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Health Net, Inc. (NYSE:HNT)

Q4 2011 Earnings Conference Call

February 3, 2012 11:00 AM ET

Executives

Angie McCabe – Vice President of Investor Relations

Jay Gellert - Chief Executive Officer

Analysts

Ana Gupte - Sanford Bernstein

Kevin Fishbeck – Bank of America Merrill Lynch

Christine Arnold - Cowen

Josh Raskin - Barclays Capital

David Windley - Jefferies

Peter Costa - Wells Fargo Securities

Carl McDonald - Citigroup

Charles Boorady - Crédit Suisse

Operator

Good morning, and welcome to the Health Net, Incorporated Fourth Quarter and Year-End 2011 Conference Call. Today's call is being recorded. At this time, I would like to turn the call over to Angie McCabe, Vice President of Investor Relations. Please go ahead, ma'am.

Angie McCabe

Thank you, David and thank you all for joining for a discussion of Health Net's fourth quarter and year-end 2011 results. During this call, we will make forward-looking statements are subject to certain risks and uncertainties. Risk factors that may impact those statements and could cause actual future results to differ materially from currently expected results are described in our filings with the SEC, as well as the cautionary statements in our press release issued in advance of this call.

In today's call, we will refer to adjusted days claims payable, which excludes reserves from health plan services costs related to the Company's capitation, provider and other claim settlements and Medicare Part-D payables and costs. This adjusted metric is not being presented in accordance with Generally Accepted Accounting Principles or GAAP. Please refer to today's press release, which is available on the Company's website, for a reconciliation of this non-GAAP financial measure with the most directly comparable GAAP financial measure days claims payable.

I will now turn the call over to Jay Gellert, Health Net's CEO.

Jay Gellert

Thank you, Angie and good morning everyone. We are pleased to report on a solid fourth quarter and a strong 2011. Key operating and financial metrics for the combined western region and government contract segments. In the fourth quarter of 2011 showed market improvements compared with the fourth quarter of 2010.

I want to focus this morning on comparing the full year of 2011 versus 2010 and reflect on our progress. I’ll compare it with our expectations laid out at our Investor Day last year and offer some additional long-term perspective on our performance. GAAP earnings per diluted share for 2011 were $0.80, which is less than our original guidance due to an unexpected legal judgment in the first quarter.

Earnings per diluted share for our Combined Western Region and Government Contract segment were $3.09 well ahead of our original guidance of at least $2.75. Improved margins and a lower share account were the primary drivers of our better than expected full year results.

One of our primary goals is to produce steady margin improvement, while the GAAP pre-tax margin was 1.5% in ’11, the pre-tax margin on our combined Western Region and Government Contract segment was 3.8%. This is a solid 60 basis point gain year-over-year and a 50 basis point fourth quarter to fourth quarter.

We’ve also focused on capital redeployment through share buybacks. In ’11 we exceeded our annual guidance by a substantial amount. We bought back 13.6 million shares for approximately $374 million. That’s more than 14% of the outstanding common shares as of the end of 2010.

Let me talk about our enrollment now. Overall, health plan enrollment rose in ’11 led by Medicaid. Our California State Health Programs business exceeded its annual enrollment goal as membership rose 12% in 2011. The economy remains an important factor in the growth of the basic medical program.

In addition, we began to enroll new seniors and persons with disabilities on June 1, 2011. At December 31, 2011, we had approximately 52,000 additional SPD members for a total of approximately 81,000.

We will continue to enroll new SPD members through May of ’12. In Commercial, enrollment in our tailored network products grew by 35% in ’11. At the end of ’11 they accounted for 31% of our total commercial enrollment compared with only 23% at the end of ’10.

In Medicare we ended ’11 with the expectation for enrollment declines as we were unable to add new individual members. However we did better than expected as we were down only 7.7% in ’11 and actually, added new members in the fourth quarter.

We entered ’12 with encouraging early signs based on current enrollment day we may exceed our annual MA membership growth guidance of 8%to 10% in the first quarter alone.

Let me now turn to our medical care ratio and premium yield healthcare cost performance data in ’11. We had originally expected a positive commercial spread between premiums and healthcare costs of 40 to 60 basis points. For the full year, it was actually positive by a 110 basis points and our ’12 guidance points the further gains.

In ’11, the positive spread drove the commercial gross margin PMPM higher by 12% compared to ’10. Since the end of 2009 it’s up by approximately 27%. Commercial healthcare PMPM cost increase in ’11 was 4%. This moderate level of healthcare inflation was due to more members and cost-efficient networks and low utilization trends throughout the year.

We are also seeing lower unit cost increases across our commercial provider networks, an encouraging development. Thanks to the efforts of our associates over the past three years, we are today a much stronger competitor in commercial markets. Our products are popular by meeting consumer needs for affordability and coverage.

We are a leader in culturally targeted health plans, which is our Latino products and we believe that brokerage increasingly appreciates our discipline and predictability. There is a lot more to say about this. In two weeks at our Annual Investor Conference, Steve Sell our Chief Commercial Officer will review our progress and outline the plan for sustaining this performance in ’12 and beyond.

Let me now turn to our Government programs. Our margins are stable in Medicaid. Rate pressure had been a fact of life for some time in California. But we continue to manage effectively within this environment. In Medicare Advantage, the 2011 full year MCR was higher than 2010 mainly due to our inability to add new enrollees for most of the year. We expect improvement in ’12.

In 2011, we successfully transitioned to a new TRICARE contract. We will operate for the full year in 2012 under the new contract. We expect the pre-tax contribution from the Government Contract segment to be between $90 million and $100 million in ’12.

Our overall financial performance in ’11 was solid. Cash flow from operations was in line with GAAP net income plus depreciation and amortization. We absorbed the cost of the legal judgment in the first quarter and still had substantial capital resources to fund operations and share repurchase.

Fourth quarter operating cash flow was affected by our receiving only two monthly CMS payments in the quarter. We had received four in the third quarter. The monthly CMS payment averages about $300 million. If the payment timing has been right, the cash flow in both the third and fourth quarters would have been in excess of $200 million.

We expect cash flow to be consistently strong going forward; we will continue to see quarter to quarter variations based on the timing of government payments. But overall, cash performance has been very good and we believe it will continue. Our G&A performance in ’11 was on target at 8.9%. It tipped up in the fourth quarter as expected. This was due to increased commercial and MA marketing expenses.

We want to achieve further G&A cost savings in ’12 and beyond in order to enhance our competitiveness and address any scale issues. We are actively exploring approaches that would allow us to reduce G&A including outsourcing opportunities.

Let me touch briefly on the pending sale of our Medicare standalone PDP business CVS Caremark. We expect to complete the transaction in the second quarter. In the interim, our January PDP enrollment numbers looks better than expected. We have a longstanding relationship with CVS Caremark, so we believe this transaction can be completed with minimal implementation risk.

We also signed a new agreement with CVS Caremark for our core PBM services. We expect it to help keep our pharmacy trend modest in ’12 and the years ahead. In closing, we believe that Health Net is very well positioned today to succeed in each of its existing businesses.

2011 clearly demonstrated that we’ve made great progress. Our diverse book-of-businesses and geographic focus are a real strength. For the future, we have many opportunities. Commercial customers are increasingly looking for affordable solutions that we believe we’ve got them.

As you know, our varied government customers are still seeking ways to curb the cost in a number of health programs. We have worked hard to position ourselves to be able to offer a great deal to each of these customers. We are focused on meeting their needs and we’ll have more to talk about at our Investor Day in two weeks. For now, we’re pleased with the quarter, gratified with ’11 and prepared to meet the challenges of the future. The hard work of our associates deserves special recognition.

Thank you, and now let me open the call for your questions.

Question-and-Answer-Session

Operator

(Operator instructions) Your first question comes from the line of Justin Lake with UBS.

Jay Gellert

Justin

Operator

Mr. Lake your line is open.

Jay Gellert

Let’s go on to the next question.

Operator

Your question has been withdrawn. Your next question comes from the line of Ana Gupte with Sanford Bernstein.

Ana Gupte - Sanford Bernstein

Thanks, good morning. The question is about your Medicare books, so as you had to disclose guidance in mid-December. It looks like you are projecting margin expansion to get to your numbers and I think you said that just now Jay, so I’m just trying to understand what the drivers are of that margin expansion including the trends and utilization of star bonuses and then as you’ve seen your selling season completed. What transpired there in terms of the California traveling seniors if you will from CIGNA has pointed, it sounds like you picked up very, very few but, do you know where they’ve all ended up?

Jay Gellert

Hey, that’s a bunch of questions. Let me take it one-by-one. The basis for our improvement in Medicare is three-fold. One, the addition of new members helps the books.

One of the factors that impaired our MLR last year was the lack of inclusion of new members. Secondly, we’ve made a number of different provider arrangements over the course of 2011 that will improve our performance in 2012. We had a number of situations where we had shared risk arrangements that we moved to full risk.

We had certain circumstances where people moved to percent of premium in a number of other things along those lines. And then third and finally, we adjusted our benefits and in each case we are either at a 3.5 or 4 in terms of the star rating so that’s all included in our consideration.

In terms of the traveling seniors as you said, for us, there are only two counties where we have a PPO arrangement, where there are traveling seniors. In those two counties we have fundamentally different benefits than WellPoint had in that case and they in total only included about 4,000 members.

In all of the other places there are HML products with, in many cases full capitation and there are instances where we’ve gotten relatively a small number of new members in a very large county. So we took those numbers into consideration when we prepared our guidance and if anything may have been a little lighter than we anticipated when we thought about it.

Ana Gupte - Sanford Bernstein

Thanks.

Jay Gellert

I would just, the final question, I really can only hypothesize if you could on where people went and I have no specific information on where all the people went.

Ana Gupte - Sanford Bernstein

And the utilization slowdown have you included that in your benefits which was submitted in June, but since then trend continued to decelerate if you will on Medicare as well?

Jay Gellert

Yeah, I think that, we actually probably moved more to capitated type arrangements they were fixed. So I think we’re protected against utilization upticks. I don’t think the downtick will have a significant effect on our planning.

Ana Gupte - Sanford Bernstein

Got it. That’s helpful. Thank you.

Operator

Your next question comes from the line of Kevin Fishbeck with Bank of America Merrill Lynch.

Kevin Fishbeck – Bank of America Merrill Lynch

Okay, thank you. Just a question here the commercial trend, I guess it did come in at a 110 basis points which is better than what you at the beginning of the year. But, I think the more recent guidance with more like, 140 to 150 and wanted to see what happened there?

Jay Gellert

Yeah, it was primarily some unit cost and utilization issues on the pharmacy side. And those will all be remedied by the renegotiated agreement we have with CVS it goes into effect in the second quarter. So it’s all included in our guidance and that was the primary thing that had affected there or a few other small things but nothing meaningful.

Kevin Fishbeck – Bank of America Merrill Lynch

Okay, and then can we talk a little bit about the opportunity seems to be picking now and A, I would like to hear your thoughts there and then maybe in particular question for Joe about the capital requirements for what we have to make in the $2 billion revenue opportunity? How much capital would you need to put in the subs to support that? And then what that might mean as far as your capital allocations plans for 2012?

Jay Gellert

Well I think that, if you read the Governor’s budget and consider the solicitations that the State has, I think that pretty much explains what we know. As you know the state intends try and get about 800 dual eligible into managed care by the end of 2013. You can only get that by going to select number of counties and so I think you can fairly easily conclude what the – at least the general outlines of a plan are in that case. Let me just answer the question on capital needs. I think that’s still very much up in the air. The exact way is the contractual arrangement will be structured in the concomitant regulatory requirements are not clear. We will be in a position to meet whatever requirements are necessary.

Kevin Fishbeck – Bank of America Merrill Lynch

Okay, but no thoughts yet about just kind of rule of thumb about how much capital as in terms of revenue you might want to put away, what you need to put away in the subs?

Jay Gellert

Well I think we have plans to do that, but it’s really premature to talk about it until we have a better understanding of the structure of the arrangement.

Kevin Fishbeck – Bank of America Merrill Lynch

Okay, just last question might be little be hard to answer to, but initial thoughts on what kind of margin you might get I mean, I guess in a business that looks like the rates are going to be set by the State of California, I would assume it will be hard to do better than your current overall net margin. Is that the right way to think about it or how would we thought about profitability in that business?

Jay Gellert

I think that, that’s probably a realistic assumption. The key thing here as it has been and all of our involvement with State of California, State of California has pressures on their budget. We have to come up with a solution that meets their budgetary needs which we believe we can and I wouldn’t anticipate greater margins than we’ve historically had.

Kevin Fishbeck – Bank of America Merrill Lynch

Okay, great. Thanks.

Operator

Your next question comes from the line of Christine Arnold with Cowen.

Christine Arnold – Cowen

Hey there, couple questions. With respect to operating cash flow in 2012, how are you thinking about that since the Northeast rain should be gone and then could you tell us how much you put up for AB97 potential retroactivity and how you are thinking about that?

Jay Gellert

We will continue to have some Northeast paydown as we do the final close down of northeast. $525 million estimate that includes consideration of that. So there will be some of that and we’ll talk about that in a little more detail at the Investor Day, so we can go through that whole issue. In terms of AB97, we think we put that consideration of AB97 into the guidance which we’ve given. And we think we are – that we can adequately handle whatever happens with that.

Christine Arnold – Cowen

And can you elaborate on what exactly you are expecting to happen there?

Jay Gellert

I really can’t elaborate on what I’m expecting because I think there is – I don’t think anyone knows. But I think there, when you do a budget there are number of things and you make provision for a whole series of things happening and at this point in time, the court has overturned rate cuts but that’s just at the trial court. There is a whole other set of issues going on and I think it’s premature to predict the outcome of that.

Christine Arnold – Cowen

And did you put a provision in for retroactivity potential in the fourth quarter?

Jay Gellert

We have adequate consideration for anything that would occur.

Christine Arnold – Cowen

And then, final question. There are network products as you enter 2012, are you seeing further traction there and how do you anticipate that business in your network products will change? I think you said it’s a 31% now.

Jay Gellert

We are actually seeing a great deal of traction. We are actually seeing it both on the purchaser side and increasingly on the provider side. So I would anticipate that over the next two or three years it will move towards half of our business.

Christine Arnold – Cowen

Great, thank you.

Operator

Our next question comes from the line of Josh Raskin with Barclays Capital.

Josh Raskin - Barclays Capital

Good morning. Just want to follow up real quick on the duals opportunity. Can you remind us your relationship with Molina what services they are providing in the Medicaid side like county and then with theoretically with the duals fall under a similar type of arrangement?

Jay Gellert

The framework that the state has proposed and that would be a continuation of the two plan models. So I guess that degree is just. They – as we are a provider to them in Riverside, San Bernadino and they are a provider to us in Los Angeles.

Josh Raskin - Barclays Capital

And I guess just on the economics, it looks, focus maybe on where they are a provider to you in that way. What does that means in terms of financial impact? Do you think in terms of margin effectiveness, Kevin’s question, is that mean that theirs differential versus your overall book or how do we think about that?

Jay Gellert

I think it’s premature to really answer that. We are in a process over the next two, three, four months where I think we’ll really get some insight into this. We’ve tried really hard to stay within the four walls of what we know rather than speculating and I really believe that that’s the best place to be.

Josh Raskin - Barclays Capital

Okay, that’s okay. And just another question on the PDP sales, I think Jay you mentioned last quarter that, you’d be able to absorb the sale of the PDP business then it would not be taxable I know obviously that timing depends a lot especially with the PDP business. But assuming at 2Q close is that’s still similar you couldn’t expect guidance EPS a change based on the sale?

Jay Gellert

I think at this point I don’t think so. I think we’ll be looking at all this in the context of our presentation on Investor Day but we feel pretty comfortable with that.

Josh Raskin - Barclays Capital

Okay, so still everything is okay.

Operator

Your next question comes from the line of David Windley with Jefferies.

David Windley – Jefferies

Just wanted to follow-up Jay on the narrow network. The math that I did just based on the numbers you are have and your press release suggests that your percentage is about 30.5 I know you said 31 close enough. But I guess relative to what you said on the third quarter it was a little over 31 and I wondered if I am over reading the math there or if you did have, if you did see your narrow network membership back up a little bit?

Jay Gellert

No we didn’t. In fact, when we get to Investor Day, we’ll talk about it in a little more detail and I think you’ll see the opposite of it.

David Windley – Jefferies

Okay and then you are commercialized, I apologize if I missed this but you are commercialized, I see a little bit of a sequential decline. Did you explain why that was?

Jay Gellert

Yeah, I think that we’ve explained before that we’ve maintained disciplined pricing; there are a few instances where there were more aggressive offers than our goal has been to stay away from getting into that.

David Windley – Jefferies

Okay and then finally on the, I guess on the PDP sale, and some of our following conversations with your colleagues there were some suggestion that one of your reasons maybe not the primary but one of the reasons was a concern of losing some of those PDP lives into the duals program and I guess I wondered if you could compare and contrast or just pose your view on your opportunities in the duals versus to kind of same you thought you might lose some of your PDP lives to other plans in the dual program?

Jay Gellert

Our understanding is that the dual programs will all be like MA integrated, but the Part-D benefit within the overall arrangement. As we have said, I think there is some really decent opportunities for us in this program but again I’d rather not speculate on the numbers until we go through the process. I think we can all wait 30, 60, 90 days and then we’ll have affirm or rather try to speculate it on specifics. Everyone has access to what’s covered round side and everyone has access to the solicitation. So I think we can all draw our own things, we think there is some really good opportunities. We believe California Medicaid is among the lowest cost programs in the country, less expensive than many other states and so we believe that there is really a basis for what’s in the Governor’s budget.

David Windley – Jefferies

But I shouldn’t read that your expectation of perhaps losing PDP or not retaining those lives that you have under your PDP program as you not being competitively well positioned for the duals?

Jay Gellert

No, no, not at all because as we indicated, we have only sold our standalone Part-D business. So that’s my comment. If you look at the comments I made in the early, it’s only standalone. So we were talking more to the fact it’s going to be an integrated product.

David Windley – Jefferies

Yeah, understood. Okay, thank you.

Operator

Your next question comes from the line of Peter Costa with Wells Fargo Securities.

Peter Costa - Wells Fargo Securities

Hi, given the seasonality of the Part-D business, can you describe what’s likely to happen to your guidance going forward when you do adjust your guidance for the sale of the business and in terms of how the contract will work with CVS?

Jay Gellert

I think we’ll talk about that on – at the Investor Day. I think we are still kind of resolving all of those issues. But I think that – we’ll be able to present that.

Peter Costa - Wells Fargo Securities

And then again I guess, moving on from there, maybe you can talk a little bit about the pharmacy trend, you talked about that being modest or more modest under the new contract. How much more modest and sort of what rate do you expect that to be, in terms of year-over-year trend?

Jay Gellert

I actually think we’re going to talk about guidance in terms of individual elements of healthcare costs that are – it’s only two weeks away and we are still finalizing all of those. But we will meliorate any issues that we saw in Q4 as a result of the new agreement and we’ll be able to present that to you at that time.

Peter Costa - Wells Fargo Securities

Okay and I guess last question just on the tax rate in the quarter was a little bit lower than the 38% you guide to on the Western and Government Contracts business. Why was that, can you talk about that a little deep?

Jay Gellert

Yes, as you know the investment income was less. It’s the result of some tax free investment returns. So they balance each other out.

Peter Costa - Wells Fargo Securities

Going forward do you expect 38% as your guidance?

Jay Gellert

I think that we are working a little bit on that and I think we’ll be able to do it. But it’s directly related to the point I just made which is that the effect of the investment portfolio. So we’ll talk about that on the 16.

Peter Costa - Wells Fargo Securities

Okay. Thank you.

Operator

Your next question comes from the line of Carl McDonald with Citigroup.

Carl McDonald – Citigroup

Thanks, so can you walk through your- where you think just the free cash position will be in 2012. So if you ended the year about $90 million you are getting 140 from the PDP and that gets you to sort of 230. The subsidiary dividend amount, is it right to think about something in the $150 million to $200 million range for ’12?

Jay Gellert

Yeah. We will be more precise when we talk to you next week, but I think you’re pretty well on track.

Carl McDonald – Citigroup

Okay, and then second question, the each blind and disabled loss ratio in California indicated previously that you thought it might be a little bit better than the 100% that you’ve been booking at. So I’d be interested in an update there and if you’ve adjusted any loss ratios for some of the reserves you would have established and back in June and July when you first took some of those members up?

Jay Gellert

Yeah. We’ve not adjusted anything and we don’t intend to make any adjustments to get through the whole transition process. As we indicated before, while it looks better we still have the tail issue which we talked about. So I think we are going to stick with the assumptions with that we previously made.

Carl McDonald – Citigroup

Okay, thank you.

Operator

(Operator instructions) Your next question comes from the line of Charles Boorady with Crédit Suisse.

Charles Boorady - Crédit Suisse

Thanks, good morning. First question is, why are you selling the PDP business. I get the financial advantages is there a strategic rational behind the sale?

Jay Gellert

Yeah I think there is. There probably are two, one is that, we are blessed with a multiplicity of strategic opportunities and I think we came to conclusion that this one doesn’t yield nearly as much as some of the others we’ve ever talked about on this call.

Secondly, it is a contracted out business and quite frankly I think we have some concerns about the ability to most easily assure compliance and that kind of a structure and the return wasn’t worth the risk and finally, I think that our overall relationship with Caremark benefits by this structure as opposed to the existing ones.

Charles Boorady - Crédit Suisse

Got it and in those risks, I mentioned you are making reference to that which caused the sanctions in MA?

Jay Gellert

Yeah I just think that if you have a small business in Ohio regulated area, that that’s not the best thing to do. We have means and vehicle and approach to do it in terms of the combined business. And we have – I think a very, very positive compliance relationship now with Caremark. But to me, the fewer small mid-moving parts you have in multiple states and things like that, the better you are.

Charles Boorady - Crédit Suisse

And then in terms of enrolling SPDs, duals or other emerging opportunities in California, is there anything about, this transaction that could make that more difficult for you in terms of not having what would be perceived to be an integrated pharmacy benefits if that’s potentially going to be required to participate?

Jay Gellert

No, in fact I think this will enhance it, because we had really good experience in the integrated benefits related to the MA product and that’s where we are really focusing our effort and our ability and I think we will actually be much stronger there as a result of eliminating our attention in these other areas.

Charles Boorady - Crédit Suisse

Okay. So it sounds like, in addition to the financial benefits you are not really giving up anything strategically and you mentioned a couple of strategic advantages am I missing something or is there a strategic disadvantage?

Jay Gellert

No, no, no and I think the point you are making is, I think we have been benefited over the last couple of years by focus. We do a lot of better in areas where we are focused, I believe that states are different. I think it’s hard to get to the same level of focus at some of the regional plans out. So carrying a bunch of other businesses that are not all that financially significant, I think diverts from a core strength which we have.

Charles Boorady - Crédit Suisse

Okay, great. And then I just had a quick question on the Medicaid question. Just so I make sure I understand your response to Carl’s question that are you thinking that you are continuing to book 100% loss ratio for SPDs?

Jay Gellert

Yes.

Charles Boorady - Crédit Suisse

Okay. So, you book that in the third quarter and in the fourth quarter? And did your guidance contemplates a 100% loss ratio being booked in that business going forward or is it kind of a glide path towards a better loss ratio in 2012?

Jay Gellert

A glide path towards the better loss ratio, as we’ve indicated the transition has some unique features that lead to a higher MLRs, because some of the – there is some duplicate claim issues because the state didn’t carry the full cash flow effect of the transition. So there is some effect in the first year. There is also some effects related to getting people into managed care from the fee-for-service system. So we expect it to glide path to a different level after that transition.

Charles Boorady - Crédit Suisse

Got it. Got it. All right, thank you.

Operator

This concludes the question-and-answer portion of today’s call, Angie McCabe, do you have any closing remarks at this time?

Angie McCabe

We appreciate for joining us this morning and we look forward to seeing you at our Investor Day on February 16 in New York. Have a good day.

Operator

This concludes today’s conference call. You may now disconnect.

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