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
Coventry Health Care Inc. (CVH) Q3 2007 Earnings Call October 26, 2007 8:30 AM ET
Operator
Good morning and welcome to Coventry Health Care's ThirdQuarter 2007 Earnings Call. Today's conference is being recorded and allparticipants are in a listen-only mode. Today's call will begin with openingremarks 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 makeforward-looking statements. Certain risks and uncertainties as described in thecompany'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 impactthose statements and could cause actual future results to differ materiallyfrom those anticipated and discussed. Dale?
Dale Wolf
Good morning everybody. Early this morning, if you have seenthe press release, we reported operating revenues of a little over $2.5 billionfor the third quarter. I would note that this is the first quarter where wehave exceeded $10 billion as a revenue run-rate, up 32% over the previous yearand 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 driversbehind these results in his remarks.
I want to first highlight the tremendous progress again thatwas made in our company this quarter. In our health plan operations, ourresults are outstanding. We have almost come to take for granted these industrybest operating margins and those remain. But over the last two quarters and aswe move forward into the fourth quarter, we're also seeing outstanding newsales. This is reflected in our organic gains and risk membership in Q2 and Q3and we also expect it to be a gain in Q4.
We had another great quarter in Medicare in every respectand our team and worker's comp, including the Concentra assets continues tooutperform. We made progress in our new market expansion, Oklahoma,South Carolina, Memphis, and we will be identifying our nextexpansion market within the next several weeks.
Our financial activity was voluminous, including our twoclosed acquisitions, bond issuance and the refinancing of our bank facility.Overall, it was just a wonderful quarter with revenues up 32% over the prioryear and earnings per share up 17% and for the year, we will see revenue growthin excess of 25% and earnings per share increased about 15% with notableaccomplishments on the strategy, finance, and operation sides as well.
My compliments to the entire Coventry team on their contributions to anoutstanding 2007. I have two or three things I want to highlight in myremaining few remarks. First, let me comment on our current initiatives inMedicaid.
You may recall that Q2 had a variety of disappointments forus relative to Medicaid, and fortunately Q3 is somewhat better. First, our lossratio improved 660 basis points over Q2. Admittedly, a lot of this is revenue relatedbut it is encouraging as it is headed in the right direction. Additionally thisweek we did receive notice from South Carolina of the approval of our initial four countynetworks and we will begin to receive new members before the end of the yearthere.
We're also focused on market expansion in Missouri, as well as, the Insure MissouriProgram, which we will pursue after the first of the year. As you know, we havea very strong presence in that state and we fully intend to participate in thisnew program.
We intend, of course, as well to participate in the upcomingTennesseebids. Certainly only time will tell how we fair there. But we're also addingresources at the corporate level to better position us to be a more aggressiveand 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 substantialoperational progress. We have recently merged the old First Health providerfile into the Coventryprovider database and now operate again with a single provider file for all thecompany's operations. We're in the midst of converting customers from the oldFirst Health operating system to our legacy system. That process will becompleted in 2008 and as our custom we will again be on a single platform.
We are of course planning as well the integration andconversion of the Vista business and theMutual of Omaha business and have dedicated resources focused on that.
In addition, we're in the process of bringing our worker'scomp system in-house and ultimately converting the former Concentra customersonto that operating system. At the same time our operating metrics, claimbacklogs, speed to answer, auto adjudication, etcetera, continue atbest-in-class. This isn’t something most of you on the phone ask about or focuson but it is at the heart of success in this business and certainly at ourcompany.
The third topic is to update you on our five growth driversfor 2008. First, our expanded health plan footprint. We're up to more than13,000 members in Oklahoma and 3,000 in South Carolina. As Imentioned before, Memphisis now actively in business and we will have another market late this year.
In Medicare, our second growth driver for '08, we have nowsurpassed the 1 million mark in senior customers. Clearly, Medicare has been abig 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, aswell as, continue to push Private Fee, Part D and some additional special needsprograms. We will undoubtedly have another terrific year in Medicare in 2008.
The third driver our individual business, same story, likelyto continue to -- outperform, certainly the base is getting bigger, and on arelative basis, it is harder but we have completed our health plan rollout andin 2008 we will experiment in some of our non-health plan markets with entry.
Fourth, worker's comp. Our collection of assets isunmatched. Our ability to provide complete solutions should enable us togenerate very nice growth in 2008 and you're seeing that in the guidance thismorning and certainly the results of this quarter are encouraging.
And lastly, we expect to realize in 2008 the benefits of thesignificant year in M&A in 2007. While I will not spend a whole lot of timeon it this morning, I can assure you that we are already working on the growthleverage for 2009, which will certainly include some of the items mentionedabove but also some additional ones, particularly, in the area of specialtyproducts, including non-health. These feel like a significant opportunity inexpanding the product offering of our company.
In sum, 2007 has gone very well and the third quarter is noexception. Our financial metrics are performing well; our business growthopportunities and execution remain excellent. The 2008 growth drivers are inplace, they feel like the right things and our planning for 2009 is wellunderway to enhance these growth opportunities.
As our recent results demonstrate and as our guidanceindicates we believe our company's growth prospects are at or near the top ofthe industry and we believe revenue growth is ultimately needed to driveearnings growth. Our team is energized and focused to deliver on thoseopportunities and to continue the substantial value creation we have before.
Now let me turn it over to Shawn for his comments, afterwhich we will take some questions.
Shawn Guertin
Thank you Dale and good morning everyone. As you have readand heard this morning, the third quarter of 2007 was yet another outstandingquarter and in fact a record setting quarter for Coventry Health Care, settingmarks for both quarterly revenue and earnings per share. These results havebeen produced with all of the typical hallmarks of strong overall earningsquality; strong cash flow generation coupled with an increase in the days andclaims payable. The fundamental drivers behind the quarter are also solid withrevenue up over 30% from the same quarter last year, and the consolidatedmedical loss ratio down 60 basis points sequentially. All-in-all, a very strongquarter for Coventry Health Care.
The biggest story for the third quarter was the closing ofthe Mutual of Omaha and Vista acquisitions.Mutual of Omahaclosed at the beginning of July and thus has been included for the fullquarter. Vista closed on September 10 andaccordingly only a partial month of results is reflected in the quarter. Theearly returns on both of these acquisitions are right in line with ourexpectations. This was our second full quarter for the Concentra business, andthe early success we saw last quarter has continued in the third quarter. Theoutlook for this business is bright as you will hear when I discuss 2008guidance.
Overall, our Commercial Business continues to performextraordinarily well. From a top line perspective, our commercial divisionmembership now exceeds 3 million members with the addition of Mutual of Omahaand Vista during the quarter. However, organicgrowth was strong in the quarter as well with the addition of 15,000 risk membersmaking this the second consecutive quarter with commercial risk membershipgrowth.
From a bottom line perspective, results continue to bestrong as well. The health plan commercial MLR for the quarter was 78.8%., whilethis is up from the same quarter last year, there's a bit more to this storythan meets the eye. In the past we have not found it instructive to discussplan specific results as there is a natural amount of fluctuation across theplans from quarter-to-quarter, however, given that there are a couple ofnarrowly defined circumstances that account for most of this increase, Ithought it may be useful this time around.
First, the acquisition results are now included in thismeasure. The inclusion of the Mutual of Omaha business for the full quarteradded about 20 to 25 basis points during Q3.
Second, in the third quarter of 2006 we had one plan inparticular, Louisiana,who had a spectacular quarter with a loss ratio in the low 60s. The loss ratiofor Louisianain the third quarter of 2007 is in the mid-80s and this swing explains most ofthe balance of the increase.
As you heard us say before, there are typically ups anddowns across the plans from quarter-to-quarter but a swing of this magnitude isa bit different and driven more by the fairly unique circumstances that existedin the Louisianamarket.
Our outlook for the full-year 2007 is that the MLR will beessentially stable versus 2006 on a same-store basis, ending up around 78%.
Let me now turn to the medical cost trend in the 2008outlook. At a fundamental level all of the critical cost drivers continue tolook very solid through the third quarter. Looking to 2008, our outlook fortrend is that it will be stable versus 2007 in the neighborhood of 7.5%. Underthe covers, we see a couple of components moving around. We expect pharmacytrends to return to more typical levels in 2008, in the range of 6% to 8%. Themain driver here is that in 2007 we experienced the favorable effect ofsimvastatin pricing and there is not a similar event in 2008. Offsetting thepharmacy move is an improved outlook on outpatient trend driven mainly byimproved utilization.
As it has been in the past our pricing philosophy oncommercial is that we price at least equal to expected medical cost trend. Thuswe expect yield increases similar to what we have experienced in 2007 and ourexpectation for the 2008 commercial medical loss ratio is for it to be flat toslightly improved versus 2007 on a same-store basis.
Both Mutual of Omaha and Vistahave historically run at a bit -- run at bit higher than this and we expectthat to continue for the first 12 to 18 months under our ownership. Working theacquisitions in for 2008 adds about 60 basis points to the same-storecommercial medical loss ratio. This would take the MLR from around 78% in 2007on 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 thesuccessful renewal of the Mail Handlers arrangement. This past week weconcluded negotiations on the Mail Handlers contract and received all requiredapprovals to renew this arrangement for six more years, possibly up to 10 yearsif certain performance milestones are met, which I expect we will achieve. Thisis a very important customer to us, and we could not be more pleased to havethis locked in on a financially sound basis for the long-term.
As part of these negotiations and somewhat in return for thelong-term arrangement, we did make concessions on the level of fees in thiscontracts. The result of this renegotiation, the addition of the Mutual ofOmaha FEHBP business and the loss of some smaller federal accounts in 2008 willresult in the FEHBP fee revenue being down approximately $50 million in 2008versus 2007.
Again, I would like to reemphasize that while revenue lossesare never desirable, I certainly feel good about having renewed this importantcustomer relationship for the next six years.
Our individual consumer and government division has been astar performer for us in 2007 and third quarter was no exception. The MedicaidMLR, which had popped up in Q2 was back to more typical levels in the quarterdriven mainly by the rate increase we received in Missouri effective July 1.
The performance of our Medicare business continues to beexceptional. The favorable results we saw on the private fee-for-servicebusiness earlier this year continue to play out as we had expected. As areminder, this was the first quarter for PEIA, the West Virginia state retiree account whichwas effective July 1. This is the majority of the MA membership increase yousee in the quarter.
The MAHMO business and the Part D business also had verystrong quarters consistent with our expectations. One quick note on Part D, asyou are aware, CMS released the amounts they calculated as due to them as partof the 2006 plan year settlement. This did not had any impact on the quarter aswe had this amount accurately and fully accrued. CMS will begin collectingthese monies in the fourth quarter and you should expect to begin to see theimpact of this in our Q4 cash flow statements.
Before I move on to 2008 guidance I wanted to offer a quicknote on the balance sheet. You will see that debt-to-cap is at 34.6% as of theend of the quarter. This is a result of the Vistaacquisition, 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 thequarter, 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 thesecond quarter of 2008 and we estimate this will require a payment of $150million.
Now turning to 2008, we are providing our initial guidancefor 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 ourupcoming Investor Day but there are a few key areas I would like to highlighton this call.
Let me start with building up the guidance from a more fundamentalperspective. Looking at the EPS growth on a same-store basis that is excludingthe three large acquisitions we closed in 2007, our existing businesses aredriving growth in EPS of 8.5% to 11.5%, very consistent with our pastdiscussions of long-term sustainable earnings growth levels.
Looking at the acquisitions, we expect them to contributeabout a nickel to EPS in 2007 and somewhere between $0.15 to $0.19 in 2008; anet increase of $0.10 to $0.14 year-over-year adding about 2.5% to 3.5% to the overallgrowth rate. Our range includes both the potential fluctuation related totypical operating metrics, as well as, the use of net free cash, which weproject to be in the neighborhood of $600 million in 2008.
So, the high-end of our range is premised on applying allthis cash to share buyback and the low-end assumes no share buyback and thecash earns investment income. This will be apparent when you examine the rangesrelated to investment income and share count in our guidance.
Earlier in my remarks I discussed the key drivers for thecommercial business, to reiterate, low single digit risk membership growth,yield increases in 2008 similar to 2007, and an MLR in the mid-78's, includinga full year of our two new health plan acquisitions.
On Medicare we expect to add approximately 100,000 newMedicare Advantage members in 2008. We expect 15,000 to 20,000 in our HMOprograms and 80,000 to 85,000 new private fee-for-service members bringing ourtotal private fee-for-service membership to 250,000.
We also expect nice growth on Part D, moving to 750,000members driven mainly by the growth in the auto-assigns as a result of oursuccessful 2008 bid.
From an MLR perspective we expect our Medicare Advantage MLRto be up approximately 200 basis points and for the Part D MLR to return tomore typical levels, up 250 to 350 basis points.
I would be remiss if I did not touch on individual andworker's compensation here as well. On a same-store basis our individualbusiness has essentially doubled in 2007 and we expect this to double again in2008. What was once a small business that was rapidly growing will become amore 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 areequally impressive as we expect fee revenue to exceed $700 million next year.Two key factors are driving this tremendous top-line growth. First Script, ourworker's compensation PBM is doing great and we are growing the business byselling more services to existing customers.
The constraints of the conference call don't allow me to getinto all the nitty-gritty that I know you want. We plan to spend much more timeand provide more detail on 2008 at our Investor Day on December 5. I believethat this snapshot dwell in the some of the key drivers behind 2008, shows thatthis should be yet another strong and solid year for Coventry Health Care and adirect result of our well diversified growing portfolio of businesses and ourprudent 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-AnswerSession
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 tounderstand the strategy behind the alliance this quarter with Aetna'sworker'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 relationshipthere between Concentra and Aetna long beforewe got involved that relationship had grown in the year prior to ourinvolvement. When we acquired Concentra we then took a look at the arrangementas it existed and considered the full range of options, everything, fromeliminating 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 customersand in certain of our markets we found that Aetnanetwork to be superior to the other choices. We have provided it at the top ofthe pyramid to those customers in those markets and think that it enhances thevalue 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 longwith 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 whatcustomers were paying, it really was not a part of the strategy specifically butthe rates that customers pay will reflect the value.
Carl Mcdonald - CIBC World Markets
And then the second question was just on the uptick in theMedicare medical loss ratio, can you walk through how much of that is relatedto the employer private fee-for-service account and how much of that is justvery favorable year this year that you're not expecting next year?
Dale Wolf
In terms of the quarter, it is almost all driven by theinclusion of the group account. I mean largely the underlying HMO loss ratiosand 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 pricereset process and the level of reimbursement that we expect to receive from CMSand the outlook on cost trends and what you do with benefit plans. So, that isall 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 couldtouch on the Part D reconciliation and it sounds like your reserves were righton there and no major surprises at the bottom line but did the process play outany differently than you were expecting in any way? The nature of the questionis basically that one of your competitors had to take a charge this quarter andI am just trying to understand is there maybe something that popped up, whatcould explain why they had to take that charge and is there anything we need toworry about going forward?
Shawn Guertin
I think the answer, the direct answer to the question byvirtue of the fact that we had it accrued correctly was it obviously did notplay out any differently than we expected, however, when you look at sort ofwhat was going on around this, there were really two major issues that involvedhow state to plan settlements in the first year would be resolved because thosehave 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 thePDE process and various bugs that worked into that process over time and howthose then would be handled if they did not get through in the finalsettlement. So, that I think is really the lion's share of what I call thecomplexity around this issue.
Doug Simpson - Merrill Lynch
Okay. And then maybe just in a different track here, in yourdiscussions with the providers, something you guys have talked about in thepast is the notion that you can go and discuss with providers the opportunityto make your discounts a little more equivalent with some of the Blues inmarket to balance the competitive landscape. Could you just update us on wherethat stands and how receptive they have been? And any color you can give usmaybe on trends between your own provider discounts and the Blues?
Dale Wolf
Doug, it is a tale of at least two, maybe three cities. Inour health plan markets, obviously our historical results and current resultsdemonstrate that our network discounts are today very competitive with theBlues and I would be bold enough to suggest in some markets even better. So theissue really is in our non-health plan markets and that has at least got twocomponents, 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 arein it to build business but it also changes the dynamic of us with providers ina new market. And so we have been very pleased in Oklahomaand Memphis and to a certain extent South Carolina at thedegree to which this local market presence changed our perception and thedynamic between us and providers and enhanced not only our ability to sellindividual 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 newhealth plan markets, which are making significant improvement in those marketsbecause of that strategy relative to the Blues, and then you kind of have theall other where we pick at it and we believe we have made improvement, but Iwould not kid you to suggest that we could compete with the Blues head up inthose 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 alittle bit to the 2009 strategy and how you are thinking about thingslonger-term. It looks like we might have a major initiative to reduce thenumber of uninsured, you are there with Medicaid and it looks like you arecontinuing to expand. What other types of opportunities are you thinking aboutkind of longer-term and particularly your reference to non-health plan ideas?
Dale Wolf
Yes, pretty basic stuff, Christine, but don't forget in theevolution of our company there is a lot of things we have not done and althoughit is now a $10 billion plus revenue stream, there are some notable placeswhere our competitors make a lot of money that we don't even do today. Forinstance, we will certainly look at our own strategy relative to behavioralhealth that has been a completely outsourced issue for us and may provide someopportunity. 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 thingfor dental and a few other things like that. So those are the kinds of thingsyou will see in 2009.
Christine Arnold - Morgan Stanley
And then how many employer accounts are you including inyour Medicare Advantage expectations? And do you still have employers GASB orother that are looking at taking Medicare Advantage that are not included inyour account? And what is that potential hunting license entail in terms ofmembership?
Dale Wolf
Shawn can enhance this; he talked about 100,000 membergrowth in MA in total, of which about 15 to 20 would be in the MA-PD classicHMO product. So, that leaves the rest for private fee-for-service. So, let'scall it 80 and of that, how much is employer and how much is individual? Wehave sold a few small accounts already, the 3,000 to 5000 members for 1/1 onthe employer side. I will come back to this but we have an enormous pipeline. Andso, there's no perfect answer to this. It will be a little bit, let's see howit 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 builtinto guidance.
Back to the pipeline, you know, I mean, the pipeline, theresults could end up being zero or the results could end up being a very bignumber. We just had to pick something and that is effectively what we have gotin there.
Christine Arnold - Morgan Stanley
And when do these guys make decisions? Is this a July toOctober like kind of West Virginia,or is it another timeframe?
Dale Wolf
No, it is all over. There is no particular cycle on thisstuff and there are people now looking at decisions for late in the firstquarter 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 Handlersrenewal, I just wanted to make sure I have that correct, you said your feerevenues 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 withmutual it was probably a little over $200 million, low 200s of a revenuestream.
John Rex - Bear Stearns
Okay. So, around 20 -- a little more than a 20% reduction infees and that $50 million essentially, I mean, that is really all margin, thatjust comes, I mean, your costs don't go down in this. So isn't it aboutessentially a $0.20 a share drag on your '08 earnings?
Dale Wolf
There are some things we can do with some of the expensesthat we have on the account that do not pass through the cost accountingarrangement but your assertion that a good chunk of that is margin is a correctassumption. We have always talked about this account being a higher than oldFirst 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 hadkind 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 theexpense side. So, it certainly is not higher than that but that is probably alittle too high.
John Rex - Bear Stearns
Okay. And then just, your longer-term outlook for MA, youhave margins coming up a couple of hundred basis -- or MLR is coming up acouple of hundred basis points in '08. Is this a business that you think -- isthat 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 thisshould be back ultimately to kind of high 80's like we used to see in thisbusiness or kind of what is your -- as you look over the next two to threeyears, what do you think about that?
Dale Wolf
That may be two different answers, John. I think over thenext two to three years it is unlikely that it will be in the high 80s. I thinkthat what we have projected for 2008 is a better estimate for the next two orthree years than the long-term trend. But I do believe that the long-term trendwould suggest higher MLRs than the industry is reporting today and we are beingsensitive to that in our annual rate process and resetting and financialexpectations.
John Rex - Bear Stearns
And then is PFFS book running a better loss ratio now thanyour 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 saylow 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 justthinking a little bit more about the top line versus bottom line expectationsfor '08. You guys are talking about a top-line growth of about 30% and thebottom line closer to 13% just using the midpoint, and that is assuming buybacksat this point. And if we look back historically, Coventry has been one of those companies thathas done a phenomenal job with the acquisitions. Dale, certainly since you havebeen there over the last 12 years, you have shown earnings growth far in excessof your revenue growth because you have been able to sort of operate thesebusinesses better. If I sort of take it one step further and look at thereturns on investment capital, or even return on equity, the numbers have notbeen coming up the last year or two. So I'm just curious in terms of yourexpansion and growth on the top line, how do you think about that in terms oflong-term capital planning, and what would your expectation be in '09 barringany new acquisitions?
Dale Wolf
I don't even know where to start.
Shawn Guertin
Well, I will let Dale answer the question. I understand yourquestion, Josh, and I will let Dale respond. I do think there are some thingsrelated to '08 in particular that stand out. Vista,for example, right on the top line puts $1.2 billion of revenue in probablymore 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 thatas well. So I understand the root of your question. I mean, ROEs are still inthe 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, butyou also have a lot of growth in private fee and insured products that arecertainly on a margin basis lower margin, but still very good sort of returnson capital that would kind of pass any kind of threshold. And I would tell youthen on acquisitions that there is no singular metric. But certainly the IRRreturn on invested capital is the one metric that we certainly try to make surethat 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 areobviously growing the top line very quickly, particularly relative to someothers in the industry. And to suggest that we would expect on our new revenuegrowth to achieve the same margins we have achieved historically on thecommercial business, we obviously would think is unrealistic, and we haven'tput that into our planning. And so you should expect with the substantialrevenue growth that the margin percentage would come down a little bit. Andthen specifically for 2008, I don't want to get back into the subject, but thatdisparity, don't forget the question that John Rex asked about Mail Handlerswhen you think about that disparity in 2008.
Shawn Guertin
That is the second part of my answer is that if you actuallylook at our risk revenue guidance, it is up 30% something. But our fee revenueguidance, which is higher margin, is up 14. So it is just sort of amathematical mismatch of what is happening sort of with the margin.
Josh Raskin - LehmanBrothers
I guess if we add back Mail Handlers, I guess it is still alittle bit below, but certainly gets you back there. And I don't want to putwords in your mouth, but it did sound like that the businesses that you'relooking to acquire, you're willing to do deals obviously that gets you returnsthat may be slightly lower than what your returns on equity are currently todaybeing that you're still in the 20% plus range?
Shawn Guertin
If it has strategic value, Josh, then yes, we have. We havebeen 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 financialplay, obviously then we would expect that to equal or exceed our ROE.
Josh Raskin - LehmanBrothers
Got you. That makes sense. And then just a last detailquestion, could you give the breakout of the acquired membership by segmentjust so that we have it vis-a-vis the model and the press release that yougave?
Shawn Guertin
Yes, I think you should actually have it in the text of thepress release.
Josh Raskin - LehmanBrothers
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 - LehmanBrothers
Okay. But none of that is ASO?
Shawn Guertin
None of that is ASO. In the ASO membership, there isprobably about 100,000 Mutual of Omaha members that are showing up in healthplan 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 therest of this stuff in the individual consumer and government, that is all Vista.
Josh Raskin - LehmanBrothers
Yeah. That was all broken. Okay. That was what I was lookingfor. Thanks.
Operator
We will go next to Bill Georges with JPMorgan.
Bill Georges -JPMorgan
Thanks. Good morning. You mentioned the trend that we haveheard a couple of your competitors discuss, which is the prospect of riskmembership growth looking forward? I'm wondering if we are seeing a turn herebecause thinking at least at the macro level, the industry has been sheddingrisk members. Can you talk a little bit about what you are seeing?
Shawn Guertin
Don't forget the enormous disparity between the risk profileof our book of business and some of those competitors that would be at top ofmind. When you talk about our book of business, our average size customer has35 or 40 employees. And so we are strongly focused on the small and the smallend of midsize. And in terms of our new sales, we are seeing absolute record salesthere. So one of the things that I think I would not describe this as a turn inthe industry or any such thing. I think it's a direct result of our expertiseand execution and focus in what we believe to be the most attractive segment ofthe risk market.
Bill Georges -JPMorgan
Okay. And you have been giving sort of anecdotal discussionof 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 thediscussion 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 relativeto the last quarter, but this quarter I don't think that you disclosed the PMPMexpense? 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 theloss ratio times the yield. That is all apples-to-apples.
Bill Georges -JPMorgan
So as it calculates then off of the face of the incomestatement, 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 theability to consolidate the many systems that you're going to be doing over thenext 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 totell you. The answer is I'm not sure yet. We're spending a lot of money thisyear and in 2008 on this system conversion process. So I'm cautiouslyoptimistic that that will yield savings. But we spend a lot more time workingit than we do projecting the savings, so we will se.
Bill Georges -JPMorgan
Okay. Thanks.
Operator
We will go to next to Justin Lakewith UBS.
Justin Lake - UBS
Thanks. Good morning. A couple of quick question. One is afollow-up on Medicare Advantage membership growth, especially on privatefee-for-service. Given the absolute membership growth there is obviously goingto be very strong, but meaningfully below '07, I would be curious to hear whatthe drivers are behind that. You know that year-over-year absolute membershipdecline?
Shawn Guertin
Well, there are a couple of things that are going on therethat may or may not explain the whole thing, but don't forget we wrote one verylarge account in 2007 which is PEIA. That by itself was 35,000 members, and wehad some other smaller employer accounts. So one of the drivers here would be anexpectation in our current 2008 numbers for employer sales that is less thanthat 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 andlock-in in 2008, i.e. the selling season ends on March 31 in 2008, and it didnot end until I forget third quarter sometime in 2007.
So that is another factor as well. In terms of ourpositioning in the marketplace, we feel very good about it. We have addedseveral distribution partners. As you know, that has been our strategy there.Our current -- or the distribution partners who are continuing into 2008 from2007, and I believe nearly everyone is continuing as a partner in 2008. I feelvery good about our market positioning, so we will see.
Dale Wolf
Justin, I guess, the one thing I would add just more sort ofmathematically is I don't think it is as big. The $100,000 is a net growthnumber. And when you think about customer retention, you are going to lose somecustomers on renewal, so you have got to sell more than that to kind of getthat 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 ofattrition 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 isthat across the book?
Shawn Guertin
No, that is higher on private fees than it is on MA HMO. MAHMO is probably closer to 10 to 15.
Justin Lake - UBS
Got it. You mentioned your distribution partners, andobviously you have done a very good job there. I'm just curious if there isanything you're hearing from that pipeline in regards to the level of momentumand interest out there for 2008 versus 2007, just maybe the number of leadsthat they have heading into the selling season or whatever you havecomparatively?
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 thepartners going into the selling season feeling good about our productpositioning is sort of that is as smart as we are on it today. The rest of itis just way too many anecdotes and noise, and I wouldn't draw any conclusionfrom it.
Justin Lake - UBS
Okay. And just a quick question about Pennsylvania. You know I think that we haveall heard about Highmark and the difficulties there. I guess I'm hearing somerumblings that capital out in central Pennsylvaniamight also be doing some interesting things from a pricing perspective. I'mjust curious if you're seeing the impact of that at this point. And maybe ifyou can give us some overview of where your exposure is in central Pennsylvania or maybefrom 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. Honestlywe're not seeing anything from capital like you suggest. Capital has been Iguess I would say our primary competitor in central PA for a long, long, longtime. Others come and go in that marketplace, but it is kind of business asusual 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 - WachoviaCapital Markets
Hi, good morning. I just wanted to clarify the kind oforganic 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 to11.5. Is the bulk of that the lower fee revenue from Mail Handlers, or arethere other moving parts in there?
Dale Wolf
No, Matt, I think when we talked of the guidance we had lastyear, when we went out was 10 to 14, and that was all-in. So that wasn’t reallysort of the underlying operatings growth. In fact, I think we have talked atdifferent times about 7 to 10, 7 to 11, 8 to 11 as sort of the underlying kindof core earnings growth, and then use of capital projects you up, maybe another3% or 4% or something depending on the year. So I would like to dispel that Ithink that is any different. Obviously, inside that same-store growth theeffect of what we have discussed on the Mail Handlers account is occurring, butfortunately we have a lot of other businesses like the Medicare businesses,like the worker's compensation business, like individual that are also pickingup 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 sameas last year's 10 to 14.
Dale Wolf
It really is.
Shawn Guertin
And we built them the same way, and in both cases, sharebuyback was included in the top of the range and not in the bottom of therange.
Matt Perry - WachoviaCapital Markets
Okay. And if we look towards later '08 and maybe I guesslonger-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 isbasically buy them at -- in the old days, we bought them when they wereactually losing a little bit of money. More recently we have been buying stuffat relatively small lower single digit margins. And over time our hope and expectationat least on the commercial piece of those businesses would be to get thecommercial margins closer to where we have historically run our commercialmargins.
Shawn Guertin
Right. So, Matt, I think about it, we will be a good 21months through Concentra by the end of '08. So that one, it will be more aboutoperating of that business and sort of a semantic discussion of what is asynergy and what is a subsequent operating improvement. But Vistamight be the one to Dale's point where they are at lower operating margins, andthat would be a longer-term opportunity for us to improve. And then, of course,whatever we can springboard to down in Floridaand into maybe new counties, new geographies off of Vista.
So out of the three of them, I would sort of say that thevisibility we have at best is that it would be sort of Vistathat could kind of have some payoff there.
Matt Perry - WachoviaCapital Markets
Okay. And just the last question, I don't want to get toofar ahead of myself here, but given three acquisitions '07, should we expecttaking 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 theskill of our operating folks in integrating acquisitions, and I am obviouslyputting them on the spot here. But we're devoting more resources to integratingwhat we have done. We're upping the timeframes on stuff. We are very sensitiveto not overloading the ship, and we will not do that, and you are going to haveto trust our judgment on that. But, we're not out of business on theacquisition front.
Matt Perry - WachoviaCapital Markets
Okay, so we should not necessarily think of it as similar towhen you did the first First Health deal and then took a long break?
Dale Wolf
That is correct.
Matt Perry - WachoviaCapital Markets
Okay. Thank you.
Dale Wolf
Matt, one thing, I saw your preview note and it sparked athought in my mind that I did not cover sort of in my comments, and it is alittle bit of a nit. But it has been confusing off and on this year to somefolks. I just want you guys to remember on '07, all the numbers that we'retalking about here are GAAP, and that includes the effect of sort of the $0.04charge. And I believe the consensus estimates out there exclude the effect ofthat. So, as folks work through '07, there really shouldn’t be any big surprisehere when you go back and look at kind of consensus in prior guidance.
Matt Perry - WachoviaCapital 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 thecomments you made about behavioral maybe and sourcing that in 2009. Could youjust spike out who your legacy outsource provider is, and has that beenMagellan or—
Dale Wolf
We have got a bunch of them. It is split up at least fourthat I can think of, so it is pretty widely spread.
Scott Fidel -Deutsche Bank
Okay. And then just thinking about the broker commissionenvironment on MA for next year around PFFS; any change there relative to 2007in terms of the competitors? Are you seeing more aggressiveness aroundcommissions or pretty stable with this year?
Dale Wolf
We're seeing a little higher push unfortunately from ourcompetitors on commissions, and we have not followed it one for one. But wehave sort of picked our spots where we had to.
Scott Fidel -Deutsche Bank
And it is fair to say that that is incorporated into thegrowth outlook on PFFS?
Dale Wolf
Yes, it is.
Scott Fidel -Deutsche Bank
Okay. And then just thinking about the legacy First HealthASO business and obviously that's baked into a couple other units, but if youcould maybe just spike out what the expectations are for that in terms of enrollmentfor 2008 and maybe just give us some visibility into just what you think forthat other ASO line in terms of enrollment next year?
Shawn Guertin
I think on what we used to call national accounts thatmembership will decline. And into '08 that is all factored as you would expectinto our guidance. I am mildly optimistic actually on the positioning for MailHandlers. We have taken a fairly conservative stance in our guidance and Ithink 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; thatfeels good. So, that line will be down I believe in '08, but it is mainly sortof a drip down on national accounts.
There is one note I would like to talk about on ASOmembership 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 wewould 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 thatwe in essence knew were going to terminate on 1/1. So we will be back to the80, which is what we thought we had as well. But you will see those 20 comingout as well on January 1, '08. And again, that was all part of sort of theexpectation around Mutual.
Scott Fidel -Deutsche Bank
Okay. And, Shawn, just directionally on the First Healthlegacy piece, sort of similar rates of declines, or do you think that slows abit relative to '07?
Shawn Guertin
I think that is probably actually similar on a percentagebasis.
Scott Fidel -Deutsche Bank
Okay. And then just one last question, just on thecommercial pricing environment and you have spiked out Pennsylvania a bit. But just interested insome of your other bigger markets whether any markets you would highlight asseeing 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 theothers, 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, mostof 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 tounderstand the Commercial net loss ratio increase in more detail. You saidMutual of Omaha was 20 to 25 bips?
Shawn Guertin
Correct.
Charles Boorady -Citigroup
Yes, by how much did Louisianaimpact it?
Shawn Guertin
It is almost all of the -- it is like call it 80 bips plusor minus on the year-over-year calculation.
Charles Boorady – Citigroup
Okay, so those two combined explain the entire increase inthe loss ratio?
Shawn Guertin
Yes, year-over-year. Yes.
Charles Boorady -Citigroup
Okay. And then you mentioned the growth in individualbusiness and that book doubling. I know it is still a very small book, but Ialso know individuals have a much lower loss ratio. Is mix enough to have anyimpact on the loss ratio? So wouldn't the growth in individuals be bringing itdown, 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 ofthat health plan loss ratio. That is in the press release. That is exclusivelygroup 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 thosestatistics?
Shawn Guertin
It is not I don't believe in the statistics right now. Ithad been fairly small and that would be something obviously going forward wecan consider. But it had been a fairly small overall line.
Charles Boorady -Citigroup
Got it, and any prior period reserve development differencesthis year versus the comparable quarter last year?
Shawn Guertin
Again, we follow the same processes, and there has reallybeen nothing material in the quarter.
Charles Boorady –Citigroup
Okay. Great. And for '08 you said to assume a similar lossratio for the commercial book next year versus this year?
Shawn Guertin
On a same-store basis, it will drift up because of reallyMutual being in for a full year and Vistabeing 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 withStifel Nicolaus.
Tom Carroll - StifelNicolaus
Hey good morning. A real quick, could you elaborate on yournon-health items that you specified for '09? I think you guided that a bit witha prior question, are we talking life LTD kind of stuff?
Dale Wolf
Yes, we are, Tom.
Tom Carroll - StifelNicolaus
Okay, and then secondly, Shawn, did you give a cash flowexpectation for '08 or not?
Shawn Guertin
Yes, I threw out a number of $600 million and that isactually what I would call the free, net free cash after we pay interest, afterwe take out CapEx and all that. So, our cash flow probably in a more technicaldefinition is higher than that. But that is the amount that ends up beingavailable at corporate that we can actually do something with.
Tom Carroll - StifelNicolaus
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. Iwould like to turn the conference over to Dale Wolf for any additional orclosing comments.
Dale Wolf
That is it. Thanks a lot, folks.
Operator
This does conclude today's conference. Thank you for yourparticipation. You may now disconnect.
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