 million and EPS of $1.50 for the second quarter of 2013.

Regarding the new non-GAAP measures we’re reporting, adjusted net income for the second quarter of 2014 was $11 million, and adjusted EPS was $0.39 per share on diluted basis. For the second quarter of 2013, adjusted net income was $31.5 million and adjusted EPS was $1.15 per share.

The decrease in adjusted net income between periods was mainly attributable to decreased segment profit and a higher effective tax rate in the current period as a result of non deductibility of the health insurer fee.

Our segment profit for the second quarter of 2014 was $45 million compared to $75 million for the second quarter of 2013 with the decrease primarily due to terminated contract and unfavorable care trends in the public sector as well as rate changes and specialty solutions. These decreases were partially offset by stronger results in commercial and pharmacy management.

Revenue in the second quarter of 2014 was $888 million, which was $45.3 million higher than in the second quarter of 2013. The revenue increase resulted primarily from the inclusion of Partners Rx revenue in the current year quarter, and the impact of new business and rate increases which were partially offset by loss of revenues associated with terminated contracts.

Regarding the AHCA and health insurer fee, we now estimate that our full year expense will be approximately $21 million. Negotiations are ongoing with our customers for contract amendments which will enable us to recover the health insurer fees, as well as the impact to our federal and state income taxes for the non-deductibility of these fees.

We currently have agreements with four customers and are in various stages of agreements with other customers. We are now confident that the majority of the impact to us from the health insurer fees will be covered by additional revenues.

Now the timing of revenue recognition during 2014, however, will depend on the timing of execution of agreements. For the second quarter, we’ve recognized $10.9 million of revenue and $5.6 million of expense related to the health insurer fee. Including the impact of non-deductibility of these taxes, the positive impact on our second quarter EPS was $0.09 per share. We expect the full year impact of the health insurer fee to be immaterial to net income.

I’ll now review each of the segments results and growth opportunities beginning with commercial. Segment profit for commercial behavioral health was $38.8 million, an increase of $3.8 million over the second quarter of 2013. The increase is mainly due to new business and prior period care development recorded in the current year quarter partially offset by terminated contracts. The favorable prior period care development was $3.3 million in the current quarter.

We continue to experience growth in health plan exchange membership throughout the quarter and we currently manage behavioral health for approximately 2 million exchange lives for our health plan customers.

Now in line with the industry our commercial health plan exchange growth was slower than anticipated earlier in the year reflective of the challenges related to the rollout. The expansion of the enrollment period has seen membership increase and is currently more in line with our expectation. We anticipate exchange membership for our customers to continue to grow throughout the year, however at a moderating pace.

We’ve recently created new behavioral health solution for health plans with duel eligible populations which we believe will present opportunities in this rapidly expanding payer segment. We recently won an ASO contract to the regional health plan to manage behavioral health for their duals leveraging our clinical expertise in working with Medicaid and Medicare populations.

We’re seeing expanding pipeline opportunities for 2015 and 2016 across the health plan, military and employer sectors. Clinical innovations and updated more competitive products are resulting in additional interest.

Growing our technological capabilities in an increasingly digital world is also one of our priorities and we recently expanded our computerized cognitive behavioral therapy offerings with the acquisition of Cobalt Therapeutics, LLC. These clinical sell service programs provide members with interactive self-managed tools to change behavior and achieve healthier outcomes, and also result in cost savings to members as well as to their employers.

Segment profit for public sector was $0.3 million, a decrease of $28.5 million from the prior year quarter. This decrease was mainly due to determination of the Maricopa contracts on March 31, unfavorable prior period care development and unfavorable care trends which were partially offset by new business and net profit tax activity.

The net unfavorable segment profit impact of prior period care development was approximately $6.8 million. In this quarter we faced some challenges related to the acceleration and the use of outpatient services on one of our risk behavioral health contracts. As a result in response to this, we’ve re-contracted our network rates, modified payment methodologies for certain services and implemented changes to our care management models. We believe these changes will effectively address the cost of care issues over the balance of the year.

Regarding the public sector pipeline the states of Texas and Georgia have released RFPs for behavioral health services, and decisions and awards are expected within the next few months. Salt Lake County Utah and Greater Arizona have released RFPs for Florida’s contracts, while other states including New Jersey and Louisiana are expected to release RFPs in the later half of this year.

In our specialty solution segment second quarter 2014 segment profit was $12 million, a decrease of $8.5 million from the second quarter of 2013. This decrease was mainly due to previously negotiated rate reductions on contract renewals, and was partially offset by the impact of new business and net increased membership from existing customers. Also the current quarter results include favorable prior period care development of $1.2 million.

Now consistent with our strategic focus on specialty solution’s diversification we continue to see increasing levels of interest in all of our products. On July 1 we launched the new musculoskeletal contract of a large academic health plan and have added several new musculoskeletal cases to our pipeline.

Medicaid MCOs also continue to produce growth. We successfully implemented the full risk RBM and cardiac contract for a national Medicaid MCO that we discussed on our last call, which is expected to have annualized revenues of approximately $50 million.

The second quarter also saw a continued growth in our exchange membership and we’re currently serving approximately 1.5 million exchange members through a number of our health plan customers. Our specialty solution pipeline remained strong with a variety of opportunities across all product areas including radiology, cardiology and musculoskeletal management.

Second quarter segment profit for the pharmacy management segment was $22.2 million, an increase of $6 million over the second quarter of 2013. This increase is primarily due to new business and the inclusion of Partners Rx and CDMI in the current quarter results partially offset by terminated business.

During the quarter we renegotiated and expanded our national pharmacy network improving our competitive positioning with respect to pricing and breadth of the network. Our organic growth continues, and in the second quarter we sold business which added over 20,000 new employer lives effective July 1, 2014.

Regarding the Medicaid MCO sales we previously discussed, the 65,000 member plan with annualized revenues of approximately $40 million was implemented on May 1, and the 60,000 member plan with annualized revenues of $60 million went live on July 1.

Our pharmacy pipeline continues multiple state fee-for-service PBA opportunities and we anticipate additional state RFPs in a later half of the year. We’re also seeing very strong interest from employers for our PBM products as well as interest in our medical pharmacy product from several health plans.

Regarding other financial results, corporate costs excluding stock compensation expense totaled $28.4 million, which is $2.8 million greater than the second quarter of 2013. This increase is due to discretionary benefits, legal fees and severance costs.

Excluding stock compensation expense, total direct service and operating expenses as a percentage of revenue, were 19.1% in the current year quarter, as compared to 16.6% for the prior year quarter, mainly due to cost to support new business, development cost associated with the Magellan Complete Care product and changes in business mix.

The effective income tax rate for the six months ended June 30, 2014 was 52.6% compared to 40.6% for the prior year period. The increase in the effective rate is mainly due to the non-deductibility of health insurer fees and valuation allowances for certain deferred tax assets.

Stock compensation expense for the current six-month period increased by $3.8 million from the prior year period, primarily due to $7.3 million of stock compensation in the current year related to restricted stock purchased by sellers in the Partners Rx and CDMI acquisition, partially offset by higher expense in the prior year period related to the former Executive Chairman’s employment agreement.

Depreciation and amortization for the current six-month period increased by $9.6 million from the prior year period attributable to fixed asset additions after the prior year period, as well as to the amortization of identified acquisition intangibles associated with the Partners Rx, AlphaCare and CDMI acquisitions.

Interest expense for the six months ended June 30, 2014 increased by $1.4 million over the prior year period. This change is mainly due to interest expense related to the continued consideration liability recorded for the CDMI acquisition.

Now turning to cash flow and balance sheet highlights, our cash flow from operations for the six months of 2014 was $137.1 million compared to cash flow from operations of $86.9 million for the prior year period.

Cash flows for the current and prior year period include the positive impact of shifts of restricted cash into restricted investments totaling $12.3 million and $31.3 million respectively, which are reflected as sources of cash from operations and uses of cash from investing activities.

As in these transfers cash flow from operations for the current year totaled $124.8 million compared to $55.6 million for the prior year period. The increase in cash flow between years are mainly attributable to net favorable working capital changes of $90.6 million partially offset by the decrease in segment profit of $22.7 million.

A primarily driver of the net favorable year-over-year working capital changes is the impact of restricted cash requirements associated with the company’s regulated entities with net increases of $12.4 million in these requirements for the prior year period as compared to net decreases of $35.1 million for the current year period.

The current year decrease in restricted cash requirements relates to determination of the Maricopa contract partially offset by additional restricted cash requirement to support growth in other public sector accounts.

The remainder of the net favorable working capital changes between periods is due to accounts receivable, inventory and medical claims payable activity associated with timing and new business. As of June 30, 2014 the company’s unrestricted cash and investments totaled $194.7 million with approximately $65.7 million of this amount related to excess capital and undistributed earnings held at regulated MD.

The company’s respected cash and investments at June 30, 2014 of $329.7 million reflect a decrease of $57.1 million from the balance at year end. The majority of this decrease is associated with the terminated Maricopa contract that resulted in reclassification of restricted funds of $55.4 million to unrestricted. Included in our original guidance was a target for new business revenue of $450 million to be recognized in 2014. We’re still on target to exceed this full year target.

We are confirming our 2014 guidance ranges for full year net income of $53 million to $69 million, segment profit of $238 million to $258 million and capital from operations of $204 million to $226 million excluding a net shift to restricted funds between cash and investments. We've updated the guidance for diluted earnings per share to a range of $1.90 to $2.47 per share based on an updated fully diluted share number of 27.9 million shares.

This update is of fully diluted share amount and reflects share repurchases and option exercises through the close of business on July 21, 2014, but excludes any potential activity that may occur during the remainder of the year.

We also are confirming our 2014 guidance range for full year adjusted net income of $74.5 million to $92.5 million and we've updated our guidance for adjusted earnings per share to a range of $2.67 to $3.32 based on the updated fully diluted share count.

These updated guidance ranges reflect an increase in interest expense for the full year to approximately $10 million. The higher interest expense results from additional cost associated with the new credit facility as well as interest expense related to the estimated contingent consideration payments pertaining to the CDMI acquisition.

We’re increasing our estimated capital expense guidance for the year to a range of $56 million to $66 million. This increase relates to additional investments we’re making to support our MCC and pharmacy growth initiatives as well as the integration of acquired companies.

With that, Barry and I are now available to answer questions and I’ll turn the call back over to the operator, operator?

Question-and-Answer Session

Operator

(Operator Instructions) The first question is from Joshua Raskin with Barclays.

Joshua Raskin – Barclays

Hi, thanks. First question just starts on the guidance side of things. First, was the second quarter result broadly in line with what you were expecting and therefore the confirmation of guidance or are you now expecting to make some corrective actions that will help mitigate a lower second quarter.

Jon Rubin

Josh, this is Jon. The second quarter results as a result specifically of the pressure we saw in cost of care for public sector were below what we we're expecting for the quarter.

So as we look and this is a couple of different questions you have in your -- in your comments but if you look at the remainder of the year, we are counting on correcting the pressure we saw in the one public sector behavioral health account I mentioned and we've got a number of initiatives that we’ve already put in place and are already starting to see the results that give confidence in our ability to do that. As well, there are other factors that we believe will improve the run rate versus second quarter over the balance of the year.

That includes one, again the improvement utilization we’re expecting in public sector. Also as we’ve seen in previous years, especially in the fourth quarter, we see disproportionate share of customer settlements and recognition of performance revenue on many of our contracts and third, we’ll have an extra month of CDMI result given the fact that we had two months in the second quarter and we’ll have obviously three months in the last two quarters.

So putting that together, we do have confidence in our ability to achieve the full year guidance, and do expect that over the third and fourth quarter for the reasons I mentioned, there will be an increasing pattern of earnings to get there.

Joshua Raskin – Barclays

Okay, got you. And then, I am just curious your guidance range remained the same just as wide and yet we are now halfway through the year, so is there more volatility in the results that you had initially anticipated or -- as opposed to narrowing it or should we think more about the higher or lower end of segment profit guidance and EPS guidance. How should we think about that range not changing?

Jon Rubin

Yeah, first Josh, I wouldn’t -- I wouldn’t certainly read anything into it either with respective to the width of the range or where we might be in the range. We still feel very good about the range. We don’t typically narrow the ranges as we go through the year unless we’re in the last few months of the -- few months of the year.

I would say again given the initiatives we’ve got in MCC, yes, you could probably argue there is a little bit more volatility over the second half of the year but -- but again that didn’t really reflect -- that didn’t really influence our decision on the width of the range. We’ve typically kept that width as we’ve gotten through the second quarter in past years.

Joshua Raskin – Barclays

Okay, and then just last question on the MMA expansion in Florida of which you guys the SMI plan now which I understand is separate than the TANF, etcetera, but you’ve talked about a reduction in the rates there, which made sense in light of the reduction in the cost.

So it sounds like there is commensurate reduction in both sides of the equation, but what sort of diligence did do you do in terms of rates and have you even gotten some of the pharmacy claims or anything processed for those members in the first month or any operational update that you could point to?

Jon Rubin

Yeah it’s very early Josh, so yes, obviously we did some pharmacy claim data and we’ve some data around the authorizations, but given the ramp up in the first month and the fact that there’s still enrollment -- enrollment changes going on, it’s too early for us really to have any real read on the actual experience.

In terms diligence though, we’ve done significant actuarial deep dives into the rates and into the costs. We’ve gotten a lot of data both from the State with the data book and from actuarial consultants that we’ve worked with and at this stage we feel as good as possible about our position going into the -- into the account and given how well we know the SMI population in Florida, we’ve got good confidence in our ability to manage it.

But at this stage, I can’t tell you that’s based on actual claims because it will take us at least another couple months before we get any really handle on even the pharmacy and the inpatient side and the outpatient side will take us longer to get a read on because in that case, we don’t really have authorization data.

We have to wait for the actual claim patterns to develop. So stay tuned. We’ll clearly give an update as we get to third quarter and should know incrementally a lot more at that stage.

Barry Smith

And Josh, Barry here. Just to add on to Jon’s point, we are fortunate to have our own PBM and PBA capabilities. So we see pretty much real-time claim adjudication going on and so we get a sense about it and as we get more experience during the course of the year, we’ll be able to make certain assumptions based upon the pharmacy claims data, disease states, condition, severity and which will be able to more far better predicting MLR going forward.

It’s just as Jon says, too early today to really know until that lays out a bit further and we see the real relationships between the pharmacy claims data and the claim flow for overall healthcare spend.

Joshua Raskin – Barclays

That’s fair. I figured out just to ask. Thanks.

Barry Smith

You bet.

Operator

The next question is from Dave Styblo from Magellan.

Unidentified Analyst

Hi good morning. Couple of questions just to follow-up on Josh’s question and the Florida SMI there. I want to make sure I understood your assumptions around, I think you said there is a higher revenue outlook, I just want to make sure I understood that correctly kind of going from maybe $350 million to something along the lines of $500 million if I think about the new midpoints. Is that the right way to be thinking about that contribution now given the new membership outlook?

Jon Rubin

Yeah, round numbers yes. Although -- again I would caution a little bit because the membership situation, the range we gave is pretty wide and within that range and even the within the ranges we gave on the cost per member it could vary quite a bit. But if you’re looking at midpoint say, I think you math is absolutely correct.

Unidentified Analyst

Okay and given -- I just want to confirm this too, given the changes in the rates and it does sound like it’s commensurate do you still expect the margin profile to be the same on these SMIs?

Jon Rubin

Yes, long term, yes. Long term yes. Near term, this year we’ll probably have net more investment because we have to prepare to serve a larger membership, which means yeah more upfront investment, but once we are up and running over a 12 to 18 month period, we certainly still expect to get to the same level of margin on a percentage basis.

Barry Smith

And just to add on again to Jon’s comments, ramping up we obviously had certain expenses to do that and we thought that we would receive higher membership but we didn’t know and so we had to make certain that we had the employees in place to make sure that service levels were at a very high level with this new plan.

All eyes around this plan throughout the country and Medicaid directors are looking at this as a model for the future and so we want to make sure that we didn’t have any stumbles during the initial implementation and I am very happy to report we had a very smooth implementation.

I was just looking at the -- some of the call stats average speed of answers nine seconds for example. Just extraordinarily well done by the team of Florida and a customer will do that and we think that’s a real smart investment for the future and the reputation of Magellan and implementing these plans in other states in the future.

Unidentified Analyst

Okay. Let me move over to the -- a couple of the other businesses real fast. On pharmacy solutions, margins, segment margins moved up nicely. Curious if that’s just sort of a one-time change because of the business mix or is that something we can expect to continue trending higher?

And then in specialty solutions, I was a little bit surprised that the margins dropped sharply sequentially even after adjust for the -- I think you guys have called up the negative prior predevelopment coming in around 11% on an adjusted basis, so that’s already kind of coming into the long term range you guys have talked about at Investor Day, curious if something has changed or this lower double-digit rate is -- margin rate is something that we’re going to be at going forward.

Jon Rubin

Yeah, so two separate questions there. First on pharmacy, I always say for the most part the improvement we’re seeing within the quarter is based on mix particularly with the acquisition of CDMI in the results for two quarter, but I do think that’s representative of near term of what -- of what we’ll see in terms of margin.

Longer term though, as we are riding more PBM business, where the cost of the drugs is included in the revenue, we’ll see -- still see margins come down on a percentage basis over time but obviously with very significant revenue growth, so dollars of margins will improve significantly as we go forward.

As I talked about the traction we're getting on sales particularly in the employer side and to the extent also with the Medicaid MCOs has been quite impressive in a quarter and we feel very confident about the earnings growth in that business.

On specialty solutions, I really don’t think there’s anything unusual in the quarter and in fact as we had talked about coming into the year, we really did expect with contracts that were being replaced this year to see margins get down more to the normalized level we’ve been describing. Ultimately we’ve said, high single, low double digits for that business and what we’re seeing in the quarter is pretty much what we would expect for the run rate over the near term but again long term, us stabilizing in that high single, low double digit range.

Unidentified Analyst

Okay, so on specialty, it sounds like a large part of your buffer gotten re-priced at lower level for the whole book to contract that much. Is that the right way to thinking about it?

Jon Rubin

Yes, it is and many of our customers actually do get recent annually. Not all of them, but many of them do. So given the strong care management we’ve had in the segment, which has led to very good margins for us as we go through the renewals although customers really appreciate the value we’ve been delivering and we’re able to maintain very strong margins, just not at the same levels we had been in the last year.

Unidentified Analyst

Great, thanks.

Jon Rubin

You bet.

Operator

The next question is from Scott Fidel from Deutsche Bank.

Scott Fidel - Deutsche Bank

Thanks. First question just on the public sector. One just in terms of the cost of care pressure that you’re seeing, can you just highlight which market geographically it is that you’re seeing and then also just give us some more details on the negative prior period development that you saw in the public sector business, what specifically that equated to.

Jon Rubin

Yeah, Scott. For a number of reasons that I don't want to talk specifically about the market because we’re working closely with the customer and we want to make sure that we’re not saying more than is warranted there, but I’ll say a number of things, one, it really was the earnings pressure we saw in the quarter really was from a single behavioral health market.

What we saw there was significant expansion of utilization in a couple of very specific categories about patient services and that’s important because it really does help our ability to quickly get our hands around it and drive it -- drive the improvement going forward and these were -- think of them as community based and some other select outpatient services where there had been some expansion of capacity and also some demand, but that was partly provider driven.

And as a result, over the past several weeks that we’ve started to see things emerge we’ve developed rapidly implemented plans to respond to this and while the plans are pretty broad and as I described in terms of network unit cost initiatives and care management initiatives, the majority of the actions and impact related to network based initiatives mostly range based or unit cost initiatives, which we’ve implemented and therefore can really start to see tangible results and in fact we’re already seeing the benefit in July of these actions that are now largely implemented.

So we do again have the direct line of sight to cost of care returning to more normal levels over the balance of the year, which again gives me confidence that this will turn around quickly as we go into the third and fourth quarter.

Barry Smith

And Scott, this is again Barry here. As you -- I am sure you all know that when we work with these states particularly, basically the public sector contract, there’s hugely a profitability of band and if we go over that projected -- project over that profitability band, we will typically reinvest those monies in the network and the community's additional services.

And so what will happen sometimes is that you’ll see trends, low cost, low MLR trends and you will start to reinvest in the community and then the trends will accelerated and then what you simply do is go back and take those monies that were given or reinvested and redirect them so you stay within that band.

So that’s always the challenge of managing these public sector contracts, we’ve been very good at doing that in the past and we expect to be very good at that in the future as well. So we hope to be able to recapture some of that and stay within those profitability bands that we negotiated into our contracts.

Scott Fidel - Deutsche Bank

Okay. And does the negative reserve development that you reported in public sector, that relate to same contract or was that another contract or market that was responsible for that.

Jon Rubin

No, I would say 90% of it related to the same contract and it really was again recognition of the acceleration that we recognized this quarter but related to first quarter and to some extent also the fourth quarter of last year. So it was mostly the same contract.

Scott Fidel - Deutsche Bank

Okay. Second question, just can you spike out for us just on the SG&A side what -- how much investment you had in MMC in the quarter and then also whether there were any Maricopa exit cost that were nonrecurring that you booked in the second quarter.

Jon Rubin

Well, if you look at it in terms of Maricopa there really weren’t a lot of exit costs in the quarter. In fact there was net activity sort of on both sides, so there really wasn’t anything significant there.

In terms of MCC in the quarter, see I think we ran about -- round numbers about $9 million of net expenses and startup losses in the quarter for the segment, just to give you a ballpark that sort of all in that, both investments and again some -- the initial activity in low volume we’re seeing the markets.

Scott Fidel - Deutsche Bank

Okay. And then just one last question, I was just relating to and maybe Barry for you, so you have the enhanced financial flexibility here with the new credit facility and maybe just talk about in the near term, you thoughts around pointing on repurchases as compared to harnessing this for future M&A and just given with the stock correcting here, it’s trading below where you had done some open market purchases, I think yourselves, so just interested in terms of repurchases at current stock price levels relative to M&A and other considerations.

Barry Smith

Well of course, I won’t -- I will talk about my own personal purchases but that is fact I did acquire stock and I am happy I did. But relative to how we think about capital deployment, it really hasn’t changed much. We do think there was to opportunity to acquire the marketplace, both in the pharmacy space and also in the health plan space.

On the pharmacy side, there are several capabilities we would like to have in-house. We currently contract, subcontract, which you can do and compete in the marketplace. We would love to have mail service for example as our own capability. We would love to have Medicare Part D as a strong capability of the company. We think that’s important particularly as we sell into the MCO market and so we need to have that capital to be able to take advantage of those opportunities.

On the health plan side, we’ve said historically, which we will do. We’ll go into five to seven states and so we’re always looking for health plans who are licensed and have an operating platform that can help us build and turbo-charge our MCC growth but also allow us more ready access to new markets and so in that, we are not looking to buy [fixed] (ph) in the health plan business.

We’re looking to buy entities that have solid operating platforms and less risk, which are inherently more expensive and so in those markets particularly where they’re attractive markets, it requires a heavier investment to get into those markets with these acquisitions, but again on either side, the pharmacy or the MCC side, we don’t look at this is a roll-up, we look at this as an opportunity to create incremental ability to turbo-charge our organic growth.

And so we want to make sure we have the capital in place to that enhance the credit facility. As was pointed out earlier by Jon, the rates are going to be more favorable. The circumstances more favorable, so with that we put those in place anticipating those acquisitions going forward.

Having said that, we also think we purchased roughly $80 million -- $81 million worth of stock in the third quarter. We feel that this is a good investment for the company and for our shareholders and so we’ll continue to acquire stock as we move forward, so really a bimodal approach to building EPS and shareholder value.

Scott Fidel - Deutsche Bank

Okay. Thank you.

Jon Rubin

You bet.

Operator

The next question is from Carl McDonald from Citigroup.

Carl McDonald - Citigroup.

Thanks. Wanted to come back to the guidance and just try to understand a little better what you’re seeing as the positive offsets in the second half relative to the earlier guidance. If I think, call it $15 million to $20 million shortfall in EBIDTA this quarter plus some incremental investments to the Magellan Complete Care, what’s the positive offset to keep the guidance in the same range?

Jon Rubin

Well Carl, there’s a number of kind of plusses and minuses in the quarter. If you know we don’t give quarterly guidance. So I won’t comment on what the second quarter might have been relative to guidance. It was lower than our expectations, perhaps not as much lower as you're suggesting.

So let me kind of think to picture this way, in the second half of the year relative to the $45 million segment profit run rate in the quarter, just a few very specific things that I point to as being accelerants; one, again the recovery and utilization in the public sector, which -- looking at that alone probably was about to $10 million to $15 million of headwind in the quarter.

So reversing that on a quarterly basis going forward, we do have some new business but there’s also some terminations, those things kind of wash, as I noted also there is round numbers about $5 million of expected customer settlements and performance revenue that we’re likely to recognize in the latter part of the this year and an extra month of CDMI earnings as well in the latter part of the year and the run rate there is round numbers $3 million plus -- $3 million or so a month.

So those are the things you think about getting from $45 million to the balance of the year that I point to considering the run rate. I think there’s other issues as well but -- there’s admin cost and things, but they tend to go both ways.

Carl McDonald - Citigroup.

Great. Thank you and then how fruitfully embedded is Florida's decision to move those with SMI into your plan in September. I just asked from the perspective of states usually and these kind of transitions do as much as they can to minimize disruption for people so it seems kind of strange to get auto assigned to one plan and then six months later get auto assigned to a new plan particularly for people that are heavily involved in accessing the system.

Barry Smith

Carl, that’s absolutely right. Normally states would not encourage more disruption. In this particular case, as you know we've had a long term relationship with AHCA and the State of Florida and I think they've done a great job for them over the years in taking care of this population.

So when they were ready from a technical viewpoint to do auto enrollment on May 1st and June 1st, of course we didn’t have the benefit of having those individuals be managed by us and the State didn’t give the benefit, individuals didn’t give the benefit.

So I think in retrospect the State great to work with and I think they have a bias towards one of these individuals to receive the best and highest quality of care and it's also their best view of how to make sure that they have the dollars to care for these individuals.

So from an economic standpoint, from quality care standpoint, my view is that AHCA feels that we’re the best solution in the state to manage this population and so it is an unusual move for the State to reverse cores and actually not reverse cores, basically auto enroll six months later and go ahead and have those individuals enroll in our plan.

We’re very pleased with that. We think we can benefit the lives of these individuals and do the right thing economically in the State as well. So it's been very thought out. We of course try to be somewhat conservative in our outlook. We thought that we’re going to have 20,000 lives. It became more and more evident. We would certainly have 20,000 lives and so we’ll report auto enrollment results as it happens.

And as we mentioned during the initial portions of the call, these individuals still have a 90-day opt out and so the question we have is after they’ve been already auto assigned to a general Medicaid plan and they’re re-auto assigned into our plan, will there be linkage to the past plan so we’ve higher opt out rate.

So we don’t know. But that’s why we have given that fairly wide range where again we’re fairly confident that we’ll at least achieve the 30,000 but it could be materially more than that and hence the range up to 50,000 lives.

Carl McDonald - Citigroup.

Thanks and then the last question is just did Horizon transition over to value options on July 1st?

Barry Smith

They did. Yes they did.

Carl McDonald - Citigroup.

Thank you

Barry Smith

Great. Thank you, Carl.

Operator

The next question is from Ana Gupte from Leerink Partners

Ana Gupte - Leerink Partners

Yeah thanks. Good morning. So I wanted to ask a couple questions. First is on the -- just the broad question is about rate adequacy considering that you’re getting more and more of your earnings and your mix of business in shifting to complete care. How comfortable are you as you look at what the states are doing, the changes that you’re seeing in the SMI reimbursement [severity] (ph) etcetera that rate adequacy is good for the public sector Medicaid like business that you’re getting increasingly levered to?

Jon Rubin

Yeah Ana, it's Jon. Look like I said earlier, we have both our internal actuarial and partnering with some of the nation’s leading actuarial consultant firms externally to really evaluate as best we can the rates in Florida and other markets where we may be entering and feel good again about the accuracy of the range.

Now having said that, as you know when there’s new members coming into the system, when there’s new programs that are being introduced, there can be some short term volatility and that’s something we’ll obviously be watching over time.

Now again over time that corrects because the rates have to be actuarially sound and have to be signed off by an actuary and as we’ve always done, we will continue to manage the relationships we have with the states and their actuaries and ensure where there aren’t any short term ups and downs that we’re managing them in partnership with the states, but to the best of our knowledge and with all the work that’s been done, we feel good going in that the rates are where they should be.

Barry Smith

And Ana, Barry here on specifically you asked about Sovaldi, in the case of Sovaldi, Sovaldi is on the PDL for the State of Florida but there is an offset rate and kind of carve out if you will, Sovaldi and Alico for example, and so we’re -- we don’t have really the exposure that one would think one would have.

And just to kind of add onto that, as you know, the utilization in our PDA or PBM benefit business for Medicaid, we’re seeing very substantial increases of Sovaldi have spend 400% year-over-year increase in Sovaldi versus a 300% increase in the commercial population.

So we do see an increased utilization within the Medicaid population for Sovaldi. [Gillian] (ph) has done very well. I think they’ve sold $3.5 billion in the second quarter they just announced earlier this week. So talk about blockbuster or a budget buster if you’re on the wrong side of risk.

Ana Gupte - Leerink Partners

Certainly have. So just specifically related to both of those I didn’t fully understand why the SMI rate went down and why you feel so comfortable that the cost of care being lower, it’s fully reflected in that lower rate and then again on Sovaldi specifically, can you tell us how the various drug plans in the State like Florida, are you all collaborating to have a common point of view on how the reimbursement should occur or each of you’re just doing your thing if you will, is it more of a correlation?

Barry Smith

Well, there certainly is a correlation forming a lot of discussion about how to appropriately manage utilization of Sovaldi as well. the challenge of Sovaldi, is it's positive, it’s a very effective drug and over 90% of the cases you have a cure rate versus 45%-50% with the older medications.

Of course, we also know it’s outrageously expensive. So there are certain prior authorization criteria that I think most of us, whether it be on the commercial side or on the state side, Medicaid side are coalescing around to make certain that it’s clinically appropriate and if it’s being administered and paid for.

So for example, there are certain genome types of the virus. Genome types 5-6 Sovaldi isn’t effective and so there are certain things like that clinically that we can do that will limit the use of Sovaldi to the appropriate population. So it’s beginning to take form, both on the commercial PBM side as well as on the state side on how best to manage it.

Ana Gupte - Leerink Partners

And then on the SMI, what gives you comfort? I thought you said it was 15-20 and it’s down to 10-15 and correct me if I am wrong. What gives you...

Barry Smith

No that’s correct Ana, but again we’re very comfortable that the adjustments to those rates are based on adjustments to cost of care and it comes from two places that we talked earlier. One, the change that the state made to reimburse hospitals directly for uncompensated care, so they’re taking out the expense and the rates are going down precisely in proportion to that.

And two, again as we look at the membership, the blend between [tenants and HD] (ph) and also the mix by region because again we’re now expecting more members as a result of the states changing enrollment in places like the Panhandle and northern parts of Florida, which are less expensive. So we’ve done the analysis, again going in or as comfortable as we can, be the rates match the exposure that we’re expecting there.

Ana Gupte - Leerink Partners

All right. One more question again, this morning you had a sort of so called competitor if you will, side pressures on the pharmacy side of it on the Medicaid business. As you think about scale and then having an in source versus outsource CDM and sources of competitive advantage?

And [indiscernible] and yourself are doing some more of it in-house. Is that a way potentially to offset some of these issues as more and more of the pressure points are heading towards pharmacy and specialty pharmacy not only because you have a quicker window into what’s going on but potentially a tailwind on the other side.

Barry Smith

I think that's right Ana. We do have -- because we have these capabilities in-house, we can really apply all the learning that we’ve done nationally and apply it in our own book of business and work with the state. We’ll certainly follow state guidelines as we administer, but we do think we have an unusual advantage because we can link the data, the analytics with both the health claims data and utilization along with the pharmacy data.

So in terms of very advanced management -- care management, and I think about it for example, in our medical pharmacy product that we believe that we’re the far -- we're the most advanced in our thinking and implementation in that space because of this linkage to the medical claim side and that understanding. So we do think that’s a very distinct advantage for us.

Ana Gupte - Leerink Partners

And then sticking with this pharmacy book of business that you have but moving away from the cost side of the equation to the top line portion, I think you said you’re doing well in the employer market but Medicaid MCOs and so on seems like it’s going very well.

I think you had talked about being a finalist in very large employer group accounts, may be in the tens of thousands, so how is that progressing and as you’re thinking about where is that you’ll win business on the PDM side of the full service PDM that’s subscale. Is it likely to be more on the Medicaid public sector side of it or more commercially oriented?

Barry Smith

Well we certainly are the main provider nationally. We serve 26 out of 50 states and also the District of Columbia. So we’re the large players on the Medicaid pharmacy administration side. We did not play historically in the employer space virtually at all and have launched very aggressively through our partners, our ex acquisition into that space and are doing extremely well.

I think I mentioned in my opening comments our employer pipeline has nearly tripled. Now the good news about that that happens to be also one of the more profitable segments, particularly the lower and midsized employer groups, which we specialize in. So that to us is where a large area of opportunity and growth is. You’ll see us also -- we have and it will continue to launch very aggressively into the MCO market.

We’ve announced some big health plan wins and we’ll continue to do that so virtually across the Board, on pharmacy we see real opportunity for increased growth. So it’s a -- we are really excited about it.

Ana Gupte - Leerink Partners

Great. Thank you. Thanks for the color.

Barry Smith

You bet, thank you. Ann.

Thank you all for joining us today. We look forward to speaking with you in October when we discuss our third quarter results. Take care and good day.

Operator

That concludes today’s conference. Please disconnect at this time.

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