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UnitedHealth Group, Inc. (NYSE:UNH)

Q3 2007 Earnings Call

October 18, 2007 8:45 am ET

Executives

Stephen Hemsley - President and CEO

Mike Mikan - EVP and CFO

Ken Burdick

Bill Munsell

David Wichmann

Simon Stevens

John Penshorn

Analysts

Charles Boorady - Citigroup

Lee Cooperman - Omega Advisors

Scott Fidel - Deutsche Bank

Peter Costa - FTN Midwest Securities

Justin Lake - UBS

Josh Raskin - Lehman Brothers

John Rex - Bear Stearns

Matthew Borsch - Goldman Sachs

Greg Nersessian - Credit Suisse

Christine Arnold - Morgan Stanley

Operator

Good morning. My name is Dennis and I will be your conference facilitator today. At this time, I would like to welcome everyone to the UnitedHealth Group Third Quarter 2007 Earnings Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer period. (Operator Instructions)

As a reminder, this conference is being recorded. This call and its contents are the property of UnitedHealth Group. Any use, copying or distribution without written permission from UnitedHealth Group is strictly prohibited.

Here is some important introductory information. This call will reference non-GAAP amounts. Reconciliation of non-GAAP to GAAP amounts is contained on the 'Investor Information' section of the company's website at www.unitedhealthgroup.com.

This call contains forward-looking statements under U.S. Federal Securities Laws. Such statements are subject to risks and uncertainties that could cause actual results to differ materially from historical experience and present expectations.

A description of some of the risks and uncertainties can be found in reports filed with the Securities and Exchange Commission from time to time, including the cautionary statements included in our annual reports on Form 10-K and quarterly reports on Form 10-Q, as well as our current report on Form 8-K, filed in connection with the company's October 18, 2007 earnings release.

Information presented on this call is contained in the earnings release and Form 8-K, dated October 18, 2007, which may be accessed from the 'Investor Information' page of the company's website at www.unitedhealthgroup.com.

I would now like to turn the conference over to the President and Chief Executive Officer of UnitedHealth Group, Stephen Hemsley.

Stephen Hemsley

Good morning and welcome to our 2007 third quarter earnings call. This morning we will review our third quarter performance, and cover other topics of interest including our initial outlook for 2008.

As always, we have a number of our executives available for your questions on this call. Afterwards, John Penshorn, Brett Manderfeld, Mike Mikan and others will also be available to respond any additional questions.

The themes for this quarter were continued fundamentals strengthening of operations and earnings growth, which we will illustrate with some highlights from this morning's press release.

In the third quarter, we earned $0.95 per share, an increase of 19% over the third quarter of 2006. Fourth quarter results are currently projected to be in the range of $0.91 to $0.92 per share.

Seasonal increases in medical costs in the commercial risk business and in Medicare Advantage marketing expenses are projected to be partially offset in the fourth quarter by seasonally strong Medicare Part D and Ingenix Health Technology results.

This would bring full year 2007 earnings to an adjusted $3.49 to $3.50 per share. This performance would be 18% above our 2006 performance and substantially above the $3.40 per share target we established at the start of 2007.

Our expectation for 2008 is a return to balanced growth, stronger operational execution to predictable earnings performance. Specifically, we anticipate earnings in the range of $3.95 to $4.00 per share. This assumes the expected closing of the Sierra acquisition before the end of 2007, and approximately $7 billion in further share repurchase between now and the end of 2008.

This preview of 2008 assumes revenues of approximately $83 billion, including Sierra and an operating margin in the 10% to 11% range.

Compared to 2007, operating earnings would be up around 7% to 9%, which as you know excludes incremental financing charges, and full-year weighted average shares would decrease by as much as 7%. Earnings per share would be up roughly 15% when compared to $3.49 to $3.50 projected for 2007.

Cash flows from operations would approach $7 billion in 2008. I am sure there is an appetite for greater visibility into 2008 and we will discuss 2008 in greater detail at our December 4th Investor Day.

Over the longer-term horizon, say 3 to 5 years, we see average annual EPS growth in the 13% to 16% range, that range encompasses organic growth, productivity advances, ongoing capital structure management in moderate levels of M&A activity.

Above all, it considers our current projected operating earnings base, which is approaching $9 billion. The pressures we see in the commercial benefits marketplace, continuation of current levels of medical inflation, as well as the opportunities we are pursuing as we continue to diversify our businesses.

Obviously, the actual growth rate will vary year-to-year, but our sense is that this range is right for now.

Focusing now on the third quarter. It featured strength in earnings, margins and cash flows, and a sequential improvement in the commercial risk medical care ratio. We also saw a growth and advancing performance in a range of business units, including Evercare, Ingenix and AmeriChoice.

Our diversified market facing business model continued to serve us well as the year progresses.

Operating earnings increased 16% year-over-year to more than $2.1 billion. And our operating margin expanded 110 basis points to 11.5%

The third quarter consolidated operating cost ratio was 14%. This ratio increased 50 basis points year-over-year, reflecting the growing impact of business mix, as businesses, such as Ingenix, meaningfully increased their contribution to our total operating cost trends, and investments we have made to improve performance in service and to senior business marketing, which we will describe shortly.

And I would point out that operating costs increased only $11 million sequentially, so the increase is minimal from an aggregate dollar impact.

Normalized cash flow from operations for the quarter were $2.1 billion, a strong ratio of 1.6 times net earnings and we are on track for full year cash flows of approximately $6.2 billion.

We repurchased $2 billion in stock in the third quarter, bringing the year-to-date total to nearly $4.5 billion. We have now bought just under 1 billion shares on a cumulative basis over the last 10 years at an average cost of about $21 per share.

Our financial position remains sound, with the debt-to-total capital utilization ratio of approximately 28%, and we have $1.5 billion in available cash.

Return on equity exceeded 24% in the quarter, reflecting positive margins and the increasingly efficient capital base.

These financial gains were matched with investments and improvements in execution of fundamentals within our core operations. We recognize that our customers and care providers want continuing focus from us in several distinct areas.

They are looking for us to continue to advance health system access and affordability. They expect our continued leadership in product innovation and capabilities, that center around the quality and effectiveness of care and that increasing consumer engagement in health care.

And they want us to continue to elevate our performance around service, cost controls and execution. We made important operating gains in each of these areas in the quarter.

In the first instance, we continue to expand our proprietary care network, already the largest and broadest single network in the country.

In the third quarter, we added 20 new hospitals and 19,500 net new physicians and health care practitioners. This includes retaining or adding some of the highest profile hospital systems in their markets. Recent examples include multi-year arrangements with BJC in St. Louis, Swedish Hospital in Seattle and St. Louis in Cincinnati.

Access to partners like these strengthens our offerings to customers in each of those local markets. Our networks meet care access standards for 97% of the U.S. population.

And today we maintain direct contractual partnerships, with roughly 85% of the health care delivery resources in this country. Network development is an area where we have made clear and significant advances.

We continue to lead on products and capabilities that increase consumer engagement, particularly around quality care.

Our premium designation programs in clinical integration designs within our broad network represent distinct capabilities that transcend any specific type of product. They increasingly help people get to the best places and practitioners for their care.

Some 15 million of our consumers now have access to physicians, specialists, premium designation programs in their market. And consumers in 85% of our markets have access to differentiated hospital quality and efficiency data online.

And our consumer-directed health benefit products achieved 24% organic growth over the last year. That is 440,000 new consumers and we serve a market leading total of over 2.3 million consumers, participating in these products today.

In the third area of interest, we have focused all year on improved accuracy and responsiveness in fundamental service processes.

I initially mentioned this on our first quarter conference call, six months later we can point to early advances that meaningfully improve the service responsiveness of our organization.

Claim service is returning to competitive performance levels at PacifiCare and we expect further advances in 2008.

In the claims area, dollar and financial accuracy are at an all-time high, consistently above 99% over the course of this year. And call quality and accuracy are sharply stronger in both consumer and physician channels as compared to 2006.

We have significantly expanded our rapid resolution service model, which uses empowered executives to provide more responsive service to resolve transactions that are more complex or are in conflict. These improvements are bearing results in meaningful ways for people.

Consumer survey show post-call satisfaction running above 90%. And brokers and employers are seeing better performance, as reflected in the strongly improved results in the service performance guarantees we provide to these customers.

We expect these gains will accelerate into 2008, supported by further reaching actions in continuing focus.

Let me touch briefly on these areas. Over the past eight months, we positioned the commercial service and operation functions, as well as our technology organization under the [Dirt Mickman] and David Wichmann, which pulls together key assets serving all of our commercial markets under two of our best operators.

We are also better aligning our services and response operations to more directly linked to the service to serve local market settings. We use our technology and service applications to provide more immediate response at local market levels, empowering our people to respond more quickly to market specific needs.

Finally, we are realigning incentive compensation for our executives, to our front-line employees to more directly tie to our performance on fundamental consumer and care provider services and satisfaction.

We will be more accountable to consumers and care providers, listening more closely than ever and providing the exceptional service to these consumers and care professionals expect and deserve from us.

Let me now turn to the businesses, beginning with the Health Care Services segment. Third quarter business developments for the public and senior market group included gaining some 95,000 seniors, while Medicaid enrollment remained stable.

The senior growth breaks out as follows: 20,000 new seniors in Medicare advantage, 35,000 in active Medicare supplement and 40,000 in stand-alone Part D plans.

Margins improved for Ovations and AmeriChoice year-over-year. In fact, it was the strongest AmeriChoice earnings quarter, with the lowest medical care ratio in a number of quarters.

We expect this performance level to continue into 2008, supported by stable medical care ratios and quite steady growth. We entered the 2008 Medicare selling season much better position for meaningful growth in last year.

There are four reasons for this optimism, more competitive products and expanding geographic footprints, great branding and improved execution.

Specifically, we go to market for 2008 with generally stabled or enhanced benefits, including strongly competitive private-fee-for-service plans.

We have expanded our Medicare Advantage footprints for 2008. For example, we see expansion markets for network-based Medicare Advantage offerings include Boston, WashingtonD.C., Chicago, Atlanta and Kansas City.

Evercare chronic illness Special Needs Plans will expand from seven states in 2000 to 34 in 2008. These are all states where we already offer Medicare Advantage, so we efficiently leverage existing local operations and where our networks are broad and strong.

From a branding perspective, we now offer the only Medicare Advantage product that carries the AARP name. We are obviously very excited about both the immediate and long-term potential for this exclusive alliance with AARP to 2014. And we are promoting this with an intensive multi-media campaign.

Finally, execution around marketing, sales and enrollment has been meaningfully strengthened, with key investments in leadership technology and infrastructure, and by the much more complete integration of Ovations in SecureHorizons.

For example, we have a stronger and better organized network of contracted and certified brokers. They are more aligned, better trained and better paid and they clearly understand the need to deliver accountable results to preserve their ability to sell AARP-branded products. We also have much greater direct access to an oversight of their day-to-day efforts.

We have launched our own internal agency with brokers fully dedicated to distributing our products, including individual insurance and chronic Special Needs Plan and traditional Medicare Advantage offerings.

All products communications, marketing and enrollment materials have been fully adapted for local market uses. They were into the local markets well before the enrollment season, which was not the case last year and which undoubtedly affected our results.

We have tightened and automated the enrollment submission process to drive simplicity, increase speed and eliminate potential [sources there]. And we have established a command center to monitor, analyze and adjust tactical approaches daily as required.

We are off to a strong start and we want to drive this campaign for the next two and half months.

On the public market side, we are well positioned for potential SCHIP expansion and are working to grow pipeline, a state program expansions and procurement opportunities including Tennessee, Iowa, Missouri and others.

Turning to our individual and employer markets, third quarter membership in this group declined by 115,000 people. Fee-based growth at UnitedHealthcare of 80,000 consumers was more than offset by employment-related attrition at Uniprise and a decline in UnitedHealth risk membership, including the 70,000 decrease from PacifiCare.

We expect that year end 2007 membership would be slightly down from the total for this group at September 30. Much of our commercial membership decline stems from a conscious decision to put profitability ahead of top line growth. Achieving both was difficult in 2006 and 2007, but in 2008, we are committed to doing so.

In 2008, we expect our commercial risk membership to decline in January then strengthen modestly quarter-by-quarter in the second half of 2008. We are refocusing on the local market dynamics and the needs of these commercial benefit markets, which continue to become more consumer oriented.

We have introduced a number of new innovative products to see these changes, directly engaging consumers and making effective health choices and decisions.

Specific new offerings address both consumerism and affordability, including the Golden Rule and Definity consumer-directed product lines. United with Me, which focuses on employee activation and wellness for the very large employers.

The new Vital Measures product line to engage, encourage and reward healthy behavior. And the recently launched Edge product line, which informs and motivates people to use the best doctors and hospitals.

This innovative package brings the market abroad, national premium designated network at significantly reduce price points by using benefit designs to encourage consumer choice that drives cost-effective quality and care.

Edge will be active in 20 markets by January, with the remainder to follow over the course of 2008.

At Uniprise, we had customers who sponsor more than 2.5 million members out of market for January 2008.

In all then we should net out to an estimated January decrease of between 80,000 and 100,000 people.

UnitedHealthcare fee-based enrollment is also expected to decline slightly in January and then grow throughout the year more than offsetting any in-year attrition at Uniprise.

Participation in risk-based offerings for UnitedHealthcare is expected to be down in January, although it is too early to quantify at what level. We are committed to sequential improvement in risk-based result for the rest of the year.

We see that improvement coming from four key areas: new products, which I just described; an expanding network; improved service; and better local market dynamics. We expect 2008 growth in diverse market segments such as student, individual, and ethnic groups and through geographic market expansion such as Sierra and more effective local market engagement across the Board.

We expect our traditional markets to strengthen progressively quarter-by-quarter in the second half of 2008, as new products gain traction with brokers and employers. These products will reach market segments that are more price sensitive than those of our traditional product lines.

The third quarter medical care ratio for UnitedHealthcare of 81.6% improved 40 basis points sequentially. UnitedHealthcare also saw a favorable increase in per member per month premium yield this quarter.

We continue to estimate the full year 2008 UnitedHealthcare medical care ratio in the range of 81.5% to 82%, implying a fourth quarter ratio of around 83%. This is an appropriate expectation given the higher utilization of services expected in the fourth quarter.

For full year 2008, UnitedHealthcare is pricing to achieve a stable medical care ratio, subject to normal seasonal variation.

Our medical cost trend continues to run in the area of 7.5% for 2007, with no notable deviations in individual cost categories.

We are projecting only a slight uptick in cost trends in 2008, principally due to changes in public policy and evidence-based care guidelines and we have incorporated that into our pricing.

There is much more to be done in this group. We are deeply committed to improving our performance and commercial benefit growth in overall service levels, productivity and innovation efforts. We expect our efforts in this domain to be evident in 2008.

Let me now turn to the enterprise services market. Again, Ingenix, Exante and newly re-branded OptumHealth all reported solid growth and profitability this quarter. In fact, we expect these three businesses to contribute more profit in 2007 than the entirety of UnitedHealth Group had in the year 2000.

OptumHealth's third quarter results were stable with the second quarter and had a solid margin of 19.1%. More than half of OptumHealth customers are external, and we believe the best growth opportunities lie in these external markets outside our walls. We are making it easier to do business with us by unifying a portfolio of companies into a single integrated and external facing entity.

One that pursues public sector business and external employers and payers business, even more aggressively and brings to those markets a wealth of integrated capabilities cost, the specialty network and health financing spectrum.

Exante continues its rapid expansion, while traditional financial institutions have been attempting to move into this market, we don't believe any traditional bank can integrate its financial services with the health care system the way Exante can.

For Ingenix, the relative momentum continues this quarter. Year-over-year revenues were up 40%, earnings from operations up 35% and revenue backlog up 46%. And each of its future business pipeline measures is up triple-digit percentages year-over-year.

The demand for Ingenix Services is growing rapidly as health plans, employers, state government, delivery system participants, and pharmaceutical and device companies are increasing their demand for data-driven products and services.

Lastly, we are driving external pharmacy benefit sales across the company. Uniprise will be providing pharmacy benefit management services on an insured basis to 1 million people in the entire plan in New York on January 1.

UnitedHealthcare will serve nearly 300,000 Georgia State Employees. In prescription solutions, recently secured fulfillment services for private health benefit systems were 1.2 million members.

Let us also update you on our rebuilding efforts in relationships and in becoming better overall stewards of this enterprise. I will offer one example in the work we are doing with a large cross-section of hospitals and physician groups to mutually streamline and improve end-to-end transactions processes and similarly, with practice management systems vendors through Ingenix [sort of] improved our direct electronic connectivity and the accuracy of the data submission.

We are working with the American College of Physicians, the American Academy of Family Physicians and the American Academy of Pediatrics under Reed Tuckson's leadership, highlighting the medical home reimbursement model with primary care physicians in select markets.

In two separate instances this quarter, regulators asked UnitedHealth to step in and assist with troubled health benefit systems. Separately, we are designing a process for meeting with some of our long-standing shareholders to engage in direct conversation about the performance elements of our executive compensation system.

And we continue to take a very structured approach to executive development, with our most talented leaders moving regularly to gain experience in new roles. We've made a number of senior leadership changes in the past 90 days.

[Dr. Bill Gillespie] has moved to become the Chief Medical Officer of Ovations, a new role for this segment. We are excited to have Dawn Owens as Chief Executive Officer of OptumHealth, and for John Prince to become the Chief Operating Officer of OptumHealth.

We have Chad Wilkins join us from U.S. Bank to lead Exante. We are fortunate to have had Jud Sommer from Goldman Sachs to service our new Head of Government Relations. And we are also delighted to have Mike Matteo to become the new Chief Executive Officer of Uniprise. Mike combines years of experience at Uniprise in both client sales and development, with great energy insight and intense customer focus.

Tracy Bahl is pursuing personal interest he has outside of UnitedHealth Group and we thank Tracy for his many years of outstanding service to Uniprise and wish him well. We are also achieving meaningful improvements through greater enterprise level oversight in coordination in order to drive our competencies really to their full potential.

In that vein, various executives have taken on additional enterprise-wide oversight responsibilities; including Mike Mikan in network, care facilitation and health care economics; Dr. Reed Tuckson in clinical policies, practices and progress; Dave Whitman in technology, operations and company-wide integration; Tom Strickland in administrative services, processes and controls; Andy Slavitt in all clinical information assets, resources and applications; and Bill Whitely in commercial marketing, distribution channels and revenue pipeline management.

At the business unit and market segment levels, an aggressive new generation of leaders is emerging. Under the direction of Tony Welters, Bill Munsell and Dave Wichmann, the season team of Ken Burdick, Mike Matteo, Rich Collins, Simon Stevens, Ken Fasola, Sheila McMillan, Rick Jelinek, Dawn Owens, Jackie Kosecoff, Andy Slavitt, Lee Valente and many other is especially strong indeed, which has been a hallmark of our company. You will see that first hand at the investor conference.

And we will continue to recruit broad-based talent and experience from outside our company and industries to enrich and diversify executive resources and stimulate new thinking. We will close with a brief summary.

This quarter, we have done what we had told you we would do. We refocused to improve fundamental execution and we maintain that sharp focus. We continue to expand and enrich the network. We have addressed specific year integration issues and expect that performance will continue to strengthen quarter-by-quarter throughout 2008.

We reengineered our marketing and sales approach to the Medicare sales season and we expect significant performance improvements. And we strengthened our discipline in pricing to cost across the commercial benefits market even at the cost of membership growth.

Through the first nine months of this year, we have exceeded the individual quarterly consensus estimates by a total of $0.14 as adjusted. This is directly the result of our diversified, adaptable and market-focused businesses. We are positioned to deliver a solid fourth quarter and to grow and expand our business in 2008.

The key financial elements for 2008, including accelerating Medicare Advantage business, stronger service performance, new product launches to re-ignite growth in commercial markets, our continued commitment to pricing discipline and our ongoing commitment to responsible capital management where we expect to make some further progress as we close out the year. That's a short and basic list and we intend to execute on it.

With that I thank you very much and we can now move to questions.

Question-and-Answer Session

Operator

(Operator Instructions). We also remind you that for purposes of getting to as many participants as possible, we ask those with the questions to limit to one question per person. We will pause for just a moment to compile Q&A roster. Your first question will come from the line of Charles Boorady with Citigroup.

Charles Boorady - Citigroup

Thanks. Good morning. My question on prior period developments, if you can bifurcate between commercial and Medicare for this year and last year, the developments in the quarter?

Stephen Hemsley

Mike, you want to respond to that.

Mike Mikan

Charles, I just do not, I mean we’ve got development across all of our medical costs or book-to-business, not just Ovations, the Medicare book or UnitedHealthcare. So I just do not break it out into its individuals components. I will tell you that with respect to UnitedHealthcare, we did see modest developments from the prior year, say around $10 million or so.

Charles Boorady - Citigroup

And Medicare Advantage, the additional selling cost that you are counting on in the fourth quarter or incrementally how much higher in the fourth quarter versus third quarter should we expect? Anyone offer a response for that?

Mike Mikan

Yeah, I mean I wouldn’t put a dollar figure on it, but I would agree there are a number of one time SG&A costs, which we will be incurring in the second half of this year, which won't be repeated in 2008 and particularly the meaningful brand marketing and other campaign launch costs associated with our new AARP Medicare Advantage Plan.

Stephen Hemsley

It won't be as intense in 2008.

Mike Mikan

Yeah, there are a number of startup costs which were building on SG&A this year.

Charles Boorady - Citigroup

Got it. So these were expenses is it going hit you in the fourth quarter for which you will see the revenues in 2008 for?

Mike Mikan

That’s right, and we wanted to incur the time level of SG&A startup costs into 2008.

Charles Boorady - Citigroup

Right. I think that’s an important point. Thank you.

Stephen Hemsley

Thank you.

Operator

Your next question will come from the line of Lee Cooperman with Omega Advisors.

Lee Cooperman - Omega Advisors

Thank you very much. I appreciate it. If you go back to the old DuPont formula ROE times retention equals to sustainable growth. We clearly are retaining much more earnings than we need to finance that business.

And historically and so far intelligently you’ve taken those excess retained earnings and put it into stock repurchase. And you are really doing so in extreme, it’s very few companies of your size and your history that pay no dividends.

So I guess the question I am really asking is how confident are you that you are doing the right thing for shareholders that are not selling back their company and effectively enlarging our ownership as you buyback stock.

And I guess this raises question as simple as that, because it is pretty extreme for a company of your size in profitability, not repaying a meaningful dividend?

Now I want to make it clear, I am not criticizing the buyback by the way, I am just trying to examine that we sort this thing through and at the end of the day, we are not going to be like CountryWide to spend $1 billion buying back stock at twice the current price and now they are under capitalize.

Stephen Hemsley

Well I appreciate the question and our perspective has been that in terms of capital use our first priority is to invest it, kind of in a consistent, a thoughtful way in a multi-year basis in the business itself, to really focus on areas of business expansion through acquisitions that bring some strategic value or bring us the capability that we get faster or more effectively through a purchase.

And then when we look at the remainder of the use of that capital and particularly relatively to our -- where we see the potential of our business and our valuation, we see the greater appreciation clearly dedicated to the continued repurchase of shares and I agree completely that the cash generation capacities of these businesses is quite remarkable.

And continue to see that as the most appropriate course and that has been our orientation and less on the orientation towards dividends. I think that's probably the most efficient approach to managing the capital.

Lee Cooperman - Omega Advisors

And I assume if you thought your stock was adequately priced, you would move away from stock repurchase?

Stephen Hemsley

If we felt that we got to a position where that disconnect with the market as a potential that we see in the business and we saw then in the long-term, we would have to consider that, yes.

Lee Cooperman - Omega Advisors

Okay. Thank you. Good luck.

Stephen Hemsley

Dividend consideration is always on the table. But when we go through that, the approach that we look at the marketplace, we see the first three as our priorities.

Lee Cooperman - Omega Advisors

Thank you. You are doing a very fine job running the company. I appreciate your efforts.

Stephen Hemsley

Thank you very much

Operator

Our next question will come from the line of Scott Fidel with Deutsche Bank.

Scott Fidel - Deutsche Bank

Thanks. So, your new long-term EPS growth target of 13% to 16%, can you talk about how you think longer term that breaks down between annual revenue growth, operating earnings growth and from capital deployment?

And then, maybe if could talk about the decision to change from the 15%, how much of that relates to the law of large numbers that you are seeing with the growth as compared to a difference in how you see the opportunities in the industry?

Stephen Hemsley

Yeah, I will let Mike and John talk about the elements of it. I would like to keep that at a reasonably higher level in this discussion, because we intend to get into this in a significantly greater depth at the investor conference.

So we think that's the best venue for that. I would say though that we think that there is very strong potential and opportunity in terms of our business model and the businesses that we are in and in the businesses that we see in a path, as we continue to pursue diversification.

But it is impacted, I think in a significant way, by the fact that we're -- our operating earnings are approaching $9 billion. And if you take the long-term growth path on that given conditions we see in the market place and the more moderate levels of medical cost inflation, which we think will persist, that we thought the guidance was appropriate in that range. And if you want to get into just couple other broader strokes of that model. Mike, do you want to respond?

Mike Mikan

Scott, it's Mike. We will go through more in detail, the long-term outlook and how we build it up. But just to give you some high level metrics, we expect long-term revenue to grow somewhere in the high single-digit range.

Operating earnings, we target on average 8% to 12% say and then the capital accretion or the use of capital whether through share repurchases or the like for acquisitions we think we can get around 5% accretion on a yearly basis. So on average we think that would target around 13% to 16% annual EPS growth rate.

Scott Fidel - Deutsche Bank

Okay, thank you.

Operator

Your next question will come from the line of Peter Costa with FTN Midwest Securities.

Peter Costa - FTN Midwest Securities

Thanks. Can you talk about what's causing a decline of the Fee based membership? Will just Aetna and [Signa] coming back, is it service issues or is it geography type of PacifiCare and Oxford, what sort of really issues there, can you get us through that a little bit?

Stephen Hemsley

Yeah I'll give you my reaction in all, I’ll add -- as such some others can predict and so forth the response but I would say that we need to strengthen our execution along a landscape of issues in terms of minimizing disruption in the market place. I would say a closer connection to local markets in local market dynamics as I said in our prepared comments.

And just basically more effective execution, energies and customer intimacy. So, I think it is a back to basics. And execution on fundamental, and a greater focus towards customers I think our elements that will bring that kind of market response back in the line. Ken?

Ken Burdick

Peter thanks for the question. Couple of things just to build on to Steve, first, we continue to reposition our PacifiCare business, and that did contribute significantly to the loss of this quarter.

We are very confident that, that work will stabilize after January of ’08. And we got some exciting things that we have introduced in the market place. In the prepared remarks, you heard Steve talk about the edge product. We just rolled that out in September, we’ve already several dozens sales as you heard in the script 15 markets by the end of this year and then 21 by January.

In the fee business, we are really looking to build on the momentum that we have gained in the consumer activation products. And we talked about United with me, vital measures, you probably read about some of that in Wall Street Journal.

And then, the comment that Steve made with regarding network, I think needs to be underscored. Year-to-date, we have added a 190 facilities and we have renewed contracts with 1,500 hospitals, most of them with multi-year deals. So we feel very, very bullish about the stability and the efficacy of our networks.

Stephen Hemsley

And if you really focus, our trend performance with respect to these large cases, this year has really been quite exceptional. So I do think it is a function of execution on basics in terms of service, account management, flexibility and customer orientation.

And basically, some of the basics that Uniprise had used very effectively in their earlier years and we are basically returning to that orientation. And I think that the market will respond as it has in the past.

Peter Costa - FTN Midwest Securities

And then on the Medicare side, is this Private-Fee-For-Service now a focus area going forward or was some of the growth that we saw this quarter from the Group retirees side, can you talk a little bit about sort of where you expect membership growth in Medicare?

Stephen Hemsley

Ken, you want to respond to that?

Ken Burdick

Well, Peter, your right that obviously, we did see increasing momentum in membership growth in this quarter with 95,000 new Medicare lives compared with 40,000 in Q2. Most of that growth on the Medicare Advantage Fund came from our network-based offerings.

Going into 2008, as Steve said earlier, we have obviously strengthened our competitive position on Private Fee-For-Service and so are participating in 49 states. The Private Fee-For-Service has expanded geographical coverage.

We are of course also though heavily committed to our network-based offerings and new AARP-branded Medicare Advantage product and the significant expansion of our Special Need Plans from 7 to 34 markets.

So this is a broad-based approach to expanding our Medicare footprint, recognizing that we participate in all of the Medicare product categories and have a balanced revenue generation from those different categories of Medicare.

Peter Costa - FTN Midwest Securities

Thank you.

Operator

Your next question will come from the line of Justin Lake with UBS.

Justin Lake - UBS

Thank you. Good morning. Couple of questions, just first a following up on the Medicare Advantage. Last year you gave us a membership number and I think it was up 150 to 175. Did I miss it this year or are you willing to talk about what you think about for Medicare Advantage next year?

Stephen Hemsley

You didn't miss it at all. We just have concluded that we prefer to go through the details of 2008 itself, as well as the discussion of the longer-term growth in the investor conference. So across the Board, we haven't provided specific membership guidance for 2008. We think that will be better done in our discussions at the investor conference.

Justin Lake - UBS

Okay. And in regards to the Medicare AARP contract, is there anything you can tell us as far as the changes in economics there. I believe there was a - you are going to be paying royalties on all of your HMO members from beginning of the year. Is that correct?

Stephen Hemsley

Yes. I think that we basically have economics attached to all of those lives, all for the full year. Do you want to comment on that Bill?

Bill Munsell

The obvious impact is that we are going to go to the market with the only Medicare Advantage product, with the AARP name. And we think that that will be important as a trusted brand, not just for next year but over the medium-term as well, given that this is a contracted that gives us some exclusive relationship with the AARP on Medicare through 2014.

Justin Lake - UBS

Sure. I guess I was just curious if there was -- if you are paying out a fee for 2008 on all the existing members? Is there some break-even number as far as the membership you need to gain through AARP in order to offset those higher costs, or did you may be do it to offset those costs through changes in the benefit designs?

Stephen Hemsley

I don't want to get into detail of the economical side of what we believe over the life of this contract, this is going to make an important contribution to our ability to grow in the Medicare space and we believe that the trust embodied in the AARP and SecureHorizons names will serve both organizations well over that timeframe.

Justin Lake - UBS

Okay, great. And just one quick question on the commercial risk side, the PacifiCare, can you break out the quarter-by-quarter, you've been trying how to break out the PacifiCare, which wasn't at a commercial risks.

And I think last quarter you said, UNH on a standalone basis had actually grown. Can you give us those numbers for the first quarter and what you expect for this quarter and what you are kind of embedding in the 2008 when you say it is going to be down?

Stephen Hemsley

I felt we said that in total in this quarter, PacifiCare represented 70,000 of decrease of about a 140,000 in the risk-based book of business. So 70,000 for this quarter.

Justin Lake - UBS

And for the first of the year, can you tell me how many PacifiCare members you expect to loose?

Stephen Hemsley

What, January of 2008?

Justin Lake - UBS

Yes.

Stephen Hemsley

There will be some fairly large cases that were insured and from our point of view not at all attractive from an economic perspective, but I don’t know if we are -- that we can actually predict what the number will be going into January and which is why we stayed away from that subject.

Justin Lake - UBS

And you did say that that would be pretty much the end of the re-pricing of PacifiCare?

Stephen Hemsley

Dave Wichmann, you want to respond to that?

David Wichmann

Sure. Just a couple of things that 70,000 is the right number and that makes the year-to-date PacifiCare repositioning to 270,000 lives, which I think is important metric.

Justin Lake - UBS

Sure

David Wichmann

Leaving the underlying growth of our legacy business. So I want to make sure that we point that out. With respect to the large -- few large case losses cases that we would have to write or rewrite at a loss, so we chose to not be as anxious for those as some others.

So there will be some of that in there. But it is entirely too early, particularly given the components of that block of business fully predict what PacifiCare losses would be for January 1 or throughout 2008.

We caution on the repositioning of PacifiCare, this is a block of business that at best was very modestly profitable and we have had to do a fair amount of repositioning with that business and that will continue into 2008. And we have fully taken that into consideration in developing our estimates.

Justin Lake - UBS

Great. Thanks for answering those questions.

Operator

Your next question will come from the line of Josh Raskin with

Lehman Brothers

Josh Raskin - Lehman Brothers

Hi, thanks good morning. Two questions just on CR, I think when you guys announced it, you have said that it was $0.04 I just want to check if that’s still the right number for 2008?

And then just more broadly speaking on Medicare, could you just help us understand sort of the strategy, I think some people are a little surprised by the bidding and I am not sure, how that came out versus your expectation from an industry perspective.

But, as you think about the next three to five years, and that new earnings growth rate, what sort of contribution and where do you think the Medicare growth is going to be?

Stephen Hemsley

I am going to handle the CR discussion.

Mike Makin

Hey Josh, Mike. We are not changing our curtness or our assumptions with respect to the accretion for CR at this time.

Josh Raskin - Lehman Brothers

Okay

Unidentified Company Representative

With respect to the parties, I mean you want to respond that?

Stephen Hemsley

Yeah. So your questions on the bidding was specifically around the dual eligible bidding limit, Josh?

Josh Raskin - Lehman Brothers

Yeah, I just think it, how you guys thought about Part D coming into 2008 and what was the impetus for the strategy that you guys brought in terms of raising the bids? It didn't look like this year the profitability was an issue in terms of the Part D and I know it's not broken out specifically, but it is sort of curious what the thoughts were?

Stephen Hemsley

Yeah, let me take that in two parts. You think about our open market Part D positioning and then dual eligible Part D positioning. As far as our open market positioning is concerned, I think [DMS] just reported that the average Part D plan premium for 2008 will be $25 [PBM].

We have a range of plans in Part D market including our value plan that has an average premium of just $22.17. If you think about the average premiums on our popular saver plan, they have only increased by 6.4% over two years during 2006 and 2008.So we think, we have bought some good value offerings out are there in the market.

As far as the dual eligible piece is concerned, I think our Part D group would rightly say that we have a very clear line of sight to the actual cost experience of these low income members, recognizing too that, that tends to be back left upside of mail or former incentives for this group. And in the light of that is our usual practice, we took a disciplined approach pricing to our costs.

So the processes what to be is in the results, what they are, as far as the few eligibility is concerned. Although as we previously reported the outcome is naturally negligible to us from an earnings perspective.

But more generally around the dual eligible bidding process, I would say that, I think the number of commentators pointed to some of the public policy challenges, obviously this methodology if it goes forward.

But it does appear to be generating more restricted form of risk for low income than the better off Part D members, and it appears that some of the low income members are about to be switched to alternative plans to instruct formally exclusively together some of the top branded medicines to their physicians who aren't prescribing it. I don't know if that comes out with the Part D point. If you want to also pursue the sort of general Medicare.

Josh Raskin - Lehman Brothers

Yeah. That was perfect for Part D, I thought I understood the strategy there. No, I think but your point Simon maybe more broadly, because just overall on Medicare where you see that in terms of growth over three to five years?

Simon Stevens

Yes, well, the sorts of things that we do particularly in coordinated Medicare Advantage, we think there is going to be strong continuing demand for. If you think Josh, for example, Monday, this week, there was a widely publicized report from the National Cancer Institute, pointing that there have been encouraging declines in cancer mortality at 2.1% a year for the last number of years and that's being driven by prevention and early detection.

If you then look at the Medicare population, what you see is the type of programs that we offer through Medicare Advantage are exactly those that are required to contribute to that kind of improvement.

Medicare Advantage in the [longer view] right for example are around 60% compared with 46% in Fee-For-Service, colorectal screening rate is 70% in Medicare Advantage, that was 58% in traditional Medicare.

So the kind of clinical value added that we are bringing to uncoordinated fragmented Fee-For-Service Medicare, I think is going to be valued, regardless of the particular financing mechanism on top of those programs.

Stephen Hemsley

And what we need to do is become more creative in terms of demonstration projects and initiatives to bring more ideas forward, because they are looking for those kinds of solutions that we have, the competency and resources to deliver on them. And that's why we are quite positive with respect to where these kinds of market can go long-term.

Simon Stevens

Yeah. I'd just say for example Evercare, which is now a $2.5 billon company, there is absolutely no reason why Evercare can't double in size in the next two to three years serving exactly this kind of market.

Stephen Hemsley

We are going to go for about 10 more minutes. So, we ought to pick the pace on this. So, the next question please?

Operator

Your next question will come from the line of John Rex with Bear Stearns.

John Rex - Bear Stearns

Thanks. I just wanted to focus back on the Ovations segment a moment. I appreciate the difficult to get talking with precision about enrollment for '08, given that open enrollment hasn't kicked off yet.

But with your benefits all filed for your new MA plans for '08, wonder if you can give us kind of a relative magnitude of what you anticipate for margins, or if you want to say MCR's business. They clearly, they would appear to drop out very, very favorable so far this year.

And again, I know you don't give precision in terms of MCRs on that segment, if you can give us some kind of order of magnitude directionally and how much you built in for cost ratio deterioration in that book based upon how your benefits were filed?

Unidentified Company Representative

Yeah, well, let me say this John. We feel about our 2008 earnings prospects for several reasons, right trend and one time 2007 SG&A costs that we are experiencing. Let me just give you a little more detail on those. 2008 Medicare Advantage rates as we previously said reasonable which has allowed us to have stable and strong benefits design going into 2008.

We are anticipating stable to modestly improving medical trends for 2008, which in part is thanks to our seniors who direct clinical model. As you know we don’t act so fast regarding that was a critical core competent in the Medicare space.

We also expect meaningful gains next year in male penetration, in generic utilization across our Medicare businesses undertaking this process off with our new Part D benefit design that effectively provides members with generic drugs for free. It’s supplied by mail and that way we are sharing these supply chain efficiencies with our members.

And of course we will continue to be properly compensated for the underlying health risk for the population we serve. That’s not a one-off event, that’s an ongoing process. So breakthrough reasonable medical trend, stable to modestly improving and then as we’ve already discussed in Charles question a number of one time SG&A costs that we were absorbing in 2007 that we don’t expect to repeat at the same level in 2008.

John Rex - Bear Stearns

So just and I just want to clarify. So would that say that you anticipate your medical cost ratios and M&A to be stable in ’08 with the’07 levels we’re seeing?

Stephen Hemsley

Well, as you know we don’t give guidance specifically on our [PCOs] and our Medicare portfolio, but I have just directed to you I think some of the factors that will drive that performance across the peak next year.

John Rex - Bear Stearns

Sure. And I guess I would step away from your comments saying that, that kind of seem like general stability in MCRs. I Just want to make sure I’m not over interpreting your comments.

Stephen Hemsley

Yeah

John Rex - Bear Stearns

Okay. And just you made one comment on -- Steve it was interesting to me in your cost trend outlook. I just want to clarify on the slight up tick in trend, you are taking about policy and evidence based care guidelines. Is there any additional detail on what’s driving that?

Stephen Hemsley

Breast cancer, testing protocols, there are couple of others, Ken you want to comment?

Ken Burdick

In addition to the revision in breast cancer screening guidelines, which means that there will be a larger number of patients considered high risk and therefore, receiving MRIs.

We've got several significant policy changes coming from the CMS, the Medicare eligibility as it relates to End Stage Renal Disease, increasing from 30 months to 42 months, will contribute to that up tick, as well as the MS-DRG.

And then finally one more point that I would add is that removal of the generic alternative to OxyContin has been factored into our cost trend projection. And all of these things have been factored into our pricing.

John Rex - Bear Stearns

Thank you

Stephen Hemsley

Next question please?

Operator

Your next question will come from the line of Matthew Borschwith with Goldman Sachs

Matthew Borsch - Goldman Sachs

Hi good morning and just wanted to say first it sounds like you guys are doing all the right stuff. Let me ask with regard to the commercial fee-based enrollment outlook and I understand the market pressures on the commercial risk side of the business.

But, it’s obviously huge change for you guys to be talking about that being down in the first quarter of next year, beginning of 2006, I think in the first quarter you added close to a million fee-based lives.

Is that, looking back on it try to understand what happened and how are you fixing it. Is that, would you, would it be fair to say that coming into to 2006 you had too many balls in the year in terms of large scale merger integrations combined with the Medicare growth and did that distracted you from some of the execution?

Stephen Hemsley

My believe that most of your writings have been very much on point on this and I would say correct, and that is we had, as we go into 2006, we had certain challenges with respect to our stock option programs and so forth, Part D was coming online, PacifiCare was coming online.

We were driving a great deal of change within our organization and I think that much of that has been addressed, and as you know, you don't really see the full impact of that until it really resonates in the market for sometime.

And I think that you are going to see, I think there is some early evidence of that and you are going to see continued evidence of a much stronger, operational executional focus and base.

I'd add to that though, a reorientation back to customer focus and basics that I think that we can perform much more effectively on in terms of how we approach the marketplace, deal with consultants in the marketplace, deal with consultant audits, deal with customers, our level of flexibility, a whole variety of areas that I think that Uniprise was well regarded for a few years back and we are putting in place in a absolutely vigorous way going forward.

Matthew Borsch - Goldman Sachs

Okay. Sounds good. Thank you very much.

Stephen Hemsley

Thank you.

Operator

Your next question will come from the line of Greg Nersessian with Credit Suisse.

Greg Nersessian - Credit Suisse

Hi. Good morning. Just a quick clarification and a follow-up. Did you say you are expecting a flat commercial MLR or did you say the business that you are renewing your pricing at a flat MLR, in other word does that contemplate the higher cost PacifiCare business thing your re-pricing term?

Stephen Hemsley

Mike.

Mike Mikan

Would you clarify the question, what period of time are you talking about?

Greg Nersessian - Credit Suisse

In 2008, I think you said you are pricing for a flat commercial MLR.

Mike Mikan

Yeah, we are pricing for a stable MLR on an internal basis.

Greg Nersessian - Credit Suisse

Okay. So that includes the contemplated re-pricing of the PacifiCare business and the other business that you are losing?

John Penshorn

This is John, Greg. You've got about 10 million members in total there. So, that may be two fine of a question. I am not sure that you would get detectable differences either way.

Stephen Hemsley

But I think the answer to that is yes. And it has been as we have worked through the PacifiCare book and that I don't know if we have real precision over what, how many cycles it takes to really, what I will say reposition the book business like that, may be Dave Wichmann has a view of it. But that has been running through our numbers.

Greg Nersessian - Credit Suisse

Okay. That's okay. Maybe I will just take it off-line. I guess my other question was just on the earnings, the quarterly earnings progression next year. Would you say, that this year's earnings progression is a reasonable proxy for next year and I guess, on underlying the question is the just the change in Part D risk quarter and is that going to impact the seasonality in your earnings progression for next year in terms of the quarters?

Stephen Hemsley

We are not giving greater guidance with respect to 2008 and I don't want to signal quarter-to-quarter progressions and so forth.

With respect to basic template of the business to be largely the same, in terms of the broad make up of it next year. So, I don't want to confirm that pattern, but I also don't want to give guidance on a quarter-to-quarter basis next year, until we have the investor conference in December

Greg Nersessian - Credit Suisse

Okay, fair enough.

Operator

Your next question will come from the line of Christine Arnold with Morgan Stanley

Christine Arnold - Morgan Stanley

Hi, there, just one last question from me here. On the SG&A ratio, kind of, as we look into 2008, do you see opportunities for improving kind of your operating cost ratio and continuing to see improvement there or do you feel like 2008 is an investment year with new products, recognizing that you do have some '07 cost that will occur?

Stephen Hemsley

Mike, maybe you want to answer that financially, and then I'd have Dave Wichmann kind of come back, because I do think there are a lot of opportunities in front of us.

Mike Mikan

A comparable mix of businesses we anticipate improving our operating cost ratio by 20% to 40% -- 20 to 40 basis points in any given year. And, so we believe if that to be true in next year, so we should see a reduction of somewhere in that range on a year-over-year basis assuming the comparable mix of businesses.

Stephen Hemsley

And Dave -- Dave has taken over kind of the broad operations, you on an enterprise-wide basis want to comment on some of the elements of that?

David Wichmann

Sure, Christine. So leading that is really, productivity expectations are improvement in productivity, which we see and that had been able to demonstrate a year-after-year. I really look at kind of, though there is a five primary areas of opportunity, obviously they'll be continuing consolidation broadening in this marketplace over the long haul. So I would expect that consolidation integration to drive greater scale efficiency.

We are very methodically and thoughtfully advancing our integrations. Right now we are very much into technology and operational process conformance stage, and there we see great opportunity to leverage our common platforms and processes in narrowing reduced cost, but also serve our consumers on a much more reliable and efficient basis. Not really look to that fueling productivity in three to five years out or so.

One of things we haven't talked a lot about in the last couple of calls is our continued promotion of self service. And what we like to look at it is that we offer a very flexible line-up of service option, self service being one of them.

In 2007, just by way of example we have to increased our transaction volumes on our portals quite considerably, consumer portal up 13% and I expect that to expand next year, now that we've achieved the number one rating on that portal again.

Our provider up a remarkable 26%, our broker up 12% and employer while flat is in the re-tooling phase right now. So I'd expect that to contribute greatly in the future.

In addition, I'll just touch on our EDI and auto-adjudication rates, which are -- we believe to be fairly industry leading and are continuously performing in the 80 plus percent range. So we're confident that that we'll continue to make advances in that area and improve our productivity as a result.

I'd also just touch on process improvement, which not only, as Steve touched on it briefly in the script, but I want to bring it out a little bit more, because I think it's a strong advance in health care.

When you get outside of your four walls and start reaching into the supply chain more broadly. And we've done that with what we referred to as our HP3 program, which is essentially re-utilizing, re-manufacturing and Six Sigma techniques working with a large hospital systems through mediate kind of common issues that exist between payers and providers in this marketplace. And we expect to have 476 hospitals under this program by the end of the year.

And I think that you'll see that, that will not only improve hospital-based operations and performance, particularly around billing and cash application things of that nature, but it'll also improve ours as well and lead to the types of enduring relationships that Steve spoke up earlier.

Stephen Hemsley

Thanks, Dave. We're going to have to conclude now. So, I know there are other questions in queue and we will start to take them off-line very actively. But we're going to have to close this. I will thank you. We will be back quarter-by-quarter, stronger levels of operations, with solid growth, earnings. Thank you very much. Have a good day.

Operator

Ladies and gentlemen, that does conclude our conference for today. You may all disconnect. And thank you for participating.

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Source: UnitedHealth Group Q3 2007 Earnings Call Transcript
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