Coventry Health Care Q3 2007 Earnings Call Transcript

Coventry Health Care Inc. (CVH)

Q3 2007 Earnings Call

October 26, 2007 8:30 am ET

Executives

Drew Asher - VP of IR

Dale Wolf - CEO

Shawn Guertin - CFO

Analysts

Carl Mcdonald - CIBC World Markets

Doug Simpson - Merrill Lynch

Christine Arnold - Morgan Stanley

John Rex - Bear Stearns

Josh Raskin - Lehman Brothers

Bill Georges - JPMorgan

Justin Lake - UBS

Matt Perry - Wachovia Capital Markets

Scott Fidel - Deutsche Bank

Charles Boorady - Citigroup

Tom Carroll - Stifel Nicolaus

Presentation

Operator

Good morning and welcome to Coventry Health Care's Third Quarter 2007 Earnings Call. Today's conference is being recorded and all participants are in a listen-only mode. Today's call will begin with opening remarks by the Chief Executive Officer of Coventry Health Care, Mr. Dale Wolf, after a brief forward-looking statement read by Drew Asher. Please go ahead, Drew.

Drew Asher

Ladies and gentlemen during this call we will make forward-looking statements. Certain risks and uncertainties as described in the company's filings with the SEC on Form 10-K for the year ended December 31, 2006 and Form 10-Q for the quarter ended June 30, 2007, may materially impact those statements and could cause actual future results to differ materially from those anticipated and discussed. Dale?

Dale Wolf

Good morning everybody. Early this morning, if you have seen the press release, we reported operating revenues of a little over $2.5 billion for the third quarter. I would note that this is the first quarter where we have exceeded $10 billion as a revenue run-rate, up 32% over the previous year and net income of almost $170 million or $1.08 a share, which is up over 17% from the prior year.

As is customary Shawn will elaborate further on the drivers behind these results in his remarks.

I want to first highlight the tremendous progress again that was made in our company this quarter. In our health plan operations, our results are outstanding. We have almost come to take for granted these industry best operating margins and those remain. But over the last two quarters and as we move forward into the fourth quarter, we're also seeing outstanding new sales. This is reflected in our organic gains and risk membership in Q2 and Q3 and we also expect it to be a gain in Q4.

We had another great quarter in Medicare in every respect and our team and worker's comp, including the Concentra assets continues to outperform. We made progress in our new market expansion, Oklahoma, South Carolina, Memphis, and we will be identifying our next expansion market within the next several weeks.

Our financial activity was voluminous, including our two closed acquisitions, bond issuance and the refinancing of our bank facility. Overall, it was just a wonderful quarter with revenues up 32% over the prior year and earnings per share up 17% and for the year, we will see revenue growth in excess of 25% and earnings per share increased about 15% with notable accomplishments on the strategy, finance, and operation sides as well.

My compliments to the entire Coventry team on their contributions to an outstanding 2007. I have two or three things I want to highlight in my remaining few remarks. First, let me comment on our current initiatives in Medicaid.

You may recall that Q2 had a variety of disappointments for us relative to Medicaid, and fortunately Q3 is somewhat better. First, our loss ratio improved 660 basis points over Q2. Admittedly, a lot of this is revenue related but it is encouraging as it is headed in the right direction. Additionally this week we did receive notice from South Carolina of the approval of our initial four county networks and we will begin to receive new members before the end of the year there.

We're also focused on market expansion in Missouri, as well as, the Insure Missouri Program, which we will pursue after the first of the year. As you know, we have a very strong presence in that state and we fully intend to participate in this new program.

We intend, of course, as well to participate in the upcoming Tennessee bids. Certainly only time will tell how we fair there. But we're also adding resources at the corporate level to better position us to be a more aggressive and active player in this market and by no means am I ready to declare victory, but positive momentum is developing.

The second area I want to cover is our substantial operational progress. We have recently merged the old First Health provider file into the Coventry provider database and now operate again with a single provider file for all the company's operations. We're in the midst of converting customers from the old First Health operating system to our legacy system. That process will be completed in 2008 and as our custom we will again be on a single platform.

We are of course planning as well the integration and conversion of the Vista business and the Mutual of Omaha business and have dedicated resources focused on that.

In addition, we're in the process of bringing our worker's comp system in-house and ultimately converting the former Concentra customers onto that operating system. At the same time our operating metrics, claim backlogs, speed to answer, auto adjudication, etcetera, continue at best-in-class. This isn’t something most of you on the phone ask about or focus on but it is at the heart of success in this business and certainly at our company.

The third topic is to update you on our five growth drivers for 2008. First, our expanded health plan footprint. We're up to more than 13,000 members in Oklahoma and 3,000 in South Carolina. As I mentioned before, Memphis is now actively in business and we will have another market late this year.

In Medicare, our second growth driver for '08, we have now surpassed the 1 million mark in senior customers. Clearly, Medicare has been a big driver of our growth the last two years and will indeed be again in 2008. We will have four additional MA-PD markets among our existing health plans, as well as, continue to push Private Fee, Part D and some additional special needs programs. We will undoubtedly have another terrific year in Medicare in 2008.

The third driver our individual business, same story, likely to continue to -- outperform, certainly the base is getting bigger, and on a relative basis, it is harder but we have completed our health plan rollout and in 2008 we will experiment in some of our non-health plan markets with entry.

Fourth, worker's comp. Our collection of assets is unmatched. Our ability to provide complete solutions should enable us to generate very nice growth in 2008 and you're seeing that in the guidance this morning and certainly the results of this quarter are encouraging.

And lastly, we expect to realize in 2008 the benefits of the significant year in M&A in 2007. While I will not spend a whole lot of time on it this morning, I can assure you that we are already working on the growth leverage for 2009, which will certainly include some of the items mentioned above but also some additional ones, particularly, in the area of specialty products, including non-health. These feel like a significant opportunity in expanding the product offering of our company.

In sum, 2007 has gone very well and the third quarter is no exception. Our financial metrics are performing well; our business growth opportunities and execution remain excellent. The 2008 growth drivers are in place, they feel like the right things and our planning for 2009 is well underway to enhance these growth opportunities.

As our recent results demonstrate and as our guidance indicates we believe our company's growth prospects are at or near the top of the industry and we believe revenue growth is ultimately needed to drive earnings growth. Our team is energized and focused to deliver on those opportunities and to continue the substantial value creation we have before.

Now let me turn it over to Shawn for his comments, after which we will take some questions.

Shawn Guertin

Thank you Dale and good morning everyone. As you have read and heard this morning, the third quarter of 2007 was yet another outstanding quarter and in fact a record setting quarter for Coventry Health Care, setting marks for both quarterly revenue and earnings per share. These results have been produced with all of the typical hallmarks of strong overall earnings quality; strong cash flow generation coupled with an increase in the days and claims payable. The fundamental drivers behind the quarter are also solid with revenue up over 30% from the same quarter last year, and the consolidated medical loss ratio down 60 basis points sequentially. All-in-all, a very strong quarter for Coventry Health Care.

The biggest story for the third quarter was the closing of the Mutual of Omaha and Vista acquisitions. Mutual of Omaha closed at the beginning of July and thus has been included for the full quarter. Vista closed on September 10 and accordingly only a partial month of results is reflected in the quarter. The early returns on both of these acquisitions are right in line with our expectations. This was our second full quarter for the Concentra business, and the early success we saw last quarter has continued in the third quarter. The outlook for this business is bright as you will hear when I discuss 2008 guidance.

Overall, our Commercial Business continues to perform extraordinarily well. From a top line perspective, our commercial division membership now exceeds 3 million members with the addition of Mutual of Omaha and Vista during the quarter. However, organic growth was strong in the quarter as well with the addition of 15,000 risk members making this the second consecutive quarter with commercial risk membership growth.

From a bottom line perspective, results continue to be strong as well. The health plan commercial MLR for the quarter was 78.8%., while this is up from the same quarter last year, there's a bit more to this story than meets the eye. In the past we have not found it instructive to discuss plan specific results as there is a natural amount of fluctuation across the plans from quarter-to-quarter, however, given that there are a couple of narrowly defined circumstances that account for most of this increase, I thought it may be useful this time around.

First, the acquisition results are now included in this measure. The inclusion of the Mutual of Omaha business for the full quarter added about 20 to 25 basis points during Q3.

Second, in the third quarter of 2006 we had one plan in particular, Louisiana, who had a spectacular quarter with a loss ratio in the low 60s. The loss ratio for Louisiana in the third quarter of 2007 is in the mid-80s and this swing explains most of the balance of the increase.

As you heard us say before, there are typically ups and downs across the plans from quarter-to-quarter but a swing of this magnitude is a bit different and driven more by the fairly unique circumstances that existed in the Louisiana market.

Our outlook for the full-year 2007 is that the MLR will be essentially stable versus 2006 on a same-store basis, ending up around 78%.

Let me now turn to the medical cost trend in the 2008 outlook. At a fundamental level all of the critical cost drivers continue to look very solid through the third quarter. Looking to 2008, our outlook for trend is that it will be stable versus 2007 in the neighborhood of 7.5%. Under the covers, we see a couple of components moving around. We expect pharmacy trends to return to more typical levels in 2008, in the range of 6% to 8%. The main driver here is that in 2007 we experienced the favorable effect of simvastatin pricing and there is not a similar event in 2008. Offsetting the pharmacy move is an improved outlook on outpatient trend driven mainly by improved utilization.

As it has been in the past our pricing philosophy on commercial is that we price at least equal to expected medical cost trend. Thus we expect yield increases similar to what we have experienced in 2007 and our expectation for the 2008 commercial medical loss ratio is for it to be flat to slightly improved versus 2007 on a same-store basis.

Both Mutual of Omaha and Vista have historically run at a bit -- run at bit higher than this and we expect that to continue for the first 12 to 18 months under our ownership. Working the acquisitions in for 2008 adds about 60 basis points to the same-store commercial medical loss ratio. This would take the MLR from around 78% in 2007 on a same-store basis to the mid-78s in 2008 on an all-in basis.

The other key item related to the commercial division is the successful renewal of the Mail Handlers arrangement. This past week we concluded negotiations on the Mail Handlers contract and received all required approvals to renew this arrangement for six more years, possibly up to 10 years if certain performance milestones are met, which I expect we will achieve. This is a very important customer to us, and we could not be more pleased to have this locked in on a financially sound basis for the long-term.

As part of these negotiations and somewhat in return for the long-term arrangement, we did make concessions on the level of fees in this contracts. The result of this renegotiation, the addition of the Mutual of Omaha FEHBP business and the loss of some smaller federal accounts in 2008 will result in the FEHBP fee revenue being down approximately $50 million in 2008 versus 2007.

Again, I would like to reemphasize that while revenue losses are never desirable, I certainly feel good about having renewed this important customer relationship for the next six years.

Our individual consumer and government division has been a star performer for us in 2007 and third quarter was no exception. The Medicaid MLR, which had popped up in Q2 was back to more typical levels in the quarter driven mainly by the rate increase we received in Missouri effective July 1.

The performance of our Medicare business continues to be exceptional. The favorable results we saw on the private fee-for-service business earlier this year continue to play out as we had expected. As a reminder, this was the first quarter for PEIA, the West Virginia state retiree account which was effective July 1. This is the majority of the MA membership increase you see in the quarter.

The MAHMO business and the Part D business also had very strong quarters consistent with our expectations. One quick note on Part D, as you are aware, CMS released the amounts they calculated as due to them as part of the 2006 plan year settlement. This did not had any impact on the quarter as we had this amount accurately and fully accrued. CMS will begin collecting these monies in the fourth quarter and you should expect to begin to see the impact of this in our Q4 cash flow statements.

Before I move on to 2008 guidance I wanted to offer a quick note on the balance sheet. You will see that debt-to-cap is at 34.6% as of the end of the quarter. This is a result of the Vista acquisition, which we funded with $400 million of new seven year senior notes, as well as $285 million drawn on our credit facility which we amended in the quarter, achieving more favorable pricing and increasing our overall capacity. We have committed to reduce the debt-to-cap to below 30% by the end of the second quarter of 2008 and we estimate this will require a payment of $150 million.

Now turning to 2008, we are providing our initial guidance for 2008 of $4.42 to $4.58 per diluted share, a GAAP increase of 11% to 15% from our projected 2007 earnings. We will be filling in much more detail at our upcoming Investor Day but there are a few key areas I would like to highlight on this call.

Let me start with building up the guidance from a more fundamental perspective. Looking at the EPS growth on a same-store basis that is excluding the three large acquisitions we closed in 2007, our existing businesses are driving growth in EPS of 8.5% to 11.5%, very consistent with our past discussions of long-term sustainable earnings growth levels.

Looking at the acquisitions, we expect them to contribute about a nickel to EPS in 2007 and somewhere between $0.15 to $0.19 in 2008; a net increase of $0.10 to $0.14 year-over-year adding about 2.5% to 3.5% to the overall growth rate. Our range includes both the potential fluctuation related to typical operating metrics, as well as, the use of net free cash, which we project to be in the neighborhood of $600 million in 2008.

So, the high-end of our range is premised on applying all this cash to share buyback and the low-end assumes no share buyback and the cash earns investment income. This will be apparent when you examine the ranges related to investment income and share count in our guidance.

Earlier in my remarks I discussed the key drivers for the commercial business, to reiterate, low single digit risk membership growth, yield increases in 2008 similar to 2007, and an MLR in the mid-78's, including a full year of our two new health plan acquisitions.

On Medicare we expect to add approximately 100,000 new Medicare Advantage members in 2008. We expect 15,000 to 20,000 in our HMO programs and 80,000 to 85,000 new private fee-for-service members bringing our total private fee-for-service membership to 250,000.

We also expect nice growth on Part D, moving to 750,000 members driven mainly by the growth in the auto-assigns as a result of our successful 2008 bid.

From an MLR perspective we expect our Medicare Advantage MLR to be up approximately 200 basis points and for the Part D MLR to return to more typical levels, up 250 to 350 basis points.

I would be remiss if I did not touch on individual and worker's compensation here as well. On a same-store basis our individual business has essentially doubled in 2007 and we expect this to double again in 2008. What was once a small business that was rapidly growing will become a more meaningful contributor in 2008 as membership, including Vista, should be in the neighborhood of 150,000 members.

For worker's compensation our expectations for 2008 are equally impressive as we expect fee revenue to exceed $700 million next year. Two key factors are driving this tremendous top-line growth. First Script, our worker's compensation PBM is doing great and we are growing the business by selling more services to existing customers.

The constraints of the conference call don't allow me to get into all the nitty-gritty that I know you want. We plan to spend much more time and provide more detail on 2008 at our Investor Day on December 5. I believe that this snapshot dwell in the some of the key drivers behind 2008, shows that this should be yet another strong and solid year for Coventry Health Care and a direct result of our well diversified growing portfolio of businesses and our prudent use of capital to enhance shareholder value.

This concludes my prepared remarks this morning. Operator, we will now open up the call to questions.

Question-and-Answer Session

Operator

(Operator Instructions). And we will go to Carl McDonald, CIBC World Markets.

Carl Mcdonald - CIBC World Markets

Great, thank you. First question was, just wanted to understand the strategy behind the alliance this quarter with Aetna's worker's comp network and what the implications from that relationship will be?

Dale Wolf

Carl, I'm not sure if you know, but there was a relationship there between Concentra and Aetna long before we got involved that relationship had grown in the year prior to our involvement. When we acquired Concentra we then took a look at the arrangement as it existed and considered the full range of options, everything, from eliminating that relationship to enhancing it as we ended up deciding to do. And it was really simply what we could do in the best interest of our customers and in certain of our markets we found that Aetna network to be superior to the other choices. We have provided it at the top of the pyramid to those customers in those markets and think that it enhances the value proposition and that is nothing more complicated than that.

Carl Mcdonald - CIBC World Markets

And I assume there will be some rate increases to go long with that now that you are in a lot of places and the only game in town?

Dale Wolf

That is customer specific based on the market rate and what customers were paying, it really was not a part of the strategy specifically but the rates that customers pay will reflect the value.

Carl Mcdonald - CIBC World Markets

And then the second question was just on the uptick in the Medicare medical loss ratio, can you walk through how much of that is related to the employer private fee-for-service account and how much of that is just very favorable year this year that you're not expecting next year?

Dale Wolf

In terms of the quarter, it is almost all driven by the inclusion of the group account. I mean largely the underlying HMO loss ratios and the individual products were very consistent from quarter-to-quarter.

Carl Mcdonald - CIBC World Markets

And then thinking about 2008?

Dale Wolf

Yes, I mean that has more to do with sort of just the price reset process and the level of reimbursement that we expect to receive from CMS and the outlook on cost trends and what you do with benefit plans. So, that is all part of the bid process and the reimbursement mechanics for next year.

Carl Mcdonald - CIBC World Markets

Got it. Thank you

Operator

We will go next to Doug Simpson with Merrill Lynch.

Doug Simpson - Merrill Lynch

Hi. Good morning. I was just wondering Shawn, if you could touch on the Part D reconciliation and it sounds like your reserves were right on there and no major surprises at the bottom line but did the process play out any differently than you were expecting in any way? The nature of the question is basically that one of your competitors had to take a charge this quarter and I am just trying to understand is there maybe something that popped up, what could explain why they had to take that charge and is there anything we need to worry about going forward?

Shawn Guertin

I think the answer, the direct answer to the question by virtue of the fact that we had it accrued correctly was it obviously did not play out any differently than we expected, however, when you look at sort of what was going on around this, there were really two major issues that involved how state to plan settlements in the first year would be resolved because those have not all been processed as of yet and then there were issues related to, frankly, the mechanical submission of the data to CMS and what is known as the PDE process and various bugs that worked into that process over time and how those then would be handled if they did not get through in the final settlement. So, that I think is really the lion's share of what I call the complexity around this issue.

Doug Simpson - Merrill Lynch

Okay. And then maybe just in a different track here, in your discussions with the providers, something you guys have talked about in the past is the notion that you can go and discuss with providers the opportunity to make your discounts a little more equivalent with some of the Blues in market to balance the competitive landscape. Could you just update us on where that stands and how receptive they have been? And any color you can give us maybe on trends between your own provider discounts and the Blues?

Dale Wolf

Doug, it is a tale of at least two, maybe three cities. In our health plan markets, obviously our historical results and current results demonstrate that our network discounts are today very competitive with the Blues and I would be bold enough to suggest in some markets even better. So the issue really is in our non-health plan markets and that has at least got two components, it is sort of interesting. Though I have not talked about it a lot, one of the advantages of our new market expansion strategy, certainly, we are in it to build business but it also changes the dynamic of us with providers in a new market. And so we have been very pleased in Oklahoma and Memphis and to a certain extent South Carolina at the degree to which this local market presence changed our perception and the dynamic between us and providers and enhanced not only our ability to sell individual and small group product but enhanced our network position as well.

So I would say that is kind of a tangential benefit of that. I would say that, so you have the health plan markets which are good, the new health plan markets, which are making significant improvement in those markets because of that strategy relative to the Blues, and then you kind of have the all other where we pick at it and we believe we have made improvement, but I would not kid you to suggest that we could compete with the Blues head up in those markets.

Doug Simpson - Merrill Lynch

Okay. Thanks

Operator

We will go next to Christine Arnold with Morgan Stanley.

Christine Arnold - Morgan Stanley

Good morning, a couple of questions here. You alluded a little bit to the 2009 strategy and how you are thinking about things longer-term. It looks like we might have a major initiative to reduce the number of uninsured, you are there with Medicaid and it looks like you are continuing to expand. What other types of opportunities are you thinking about kind of longer-term and particularly your reference to non-health plan ideas?

Dale Wolf

Yes, pretty basic stuff, Christine, but don't forget in the evolution of our company there is a lot of things we have not done and although it is now a $10 billion plus revenue stream, there are some notable places where our competitors make a lot of money that we don't even do today. For instance, we will certainly look at our own strategy relative to behavioral health that has been a completely outsourced issue for us and may provide some opportunity. We believe it or not don't sell anybody any life insurance today, and that is sort of like the power windows, and we need to do that. Same thing for dental and a few other things like that. So those are the kinds of things you will see in 2009.

Christine Arnold - Morgan Stanley

And then how many employer accounts are you including in your Medicare Advantage expectations? And do you still have employers GASB or other that are looking at taking Medicare Advantage that are not included in your account? And what is that potential hunting license entail in terms of membership?

Dale Wolf

Shawn can enhance this; he talked about 100,000 member growth in MA in total, of which about 15 to 20 would be in the MA-PD classic HMO product. So, that leaves the rest for private fee-for-service. So, let's call it 80 and of that, how much is employer and how much is individual? We have sold a few small accounts already, the 3,000 to 5000 members for 1/1 on the employer side. I will come back to this but we have an enormous pipeline. And so, there's no perfect answer to this. It will be a little bit, let's see how it goes, but if you thought about it in terms of the 80 private fee, sort of, 20 being employer, you would not be far off with what we have sort of built into guidance.

Back to the pipeline, you know, I mean, the pipeline, the results could end up being zero or the results could end up being a very big number. We just had to pick something and that is effectively what we have got in there.

Christine Arnold - Morgan Stanley

And when do these guys make decisions? Is this a July to October like kind of West Virginia, or is it another timeframe?

Dale Wolf

No, it is all over. There is no particular cycle on this stuff and there are people now looking at decisions for late in the first quarter and certainly for 4/1 but all throughout the year.

Christine Arnold - Morgan Stanley

Okay. Thank you

Operator

We will go next to John Rex with Bear Stearns.

John Rex - Bear Stearns

Thank you, a question on your comments on the Mail Handlers renewal, I just wanted to make sure I have that correct, you said your fee revenues are coming down $50 million annually, is that correct?

Dale Wolf

Correct.

John Rex - Bear Stearns

So that is like a 20% reduction in your fees if I'm not -- if I am thinking about this correctly, is that right?

Dale Wolf

Yes, the math, I mean, this was pre-mutual this -- but with mutual it was probably a little over $200 million, low 200s of a revenue stream.

John Rex - Bear Stearns

Okay. So, around 20 -- a little more than a 20% reduction in fees and that $50 million essentially, I mean, that is really all margin, that just comes, I mean, your costs don't go down in this. So isn't it about essentially a $0.20 a share drag on your '08 earnings?

Dale Wolf

There are some things we can do with some of the expenses that we have on the account that do not pass through the cost accounting arrangement but your assertion that a good chunk of that is margin is a correct assumption. We have always talked about this account being a higher than old First Health average profit stream but there are some things we can do.

John Rex - Bear Stearns

But I would not probably be out of line to say it is about a $0.20 a share drag on -- in terms of when you went to do your forecast, you had kind of like you are backing off about $0.20 from where you could have been, correct?

Dale Wolf

I think that would ascribe that we could do nothing on the expense side. So, it certainly is not higher than that but that is probably a little too high.

John Rex - Bear Stearns

Okay. And then just, your longer-term outlook for MA, you have margins coming up a couple of hundred basis -- or MLR is coming up a couple of hundred basis points in '08. Is this a business that you think -- is that where you think this can sustain when you look at your book of business? But that's still kind of historically a pretty good MA MCR. Do you think this should be back ultimately to kind of high 80's like we used to see in this business or kind of what is your -- as you look over the next two to three years, what do you think about that?

Dale Wolf

That may be two different answers, John. I think over the next two to three years it is unlikely that it will be in the high 80s. I think that what we have projected for 2008 is a better estimate for the next two or three years than the long-term trend. But I do believe that the long-term trend would suggest higher MLRs than the industry is reporting today and we are being sensitive to that in our annual rate process and resetting and financial expectations.

John Rex - Bear Stearns

And then is PFFS book running a better loss ratio now than your MA book?

Dale Wolf

Than in the HMO?

John Rex - Bear Stearns

Yes.

Dale Wolf

No.

John Rex - Bear Stearns

Okay. And then just one point of clarification, did you say low single digits for commercial enrollment growth, is that right?

Dale Wolf

Correct.

John Rex - Bear Stearns

Great. Thank you.

Operator

We will go next to Josh Raskin with Lehman Brothers.

Josh Raskin - Lehman Brothers

Hi, thanks, good morning. The first question I have just thinking a little bit more about the top line versus bottom line expectations for '08. You guys are talking about a top-line growth of about 30% and the bottom line closer to 13% just using the midpoint, and that is assuming buybacks at this point. And if we look back historically, Coventry has been one of those companies that has done a phenomenal job with the acquisitions. Dale, certainly since you have been there over the last 12 years, you have shown earnings growth far in excess of your revenue growth because you have been able to sort of operate these businesses better. If I sort of take it one step further and look at the returns on investment capital, or even return on equity, the numbers have not been coming up the last year or two. So I'm just curious in terms of your expansion and growth on the top line, how do you think about that in terms of long-term capital planning, and what would your expectation be in '09 barring any new acquisitions?

Dale Wolf

I don't even know where to start.

Shawn Guertin

Well, I will let Dale answer the question. I understand your question, Josh, and I will let Dale respond. I do think there are some things related to '08 in particular that stand out. Vista, for example, right on the top line puts $1.2 billion of revenue in probably more than 10% of the company. But obviously the accretion for that is not 10% of our earnings. And I think you have some things kind of operating like that as well. So I understand the root of your question. I mean, ROEs are still in the low 20s, and I would say that you always have mixes of business by margin.

And so what you see in '08, you have got the M&A, but you also have a lot of growth in private fee and insured products that are certainly on a margin basis lower margin, but still very good sort of returns on capital that would kind of pass any kind of threshold. And I would tell you then on acquisitions that there is no singular metric. But certainly the IRR return on invested capital is the one metric that we certainly try to make sure that we're always above water on. Do you want to add anything to that, Dale?

Dale Wolf

I guess two things I thought of. One is that we are obviously growing the top line very quickly, particularly relative to some others in the industry. And to suggest that we would expect on our new revenue growth to achieve the same margins we have achieved historically on the commercial business, we obviously would think is unrealistic, and we haven't put that into our planning. And so you should expect with the substantial revenue growth that the margin percentage would come down a little bit. And then specifically for 2008, I don't want to get back into the subject, but that disparity, don't forget the question that John Rex asked about Mail Handlers when you think about that disparity in 2008.

Shawn Guertin

That is the second part of my answer is that if you actually look at our risk revenue guidance, it is up 30% something. But our fee revenue guidance, which is higher margin, is up 14. So it is just sort of a mathematical mismatch of what is happening sort of with the margin.

Josh Raskin - Lehman Brothers

I guess if we add back Mail Handlers, I guess it is still a little bit below, but certainly gets you back there. And I don't want to put words in your mouth, but it did sound like that the businesses that you're looking to acquire, you're willing to do deals obviously that gets you returns that may be slightly lower than what your returns on equity are currently today being that you're still in the 20% plus range?

Shawn Guertin

If it has strategic value, Josh, then yes, we have. We have been fairly public that we sort of a minimum threshold is kind of mid-teens, but for a strategic deal, which to my point before is slightly below our ROE, which is in the low 20s. But for something that if it was more of a financial play, obviously then we would expect that to equal or exceed our ROE.

Josh Raskin - Lehman Brothers

Got you. That makes sense. And then just a last detail question, could you give the breakout of the acquired membership by segment just so that we have it vis-a-vis the model and the press release that you gave?

Shawn Guertin

Yes, I think you should actually have it in the text of the press release.

Josh Raskin - Lehman Brothers

So the 168 on the Commercial, that is all group risk?

Shawn Guertin

That is correct, and that is about roughly 150 for Vista and 18 for Mutual.

Josh Raskin - Lehman Brothers

Okay. But none of that is ASO?

Shawn Guertin

None of that is ASO. In the ASO membership, there is probably about 100,000 Mutual of Omaha members that are showing up in health plan ASO. And in the FEHBA membership or the other ASO I think we call it now, there's about 111 I think, around 110,000 that are also from Mutual. And the rest of this stuff in the individual consumer and government, that is all Vista.

Josh Raskin - Lehman Brothers

Yeah. That was all broken. Okay. That was what I was looking for. Thanks.

Operator

We will go next to Bill Georges with JPMorgan.

Bill Georges - JPMorgan

Thanks. Good morning. You mentioned the trend that we have heard a couple of your competitors discuss, which is the prospect of risk membership growth looking forward? I'm wondering if we are seeing a turn here because thinking at least at the macro level, the industry has been shedding risk members. Can you talk a little bit about what you are seeing?

Shawn Guertin

Don't forget the enormous disparity between the risk profile of our book of business and some of those competitors that would be at top of mind. When you talk about our book of business, our average size customer has 35 or 40 employees. And so we are strongly focused on the small and the small end of midsize. And in terms of our new sales, we are seeing absolute record sales there. So one of the things that I think I would not describe this as a turn in the industry or any such thing. I think it's a direct result of our expertise and execution and focus in what we believe to be the most attractive segment of the risk market.

Bill Georges - JPMorgan

Okay. And you have been giving sort of anecdotal discussion of small group employers because of cost pressure shedding health insurance?

Dale Wolf

Right.

Bill Georges - JPMorgan

Okay. I think you guys touched on this a little bit in the discussion about your medical loss ratios and some of the moving parts there. But when you look at the yield calculation that has come in modestly relative to the last quarter, but this quarter I don't think that you disclosed the PMPM expense? Can you tell us what that was in the quarter? Last quarter it was 4.9, I think.

Shawn Guertin

You just -- I think that you just have to do the math on the loss ratio times the yield. That is all apples-to-apples.

Bill Georges - JPMorgan

So as it calculates then off of the face of the income statement, is it a fair number?

Shawn Guertin

Yes, that is the number we have always disclosed.

Bill Georges - JPMorgan

Okay. And just a last quick question, as you talk about the ability to consolidate the many systems that you're going to be doing over the next few years, what should we think about in terms of SG&A improvements?

Shawn Guertin

I think there's too many moving parts there to be able to tell you. The answer is I'm not sure yet. We're spending a lot of money this year and in 2008 on this system conversion process. So I'm cautiously optimistic that that will yield savings. But we spend a lot more time working it than we do projecting the savings, so we will se.

Bill Georges - JPMorgan

Okay. Thanks.

Operator

We will go to next to Justin Lake with UBS.

Justin Lake - UBS

Thanks. Good morning. A couple of quick question. One is a follow-up on Medicare Advantage membership growth, especially on private fee-for-service. Given the absolute membership growth there is obviously going to be very strong, but meaningfully below '07, I would be curious to hear what the drivers are behind that. You know that year-over-year absolute membership decline?

Shawn Guertin

Well, there are a couple of things that are going on there that may or may not explain the whole thing, but don't forget we wrote one very large account in 2007 which is PEIA. That by itself was 35,000 members, and we had some other smaller employer accounts. So one of the drivers here would be an expectation in our current 2008 numbers for employer sales that is less than that for 2007. That is one factor. The other factor unquantified, but is -- don't forget the game has changed a little bit. There is no lock-in in 2007 and lock-in in 2008, i.e. the selling season ends on March 31 in 2008, and it did not end until I forget third quarter sometime in 2007.

So that is another factor as well. In terms of our positioning in the marketplace, we feel very good about it. We have added several distribution partners. As you know, that has been our strategy there. Our current -- or the distribution partners who are continuing into 2008 from 2007, and I believe nearly everyone is continuing as a partner in 2008. I feel very good about our market positioning, so we will see.

Dale Wolf

Justin, I guess, the one thing I would add just more sort of mathematically is I don't think it is as big. The $100,000 is a net growth number. And when you think about customer retention, you are going to lose some customers on renewal, so you have got to sell more than that to kind of get that number. So it is really not down as much as it appears on the surface.

Justin Lake - UBS

That is a good point. I was curious -- what kind of attrition numbers are you building into that?

Shawn Guertin

Somewhere in the 15 to 20% range.

Justin Lake - UBS

Okay. And that is higher on private fee-for-service, or is that across the book?

Shawn Guertin

No, that is higher on private fees than it is on MA HMO. MA HMO is probably closer to 10 to 15.

Justin Lake - UBS

Got it. You mentioned your distribution partners, and obviously you have done a very good job there. I'm just curious if there is anything you're hearing from that pipeline in regards to the level of momentum and interest out there for 2008 versus 2007, just maybe the number of leads that they have heading into the selling season or whatever you have comparatively?

Dale Wolf

It is both too early and too uncertain to even project that. I think the feedback or the comments I made before about the feedback from the partners going into the selling season feeling good about our product positioning is sort of that is as smart as we are on it today. The rest of it is just way too many anecdotes and noise, and I wouldn't draw any conclusion from it.

Justin Lake - UBS

Okay. And just a quick question about Pennsylvania. You know I think that we have all heard about Highmark and the difficulties there. I guess I'm hearing some rumblings that capital out in central Pennsylvania might also be doing some interesting things from a pricing perspective. I'm just curious if you're seeing the impact of that at this point. And maybe if you can give us some overview of where your exposure is in central Pennsylvania or maybe from a membership standpoint?

Dale Wolf

Shawn will have the membership specifically for central PA, but obviously it is a big market for us, an important market to us. Honestly we're not seeing anything from capital like you suggest. Capital has been I guess I would say our primary competitor in central PA for a long, long, long time. Others come and go in that marketplace, but it is kind of business as usual in central PA today.

Justin Lake - UBS

Okay, great, thank you very much.

Operator

We will go next to Matt Perry with Wachovia Capital Markets.

Matt Perry - Wachovia Capital Markets

Hi, good morning. I just wanted to clarify the kind of organic EPS growth outlook. I guess last year at this time you talked about 10% to 14% organic EPS growth. This year, somewhat lower, I think you said 8.5 to 11.5. Is the bulk of that the lower fee revenue from Mail Handlers, or are there other moving parts in there?

Dale Wolf

No, Matt, I think when we talked of the guidance we had last year, when we went out was 10 to 14, and that was all-in. So that wasn’t really sort of the underlying operatings growth. In fact, I think we have talked at different times about 7 to 10, 7 to 11, 8 to 11 as sort of the underlying kind of core earnings growth, and then use of capital projects you up, maybe another 3% or 4% or something depending on the year. So I would like to dispel that I think that is any different. Obviously, inside that same-store growth the effect of what we have discussed on the Mail Handlers account is occurring, but fortunately we have a lot of other businesses like the Medicare businesses, like the worker's compensation business, like individual that are also picking up that slack and sort of getting us back to a more sort of normative range.

Shawn Guertin

Which ultimately means that this year's 11 to 15 is the same as last year's 10 to 14.

Dale Wolf

It really is.

Shawn Guertin

And we built them the same way, and in both cases, share buyback was included in the top of the range and not in the bottom of the range.

Matt Perry - Wachovia Capital Markets

Okay. And if we look towards later '08 and maybe I guess longer-term, the accretion from the three acquisitions you have done this year; is there more to go I guess in '09 is my question?

Dale Wolf

We hope so. I mean, our history on these acquisitions is basically buy them at -- in the old days, we bought them when they were actually losing a little bit of money. More recently we have been buying stuff at relatively small lower single digit margins. And over time our hope and expectation at least on the commercial piece of those businesses would be to get the commercial margins closer to where we have historically run our commercial margins.

Shawn Guertin

Right. So, Matt, I think about it, we will be a good 21 months through Concentra by the end of '08. So that one, it will be more about operating of that business and sort of a semantic discussion of what is a synergy and what is a subsequent operating improvement. But Vista might be the one to Dale's point where they are at lower operating margins, and that would be a longer-term opportunity for us to improve. And then, of course, whatever we can springboard to down in Florida and into maybe new counties, new geographies off of Vista.

So out of the three of them, I would sort of say that the visibility we have at best is that it would be sort of Vista that could kind of have some payoff there.

Matt Perry - Wachovia Capital Markets

Okay. And just the last question, I don't want to get too far ahead of myself here, but given three acquisitions '07, should we expect taking a break from M&A in '08?

Dale Wolf

Drew is vehemently shaking his head no. So--

Drew Asher

I do not think so is the answer. I cannot stress enough the skill of our operating folks in integrating acquisitions, and I am obviously putting them on the spot here. But we're devoting more resources to integrating what we have done. We're upping the timeframes on stuff. We are very sensitive to not overloading the ship, and we will not do that, and you are going to have to trust our judgment on that. But, we're not out of business on the acquisition front.

Matt Perry - Wachovia Capital Markets

Okay, so we should not necessarily think of it as similar to when you did the first First Health deal and then took a long break?

Dale Wolf

That is correct.

Matt Perry - Wachovia Capital Markets

Okay. Thank you.

Dale Wolf

Matt, one thing, I saw your preview note and it sparked a thought in my mind that I did not cover sort of in my comments, and it is a little bit of a nit. But it has been confusing off and on this year to some folks. I just want you guys to remember on '07, all the numbers that we're talking about here are GAAP, and that includes the effect of sort of the $0.04 charge. And I believe the consensus estimates out there exclude the effect of that. So, as folks work through '07, there really shouldn’t be any big surprise here when you go back and look at kind of consensus in prior guidance.

Matt Perry - Wachovia Capital Markets

Right, thanks.

Operator

We will go next to Scott Fidel with Deutsche Bank.

Scott Fidel - Deutsche Bank

Thanks, good morning. First question is just relative to the comments you made about behavioral maybe and sourcing that in 2009. Could you just spike out who your legacy outsource provider is, and has that been Magellan or—

Dale Wolf

We have got a bunch of them. It is split up at least four that I can think of, so it is pretty widely spread.

Scott Fidel - Deutsche Bank

Okay. And then just thinking about the broker commission environment on MA for next year around PFFS; any change there relative to 2007 in terms of the competitors? Are you seeing more aggressiveness around commissions or pretty stable with this year?

Dale Wolf

We're seeing a little higher push unfortunately from our competitors on commissions, and we have not followed it one for one. But we have sort of picked our spots where we had to.

Scott Fidel - Deutsche Bank

And it is fair to say that that is incorporated into the growth outlook on PFFS?

Dale Wolf

Yes, it is.

Scott Fidel - Deutsche Bank

Okay. And then just thinking about the legacy First Health ASO business and obviously that's baked into a couple other units, but if you could maybe just spike out what the expectations are for that in terms of enrollment for 2008 and maybe just give us some visibility into just what you think for that other ASO line in terms of enrollment next year?

Shawn Guertin

I think on what we used to call national accounts that membership will decline. And into '08 that is all factored as you would expect into our guidance. I am mildly optimistic actually on the positioning for Mail Handlers. We have taken a fairly conservative stance in our guidance and I think only have that down like 10,000 members. But our product positioning, especially with our new plan offering, if it is not '08, maybe it is '09; that feels good. So, that line will be down I believe in '08, but it is mainly sort of a drip down on national accounts.

There is one note I would like to talk about on ASO membership that is sort of funny. This would be on the health plan ASO line. You recall when we announced the Mutual of Omaha transaction, we assumed we would get 80,000 ASO members, and if, the previous discussion you will recall, we actually have 100 now. And that is because some members are coming over that we in essence knew were going to terminate on 1/1. So we will be back to the 80, which is what we thought we had as well. But you will see those 20 coming out as well on January 1, '08. And again, that was all part of sort of the expectation around Mutual.

Scott Fidel - Deutsche Bank

Okay. And, Shawn, just directionally on the First Health legacy piece, sort of similar rates of declines, or do you think that slows a bit relative to '07?

Shawn Guertin

I think that is probably actually similar on a percentage basis.

Scott Fidel - Deutsche Bank

Okay. And then just one last question, just on the commercial pricing environment and you have spiked out Pennsylvania a bit. But just interested in some of your other bigger markets whether any markets you would highlight as seeing sort of easing or increased competition, relative to last quarter.

Dale Wolf

I don't think so. I think that, as we have said a 100 times, these two or three markets at any time that are more competitive than the others, and they probably are today, and there will be different ones tomorrow. But there's no pervasive change in the pricing environment, and in fact, most of it by market hasn’t changed either.

Scott Fidel - Deutsche Bank

Okay, thanks.

Operator

We will go next to Charles Boorady with Citi.

Charles Boorady - Citigroup

Thanks, good morning. Most were answered. I just want to understand the Commercial net loss ratio increase in more detail. You said Mutual of Omaha was 20 to 25 bips?

Shawn Guertin

Correct.

Charles Boorady - Citigroup

Yes, by how much did Louisiana impact it?

Shawn Guertin

It is almost all of the -- it is like call it 80 bips plus or minus on the year-over-year calculation.

Charles Boorady – Citigroup

Okay, so those two combined explain the entire increase in the loss ratio?

Shawn Guertin

Yes, year-over-year. Yes.

Charles Boorady - Citigroup

Okay. And then you mentioned the growth in individual business and that book doubling. I know it is still a very small book, but I also know individuals have a much lower loss ratio. Is mix enough to have any impact on the loss ratio? So wouldn't the growth in individuals be bringing it down, and if so, is there something else that is offsetting and taking it up?

Shawn Guertin

No, the individual business isn't entirely stripped out of that health plan loss ratio. That is in the press release. That is exclusively group business.

Charles Boorady - Citigroup

Where is the individual loss ratio --

Shawn Guertin

Low 60s.

Charles Boorady - Citigroup

And where would that show up? Or is it just not in those statistics?

Shawn Guertin

It is not I don't believe in the statistics right now. It had been fairly small and that would be something obviously going forward we can consider. But it had been a fairly small overall line.

Charles Boorady - Citigroup

Got it, and any prior period reserve development differences this year versus the comparable quarter last year?

Shawn Guertin

Again, we follow the same processes, and there has really been nothing material in the quarter.

Charles Boorady – Citigroup

Okay. Great. And for '08 you said to assume a similar loss ratio for the commercial book next year versus this year?

Shawn Guertin

On a same-store basis, it will drift up because of really Mutual being in for a full year and Vista being in for a full year by about 60 basis points.

Charles Boorady - Citigroup

60 bips, okay, great, thank you.

Operator

(Operator Instructions). We will go next to Tom Carroll with Stifel Nicolaus.

Tom Carroll - Stifel Nicolaus

Hey good morning. A real quick, could you elaborate on your non-health items that you specified for '09? I think you guided that a bit with a prior question, are we talking life LTD kind of stuff?

Dale Wolf

Yes, we are, Tom.

Tom Carroll - Stifel Nicolaus

Okay, and then secondly, Shawn, did you give a cash flow expectation for '08 or not?

Shawn Guertin

Yes, I threw out a number of $600 million and that is actually what I would call the free, net free cash after we pay interest, after we take out CapEx and all that. So, our cash flow probably in a more technical definition is higher than that. But that is the amount that ends up being available at corporate that we can actually do something with.

Tom Carroll - Stifel Nicolaus

Great. That is exactly what I was looking for. Thanks.

Dale Wolf

If there is one more question out there, we will take it, and then we're going to close and follow-up as necessary.

Operator

Actually at this time there are no further questions. I would like to turn the conference over to Dale Wolf for any additional or closing comments.

Dale Wolf

That is it. Thanks a lot, folks.

Operator

This does conclude today's conference. Thank you for your participation. You may now disconnect.

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