HealthSpring Inc. Q3 2007 Earnings Call Transcript

Oct.31.07 | About: Cigna Corp. (CI)

HealthSpring Inc. (Pending:HS)

Q3 2007 Earnings Conference Call

October 31, 2007, 10:00 am ET

Executives

Herbert Fritch - Chairman, President and CEO

Kevin McNamara - EVP and CFO

Analysts

Justin Lake - UBS

Michael Yuan - Bank of America Securities

Michael Baker - Raymond James and Associates

Matt Perry -Wachovia Capital Markets

Carl McDonald - CIBC World Markets

Darin Miller - Goldman Sachs

Charles Boorady - Citigroup

Josh Raskin - Lehman Brothers

Operator

Good morning. And welcome to the HealthSpring ConferenceCall to review its financial results for the Third Quarter and Nine Monthsended September 30, 2007. The financial results were issued yesterday after theclose of market trading.

If you did not receive a copy of the press release, you mayfind a copy under the Investor Relations tab on the HealthSpring website, www.healthspring.com.

Before we begin, HealthSpring wishes to express that somestatements made in this call will be forward-looking statements, as defined inthe Private Securities Litigation Reform Act of 1995.

Actual performance of the company may differ from thatprojected in such statements. Investors should refer to statements regularlyfiled by the company with the Securities and Exchange Commission for adiscussion of those factors that could affect the company's operations and theforward-looking statements made in this call.

The information being provided today is as of this date onlyand HealthSpring expressly disclaims any obligation to release publicly anyupdates or revisions to these forward-looking statements to reflect any changesand expectations.

In addition, certain non-GAAP financial measures maybecovered in this presentation. These non-GAAP measures are reconciled to themost comparable GAAP measures in the press release or on the company's website.

At this time, I'll turn the call over to Mr. Herbert Fritch,Chairman, President and Chief Executive Officer of HealthSpring. Please goahead, sir.

Herbert Fritch

Thank you, operator. We are pleased to report solid thirdquarter results and positive developments in our business that support well for2008 and beyond. On the strength of these results and developments we are also pleasedto increase earnings guidance for the full year 2007.

On the membership front we continued to grow during lock-inbut at a slower rate than last year. We believe the main reason for the reducedpace is the increase in special needs plans competitors in a number of ourmarkets.

We intend to counter this competitive effect in 2008 byintroducing Chronic Care and Institutionalized Special Needs plans in all ofour existing markets and believe we'll be in better position during the lock-inperiod next year.

The membership in the PDP product continues to be a brightspot as we benefit from our national expansion in 2007 and from being belowregional benchmarks in 29 of 34 regions. As of September 30, 2007, we had128,127 PDP members and that number continued to grow to 134,802 in ourNovember 2007 plan payment report.

We are looking forward to future growth in PDP membershipduring 2008. Our 2008 bids remained below benchmarks in all of our -- in all 29of our current regions and we're also below the benchmark in California. Theregion with the largest number of dual-eligibles and one where some of thelarger incumbent plans were displaced.

Based on our bids, CMS preliminary estimates that are PDPsare eligible for an auto-assignment of approximately 117,000 additional membersas of January 1, 2008.

A caution however, that prior experience suggests asubstantial percentage of these new auto-assignments will select another PDP inthe two to four months following this initial assignment.

On the medical expense side, we finished the quarter withMedicare MLRs of 81.8% and 81.9% excluding the PDP component. Although higherthan our initial target of 80%, we have seen enough positive incrementalresults in Texas and Tennessee to reduce our guidance for the full year to arange of 80% to 81% MLRs on MAPD.

In our 2008 bids, we have attempted to mitigate the adversecost trends we experienced in 2007 by among other things exiting unprofitableproduct lines in a limited number of counties particularly in Alabama andTennessee re-contracting certain providers and in Tennessee establishing tieredprovider networks.

The PDP product continues to perform better than expected.PDP MLRs for the quarter and year-to-date are confusing and will be discussedby Kevin in more detail later. We now project the full-year PDP MLR in the 83%to 86% range, which remains a little better than our original expectation.Given the growth in PDP membership expected for 2008 the positive MLR resultsexperienced this year position us well for the future.

We are also pleased to have completed the Leon MedicalCenters Health Plans acquisition on October 1st. We immediately benefit from anearnings secretion standpoint but also believe the Leon model will serve as ablueprint for customer-service oriented medical care that we can expand acrossour provider network.

In an increasingly cluttered competitive environment theability to reduce disenrollment levels has become a key part of an MA plansability to grow and prosper. Leon Medical Centers Health Plans disenrollmentrates are half of the disenrollment rates experienced by the rest of ourmarkets, in spite, of being in the highly competitive Miami market.

The Leon facilities are much better appreciated in personand we are finalizing plans to host our Investor Day in Miami in January, moreto come on that event in the next few weeks.

We feel very positive about the addition of this asset toHealthSpring as it positions us for growth in 2008 and beyond, and with thegrowth of our standalone PDP business. We now have four major markets plus thePDP business providing diversification and insulation from a single market'stemporary adverse trends.

The presence in the Miami market also helps dilute ourexposure to political changes in the MA payment methodologies that reduce MArates the fee-for-service costs because Miami-Dade County is one of only ahandful of counties where Medicare Advantage benchmarks are equal to theunderlying fee-for-service costs.

We also recently opened our second LivingWell Health Centersin Mobile, Alabama and expect to open two more centers during the first half of2008. We continue to -- improve upon the LivingWell concept with each newopening and believe it represents a significant positive evolution and higherquality healthcare delivery to our members.

Our experience with the Gallatin, Tennessee LivingWellHealth Center confirms that the concept is an effect of tool in reducingdisenrollment rates.

From an earnings perspective we are pleased with the $0.39 earningsper share for the quarter, although the fourth quarter is subject to the mostseasonal variation in medical costs. Assuming continued utilization in linewith historical experience and after giving effect to the Leon Medical CentersHealth Plans acquisition we are increasing our 2007 full year earnings guidanceto $1.40 to $1.45 per share.

With that, let me turn the call over to Kevin to review thefinancial details of the quarter before we open the floor for questions.

Kevin McNamara

Thanks, Herb. Prior to discussing our third quarter resultsI'd like to remind everyone of the update we made to our second quarter numberssubsequent to our last earnings release call we held with you back in August.

As reported in our second quarter earnings release anddiscussed with you on our call in August, we received preliminary notificationfrom CMS in July regarding a retroactive rate adjustment amount for 2006.

We have referred to this payment at the end the year for theprior year payment. At the time of our earnings release we were reviewing andanalyzing the preliminary retroactive rate adjustment information with anexpectation of recognizing additional premium revenue in the third quarterended September 30, 2007, upon the completion of our analysis.

As noted in an 8-K filing on August 9th and our secondquarter 10-Q filed on August 14th, we completed our analysis priorto filing the 10-Q for the second quarter and gave effect to the retroactiverate adjustment in our second quarter results filed with the SEC.

This adjustment resulted in the following changes to ourpreviously discussed press release numbers. One, Medicare premiums increased by$15.5 million, two, Medicare medical expense increased by $3.6 million, three,Medicare MLR improved from 81.9% to 79.3%, and diluted earnings per shareincreased by $0.14.

Moving to the current quarter, we reported third quarter netincome of $22.4 million or $0.39 per diluted share, compared to a prior yearreported EPS of $0.54. The prior year third quarter results include afor-the-year in-the-year retroactive risk adjustment payment of $12.3 millionor $0.12 per share after providing risk sharing and income tax expenses.

No similar payments were recorded in the 2007 third quarterbecause we are accruing for-the-year in-the-year payment in 2007. Significantfactors impacting third quarter 2007 results were one, a 13.6% year-over-yearand a 1.1% sequential growth in our Medicare Advantage membership, two, a 45.2%year-over-year and 8.5% sequential growth in our PDP membership, three, a 3.3%increase as adjusted in the PMPM rates for our Medicare Advantage memberspartially offset by a decline in the PMPM rates for our PDP members.

For the nine months ended September 30, 2007, our MedicareAdvantage rates were up 5.4% versus the prior year, four, the previouslydiscussed erosion in our Medicare Advantage MLRs albeit at a moderated ratefrom that experienced earlier in the year.

Five, a negative impact on operations in the three monthsended September 30, 2007 of $3.5 million as a result of adjusting the company'sestimate of amounts due CMS for the 2006 Part D plan year to amounts set forthin the final settlement notification from CMS.

Six, a moderate increase in SG&A expenses in the thirdquarter of 2007, compared with the prior year's third quarter and seven,investment income of approximately two times last year's third quarter.

Additionally, I’ll spend a few minutes at the end of mycomments discussing the Leon acquisition and related financing, which werecompleted on October 1st. Before I do that, let me now spend a few minutes oneach of the factors driving the current quarter's results.

With respect to membership, we reported 126,616 MedicareAdvantage and 128,127 PDP members at the end of the third quarter reflectinghealthy growth on both a year-to-year and sequential quarter basis. As we'vedone in prior quarters you can find by market membership details within thebody of the earnings release.

On a year-to-date basis we have increased our MedicareAdvantage membership by 13.6% and appear on track to achieve 10% to 15% annualmembership growth before giving consideration to grow from the Leonacquisition.

PDP membership is up 44.4% year-to-date, which issignificantly higher than our expectations at the start of the year. Wecontinue our strategy of targeting the dual-eligible population for PDPmembership growth receiving our share of this population principally throughthe auto-assignment process.

We rolled out our PDP product nationally at the beginning ofthis year and as a result the majority of our PDP membership growth in 2007consists of members residing outside of our core MA markets.

We are pleased that our year-to-date growth has exceeded ourgoals and we continue to grow this membership base. As of CMS’ November paymentreport our PDP membership stood at 134,802. MA membership reported in thispayment report was 126,849 reflecting continued growth albeit at asignificantly slower pace in the PDP membership growth.

While these reported numbers vary slightly from ourmembership used for accounting recognition purposes due to a number ofreconciling items. We’ve found that the CMS numbers serve as a good proxy forrelative growth.

Commercial membership was 12,453 at September 30, 2007. Aspreviously disclosed we had a number of groups choose not to renew during thepast year and as such, we projected our commercial business will representapproximately 3% of our overall revenue in 2007 and is likely to decline as apercentage of revenue going forward.

We currently expect a further significant step down in ourcommercial membership on January 1st and this fact coupled with the Leonacquisition will likely result in a 2008 commercial revenue mix of less than1%.

Total revenue in the third quarter was $366.3 million, anincrease of $22.5 million or 6.5% versus the prior year third quarter. Afteradjusting the 2006 amounts to exclude the $12.3 million of retroactive riskpayments recognized during that quarter, Medicare Advantage revenue was up17.9% or $47.8 million to $315.2 million, compared to $267.4 million in theprior year.

Contributing to this increase was the 3.3% increase in PMPMrates on our MA members coupled with the 14.1% growth in member months. As weproject out the year-end, please remember that full year Medicare Advantagecomparisons will reflect retrospective risk adjustments related to prior-yearfinal settlements of $15.2 million recorded in the second quarter of 2007 and$5.7 million recorded in the fourth quarter of 2006.

Additionally, the third quarter of 2006 includedfor-the-year in-the-year retroactive risk adjustment payments of $12.3 millionrelated to the first half of 2006. In 2007, we accrued for this payment duringthe first half of the year.

PDP premiums were $26.9 million in the third quarter of2007, an increase of $4.4 million or 19.6% versus the third quarter in 2006. Adecline in bid PMPM rates was more than offset by the 45.2% increase in PDPmembership.

I caution however, that actual reported PMPM rates will varysubstantially from this bid rate when risk corridor and other periodicadjustments under the Part D program are taken into account.

Commercial revenue declined by $19.2 million or 63.8%,membership was the primary driver of the decline. Fee revenue for the quarterdecreased $1.7 million, as compared to the third quarter of last year. Thedecrease was primarily the result of the loss of the AHC Management contract atthe end of last year. For the first nine months of 2006 the AHC contract accountedfor $3.5 million of fee revenue.

Investment income was up just over 100% due to thesignificant increase in cash balances coupled with higher overall yields,please note that we expect investment income to decrease on a sequential basisas a result of the settlement of $103.7 million with CMS for 2006 Part Dactivity and the use of approximately $56 million of cash held at unregulatedsubsidiaries together with the $12 million of funds deposited in escrow as asource of funds to acquire Leon Medical Health Centers Health Plans on October1, 2007.

Additionally, we expect increases in interest expense infuture quarters as a result of our borrowing $300 million under our new creditfacility, more on that later.

Before I discuss our medical expense in the quarter, let mereview the impact of the 2006 Part D settlement on our results. As we noted inour earnings release we received notification from CMS this month that ourobligation to CMS to settle certain Part D payments for the 2006 plan yearamounted to $103.7 million.

As a result of adjusting our estimate of amounts due CMS forthe 2006 plan year to amounts set forth in the final settlement notificationfrom CMS we recognized a negative impact on operations in the current quarterof $3.5 million, which increased our MLRs by approximately 440 basis points inthe PDP business, 60 basis points in the MAPD business and 100 basis points onthe total Medicare MLR for the three months ended September 30, 2007.

We anticipate that CMS will offset the settlement amountagainst premium payments in the fourth quarter of 2007. Combined medicalexpenses of $288.3 million, an increase of $31.8 million or 12.4% versus theprior year's third quarter.

With respect to the components and the relative metrics MAmedical expense was $258.3 million, an increase of $43.2 million or 20.1%versus the comparable prior year quarter.

On a PMPM basis, MA medical expenses were $682.26, anincrease of $40.66 or 6.3% versus $641.60 in the prior year third quarter andthat's after adjusting the prior year statistic for the effect of recordingretroactive risk adjustments previously discussed. The MA MLR on a reportedbasis was 81.9% for the current quarter versus the prior year 76.9%.

However, this comparison is apples and oranges as theprior-year MLR reflects the receipt of a risk payment, whereas the current yearreported does not. On an apples-to-apples basis the current year is 81.9% MLRwould compare to 79.6% in the prior year, reflecting erosion of 230 basispoints.

Approximately 60 basis points of the erosion in the MLRyear-over-year is attributable to the previously discussed 2006 Part D finalsettlement with the remaining 170 basis points being attributable to medicaltrends.

PDP MLR deteriorated versus the prior-year's third quartercoming in at 80.2% versus 60.8%. On a year-to-date basis our PDP MLR is morecomparable with that of the prior year, finishing at 88.8% versus the prioryear's 81.9%.

Adjusting the year-to-date PDP MLR to exclude the effect ofthe 2006 Part D reconciliation that we recorded this quarter results in an MLRof 87.3% versus 81.9% for the prior year. The increase is due to lower PDPpremiums this year per bid design. We still expect our PDP Part D results toimprove over the balance of the year and have refined our guidance for anannual PDP MLR in the range of 83 to 86%.

SG&A expenses for the quarter were $40.2 million anincrease of $2.3 million or 6.1% versus the prior year. The increase in thecurrent quarter was primarily the result of an increase in headcount. As apercent of revenue, SG&A was flat quarter-to-quarter. As noted in priorcalls, we expect SG&A to be seasonally weighted to the first and fourthquarters as a result of the marketing costs associated with shortened open enrollmentperiod.

That being the case, we expect SG&A both in terms ofdollars and as a percentage of revenue to increase next quarter, but to finishthe year on an annual basis at or below 12% of revenue as we've targetedthroughout the year.

The increase in percentage of revenue terms will not be aspronounced due to the inclusion of the Leon operations during the fourthquarter of 2007. They have historically operated at much lower SG&A expenseas a percentage of revenue.

Moving to the balance sheet and cash flow. Our balance sheetat September 30, 2007 reflected cash and cash equivalents of $409.8 million.Unregulated cash was $90.1 million.

Days claims payable decreased to 38 or by one daysequentially compared to 39 at June 30, 2007. Please note that the Q3 pressrelease references a days claim payable statistic of 40 for the 2007, secondquarter. It actually was 39 as reported in our third quarter 10Q and pressrelease.

Year-to-date, the medical claims liability is down $3.8million. This is attributable to an approximately $8.7 million reduction in thecommercial claims liability in line with the reduction in our Commercialbusiness.

The Medicare claims liability is up in line with thebusiness and changes in the pharmacy and other components of the medical claimsliability approximately offset one another. In the 10-Q for the third quarter,we will begin including a schedule detailing the components of the medicalclaims liability.

Operating cash flow for the quarter was a source of $40.8million or 1.8 times net income for the current quarter versus a source of$53.5 million or 1.7 times net income, in the prior year third quarter. In bothcases is adjusted for an early payment at the CMS premium.

On a year-to-date basis, cash flow from operations was $62.3million or 1.1 times net income compared with $98.3 million or 1.6 times netincome for the nine months ended September 30, 2006.

The main drivers of this variance were. One, an $8.8 millionnegative variance related to our accrual of premium amounts from CMS associatedwith current-year rate adjustments. Two, a $9.6 million negative variancerelated to our pharmacy and entry into the Part D business in 2006. Three, a$6.1 million negative variance related to the runoff of Commercial medicalclaims on groups no longer covered in 2007. Four, a $6 million negativevariance related to the timing of incentive compensation payments. And five, a$5.6 million negative variance related to the timing of tax payments.

We do expect annual cash flow from operations to exceed netincome for the year.

As Herb, mentioned during his comments. We were pleased thatwe completed the Leon Medical Centers Health Plans acquisition on October 1st.We are excited about what this transaction brings to our Company and believethere will be positive synergies between our two organizations.

Already, we are learning a great deal about their high levelof customer service and hope it will have a positive impact on our memberretention and growth going forward. Reviewing a few of the deal specifics, theacquisition purchase price consisted of $355 million in cash at closing.

As part of our transaction, we also entered into an excusivelong-term provider contract with Leon Medical Centers an operator of fiveMedicare-only medical clinics located throughout Miami-Dade County.

The provider contract includes a risk-sharing arrangement,whereby both HealthSpring and LMC will share equally in the surplus or deficitof the health plan relative to targeted medical loss ratios, which areinitially set at 80%.

The transaction consideration also included the issuanceinto escrow of approximately 2.7 million HealthSpring shares at closing, thatwill be released from escrow in the event that Leon Medical Centers completestwo additional medical centers before November 2009.

It is anticipated that these shares will not appear in ourfully diluted share account for EPS purposes, until the centers are closer tocompletion. Although, we do not intend to break out the Florida market resultsgoing forward, let me spend a few minutes commenting about the expected ongoingfinancial impact of the acquisition.

And the related $300 million term loan and $100 millionunfunded revolver we negotiated to finance part of the transaction. As wementioned during the call announcing the transaction, much of the filing datarelating to the health plan is available publicly through statutory filings.

Let me give you a few highlights that I think will sharesome light on what we expect the impact will be on our fourth quarter financialresults.

The plan generated approximately $160 million in revenue forthe six months ended June 30, 2007. Membership has continued to increase sincethat point, although at lock-in it is tough to see significant growth.

We expected the current revenue run rate of approximately$80 to $85 million per quarter is achievable. Medical costs in this businesshave continued to improve throughout the year. And we anticipate that ourcontractual risk-sharing MLR target of 80% is achievable for the fourth quarterof 2007.

In line with the experience of our other markets, we wouldexpect that open enrollment marketing expenses would increase SG&A duringthe fourth quarter of this year, albeit from a lower starting point for Leon.

Below the operating income line there is some othersignificant costs related to the Leon acquisition that we wanted to make sureare taken into account. We will see a sizable increase in amortization expenserelated to the acquisition because of the intangible assets that were createdin the deal.

While the analysis will not be finalized until thecompletion of the opening balance sheet, on an annual basis, we currentlyexpect to see between $10 and $11 million in incremental annual amortizationexpense beginning in the fourth quarter of 2007.

On October 1, 2007 the Company also entered into a new $400million five-year credit agreement, which is comprised of $300 million infunded term loans and $100 million unfunded revolving credit facility. Proceedsfrom the term loan were used to finance a portion of the $355 million in cashcosts of the Leon acquisition.

These loans carry interest on the basis of a base rate or aLIBOR rate, plus an apple go or margin, which is tied to the Company'sconsolidated debt to EBITDA leverage ratio. The initial margin is 250 basispoints.

In addition, the Company is responsible for the commitmentfee on the unfunded revolving credit facility, which is also tied to theleverage ratio and is initially set at 50 basis points.

While the interest expense we will record during the fourthquarter of 2007 will fluctuate based upon the movement of LIBOR rates for thenext two months, we expect to see Q4 interest expense in the range of $6 to$6.5 million, inclusive of unfunded revolver commitment fees and theamortization of deferred financing fees associated with the new creditfacility.

Finally, as I mentioned before, we should also see asequential decline in our interest income due to the fact that we usedapproximately $56 million in cash from unregulated subsidiaries in addition tothe $12 million escrow from our balance sheet to finance the remaining cashportion of the purchase price and associated transaction expenses.

It is our current intention to pay down this debt ahead ofthe required amortization payments. That being said, we would expect interestexpense to step down over time so long as interest rates do not movesignificantly against us.

The net of the Leon operations and the amortization andinterest expense should result in an accretion of approximately $0.01 to ourfourth quarter 2007 earnings per share. We expect an organic growth of thebusiness, debt repayments, and SG&A leverage will dramatically improve theaccretion from this transaction in 2008.

With respect to our 2007 guidance, we are increasing ourprevious release GAAP EPS guidance to $1.40 to $1.45. Revised guidance includesamounts resulting from the acquisition of Leon Medical Centers Health Plans onOctober 1, 2007.

Additionally, guidance includes the $0.05 charge we tookduring the second quarter of 2007, resulting from the impairment of intangibleassets.

Key assumptions behind this guidance are yearend membershipin the MA business of 153 to 154,000, PDP membership at yearend ofapproximately 135,000, revenue of approximately $1.55 billion. MLRs in the MAbusiness of 80 to 81%, PDP MLRs of 83 to 86% a weighted average share count of57.4 million and a tax rate of 36%.

As we did last year, we intend to provide detailed 2008guidance during our Investor Day. Stay tuned for all the details, but we arecurrently planning for the event to be held in Miami in January. And we'llinclude a tour of the Leon facility.

Operator, that concludes our prepared remarks. We can nowopen the line for questions.

Questions-and-AnswerSession

Operator

Thank you, sir. (Operator Instructions) We go first toJustin Lake of UBS.

Justin Lake - UBS

Thanks, good morning.

Herbert Fritch

Good morning, Just.

Kevin McNamara

Good morning.

Justin Lake - UBS

A couple of questions. First and I know -- I know it's alittle early to talk about '08 independent firms, but just, I am sure, now thatwe've started marketing.

I'd be curious to hear your thoughts on how you see thesituation shaping up, especially around commission structures.

And your thoughts around how impressed people are being for2008 and also around benefit.

Herbert Fritch

Well, I think it's slightly more competitive, I guess is theway I'd put it. I mean it certainly hasn't decreased in terms of the number ofcompetitors.

There are more SNIP plans and special products. And I think,in some markets commissions are flat and some others are being bid up a littlebit.

Justin Lake - UBS

Okay. So flat to up, I know you particularly in Alabama anda little bit in Tennessee, compete with United Healthcare on the HMO product.

And they're going to have an AARP offering out in 2008 foran HMO. I'm just curious how you think the impact of that might be for yourbusiness.

Herbert Fritch

Yes. It's really had to say. We're certainly seeing a lot ofadvertising for it. Pure speculation on my part, but I think ours has a prettyloyal following that currently is mostly in our supplements that Unitedunderwrites.

I expect that's where a lot of their members are going tocome from would be my guess.

Justin Lake - UBS

Right. And just finally, a question around medical costs.You took down your -- looks like the third quarter, if you ex out this Part Dreconciliation showed some stability from a medical cost standpoint versus theissue the issue you saw in the first half of the year.

As you think out to the fourth quarter. And you did takedown your guidance for the full year. I'm just curious as to how much of thatdo you think is just the impact of Leon versus further improvement in medicalcosts in '07?

And then, have you had a chance to kind of really sit backand think about how much -- how much your bid for '08 were able to reflectthose higher costs in 2010 as in the first half of '07. And how you think itrejected of MLR might progress.

Kevin McNamara

Justin, I'll take part of that and let Herb take the rest.With respect to Leon and you can back into the other math. I mean we've gotLeon loaded in at the target 80% in the fourth quarter.

Justin Lake - UBS

Okay. So that would account for some of the benefit, but notall.

Kevin McNamara

The rest would be trend. And I'll let Herb go from there.

Herbert Fritch

Yes. I don't think, Justin much has changed on the bidcomponent compared to what we've discussed in the past. We didn't get all ofthe costs increase on the MAPD into our bids.

If there is any new news, I guess it's that similarly on thePDP bids not similarly in the opposite direction. We've had actually betterexperience this year than we anticipated and that better experience didn't getreflected in our bids for 2008 either.

Justin Lake – UBS

Got it. Thanks a lot.

Operator

Thank you. We go next to Michael Yuan, Bank of America.

Michael Yuan - Bancof America Securities

Hi. Thank you. A question on, Leon. I know some of thefinancing has changed since your initial assumption of the LIBOR 200 or LIBOR250 and it slow little earlier. Do you still expect that to add $0.15 nextyear?

Herbert Fritch

You know, we're going to get -- give very detailed guidanceon 2008 in January, but as we sit and work through all the intricacies of thatand refine our calculations we still think we'll see at least $0.15 from that.

Michael Yuan - Bancof America Securities

Great. And then just on the re-contracting in Tennessee,what percentage can you actually re-contract. And how long do you think thatwill take to complete?

Herbert Fritch

The re-contracting has largely been around our physicianengagement models, organizing doctor groups and getting them onto models thatinvolve greater incentives. We've increased substantially this year.

I'd say we're up from 10 to 15% up to close to 40%. Weexpect, we'll by next year -- we'll have well over 50% of our members andphysicians under those models in Tennessee.

Michael Yuan - Bancof America Securities

Great. Thank you.

Operator

Thank you. We’ll go next to Michael Baker, Raymond James.

Michael Baker -Raymond James and Associates

Yes. I was wondering, given recent developments of one ofyour competitors in Florida, if you've thought about a more aggressive marketexpansion going forward in that region?

Herbert Fritch

You know, we are trying to undertake some more significantexpansions, but with the timing process at CMS you're getting pretty late rightnow to expand market areas for January of 2009.

And to start something from scratch right now you'd probablybe looking at January 2010.

Michael Baker -Raymond James and Associates

Thanks for the commentary.

Operator

Thank you. We’ll go next Matt Perry, Wachovia Capital Markets.

Matt Perry - WachoviaCapital Markets

Hi. Good morning. Just a couple of quick questions. First onyour comments on special needs plans, I guess, could you give us any indicationof, I guess, how actively you'll be marketing those during open enrollment, oris that more kind of a product to be concentrated on after open enrollmentcloses?

And then any indication of how many members, you thinkyou'll be able to sign up in those products?

Herbert Fritch

I think it is probably -- well, not exclusively, more thelatter. I think it's a product that we're going to try and really get focusedon after open enrollment. I'd just comment that our growth during lock-in lastyear was a net of about 1,000 members a month. This year, we're more -- we'reunder 500, more in the 300 to 400-member range.

And I think our expectation is we had hoped to at least getback to that 1,000 member a month, kind of number, but we'll look at that moreclosely as we get more experience with the products.

Matt Perry - WachoviaCapital Markets

Okay. And then secondly, if I understood your commentscorrectly on PDP auto-assignment, you said you might be eligible for 117,000but that some portion of those might choose other plans. Is there anything youcan tell us about your experience in '07 that might allow us to at leastballpark what percentage of those 117,000, you might pick up in '08?

Herbert Fritch

Just based on a study on a much smaller number that wereceived last year, we lost about 10% before January and ended up over the nextfew months losing another 10% to 15%, although that was offset by new adsduring those months post January.

Matt Perry - WachoviaCapital Markets

Okay. So you might be able to hold onto two-thirds orthree-quarters of that amount, do you think?

Herbert Fritch

I think our expectation is 75% to 80% of them ultimately,but -- and again, we do expect, as we have this year. We've had net growthevery month and we expect that will kind of come on top of that more or lessnew members.

Matt Perry - WachoviaCapital Markets

Okay. And then just lastly, am I thinking about '08 PDPper-member per-month revenues correctly, because it looks, simply just lookingat your bids it looks like the average for '08 might be down $5 versus '07, soshould we see kind of a $5 decline in PMPM in '08.

Herbert Fritch

You can sort of hard circle the $5. I think directionallythey'll go down and I think order of magnitude they'll go down about half thelevel they went down from '06 going into '07.

Matt Perry - WachoviaCapital Markets

Okay, great. Thanks a lot.

Operator

Thank you. We are going next to Carl McDonald, CIBC.

Carl McDonald - CIBCWorld Markets

Thank you. I just had another question on the PDP. The riskcorridor gets a little bigger for you in 2008 and relative to the commentarythat the bid you submitted for 2008 didn't necessarily catch the fact thatutilization costs have been a lot lower this year. Will that be a significantbenefit for you next year? How would you characterize that?

Herbert Fritch

Yes, it sure helps. I mean, obviously, if you're havingfavorable experience you'd like to keep as much of the risk as possible so thatshould be a benefit.

Carl McDonald - CIBCWorld Markets

Any sense of the magnitude that you can give us?

Herbert Fritch

Well, I mean, I think you'd keep another 2.5% of thepositive. In other words, if you have favorable experience you keep 5% of it asopposed to 2.5% before you start sharing a lot. I think everybody now is basingbids based more and more on actual experience, so I think the variationshouldn't -- 5% variation on your target would be a lot.

And I don't think we're anticipating seeing a whole lot, ifany, risk corridor adjustments at the end of 2008, but we'll see. Thatcontinues to develop and we get smarter every month about that.

Carl McDonald - CIBCWorld Markets

All right. And I'd also be interested in your thoughts onwhether you think -- or whether you see a durational effect in your Medicarebusiness, Medicare Advantage, in terms of -- is there a significant differencein loss ratio for members, say their first 12 months versus members that havebeen in the plan for a longer period of time?

Herbert Fritch

We've been pretty vocal about --we do believe what's thecase, and no, we absolutely think so and are suspect of business that's lessthan three years old of being mature to a steady, predictable point on lossratios.

Carl McDonald - CIBCWorld Markets

And, any sense of what the magnitude is, difference in termsof loss ratio between the two?

Herbert Fritch

It's significant from what we've seen and I'll just -- Imean, we've seen variations by market as much as 15 to 20 points over athree-year period.

Carl McDonald - CIBCWorld Markets

And last question on that is, your sense of that because themembers that you're signing up tend to be younger, healthier, or is it just thesituation that members just need some time to figure out what the benefits are?

Herbert Fritch

You know this is all speculation and theory and I don't knowthat we've proved much. My theory has been that a huge part of Medicareexpenses are incurred in the last six months of life and beneficiaries that arein end-to-life events typically aren't changing their insurance plans.

But I do believe that these are old people so the fact thateven if they were healthy when you signed them up, after you've had them for ayear or two, they start to incur the same kinds of diseases as the generalpopulation at comparable rates. And at that point, your medical managementsystems need to be in place.

Carl McDonald - CIBCWorld Markets

Thank you.

Operator

We are going next to Matthew Borsch, Goldman Sachs.

Darin Miller -Goldman Sachs

Good morning. This is Darin Miller sitting in for Matt.Question on SG&A, on an absolute level it was down sequentially. Can youprovide some color on that?

Kevin McNamara

I'm not sure I follow you on that. On an absolute level itbeing down, Darin. I mean, it was up 6.1% in dollars.

Darin Miller -Goldman Sachs

It looks like in dollar terms it was down about $3 million.

Kevin McNamara

I don't follow that, Darin. I'll have to call you backoffline on that.

Darin Miller -Goldman Sachs

Sure. I'll follow up with you on that. Texas Medicareenrollment looks like it was down sequentially.

Herbert Fritch

I believe it was about flat. I don't know that it wasactually down but sure it didn't increase much.

Darin Miller -Goldman Sachs

And most of your other markets had modest increases. I wasjust wondering if there was anything going on that you can comment on thatmarket.

Herbert Fritch

The Houston marketplace is the most competitive that we haveand clearly our biggest competitor down there is probably the most aggressivein terms of benefits. And so I think that leads to a little slower growth inthat market.

Darin Miller -Goldman Sachs

Okay. And I'm sorry if you've already commented on this. Thehigher outpatient costs you saw earlier this year, can you provide an update asfar as an explanation that was driving that and steps you're taking to addressthat?

Herbert Fritch

Well, we're looking at some recontracting otherauthorization things. The trends have moderated somewhat. They're still higherthan we'd like and still, I think, higher than physician or inpatient trendsbut they're not at the levels we were seeing earlier in the year.

Darin Miller -Goldman Sachs

Great. Thank you.

Operator

Thank you. We are going next to Charles Boorady of Citi.

Charles Boorady -Citigroup

Good morning. On a same-store basis here, MA enrollmentguidance for the year, did that actually -- did you actually lower thatsame-store, excluding Leon, and if so, can you explain that?

Kevin McNamara

I think, Charles, it's what we alluded to -- the answer isyes. We lowered it slightly, I think, 1 to 2,000 lives, and the answer is justwhat I talked about. We haven't seen the same level of net enrollment growthduring lock-in that we saw in prior years but we're still growing. It's notdramatic but it's slightly lower.

Charles Boorady -Citigroup

Okay. And the improved medical trends, did that reflect mixof Leon, bringing your expected trend down at all?

Kevin McNamara

No. That's fourth quarter. Leon's not in the results, butthe annual, yes.

Herbert Fritch

For the annual, there is one factor. I mean, Leon is comingin -- I think we're projecting it at 80 for the fourth quarter, which is at thelow end of the range.

Charles Boorady -Citigroup

Okay. And what percent complete are you on claims thatrelate to the period when you had a slight surprise on medical trends forearlier -- or earlier this year?

Kevin McNamara

We'd be -- earlier this year -- we pay very quickly, so withone month run-out, we're 80% complete and with two months run-out we're closeto 90% complete.

Charles Boorady -Citigroup

So, in hindsight, was there anything new that you've learnedfor getting closer to 100% complete on the claims related to that period?

Kevin McNamara

I think the experience compared to when we made theannouncement actually came in a little better than we were thinking. It's stillnot good, but it wasn't as bad as we thought.

Charles Boorady -Citigroup

In terms of diagnosing the root causes of it and whetherthat's something that is going to be more predictable going forward, or is itreally unpredictable in hindsight?

Kevin McNamara

I'd say it was unpredictable in hindsight. I mean, it's avariety of smaller factors. It isn't just a single factor. It varies a bit bymarket. And we're trying to hone our routine analytical reports to pick up onthese nuances but that outpatient component is a whole hodgepodge of things andprobably is the most challenging to pin down. But I think we're getting betterat it.

Charles Boorady -Citigroup

All right. Last question on the WellCare Group. Were yousurprised by the magnitude of that search of 200 agents searching headquarters?

Kevin McNamara

I haven't talked to anybody that has seen that or anythinglike it coming. Yes, absolutely. Like everyone else in the industry, I thinkwe're just staying tuned and try to figure out what's really going on.

Charles Boorady -Citigroup

How do you respond in terms of your own internal controls,government relations, etcetera? Is there any response that you take as acompany when you see something like that happen?

Kevin McNamara

Well, actually, it feels pretty good. A number of months agowe hired a full-time chief compliance officer. She's been working with theBoard to strengthen our internal compliance programs and I don't think we'redoing anything differently because of WellCare.

I feel pretty good that we continue to strength internalcompliance and make progress on that. We're not aware of any material issues byany means but it's just something we have to constantly pay attention to ifyou're dealing with the government.

Charles Boorady -Citigroup

Do you think the government will sort of reach out to theindustry and communicate with you and others what kinds of things they tookissue with so that corrective action can be taken, if necessary, in aconstructive way as opposed to waiting to see if 200 Feds appear on your frontlawn?

Herbert Fritch

We certainly hope so. I think we're all looking to find outthe details of exactly what the issues are and obviously to the extent, weunderstand a little better we'll look awfully hard to make sure we don't haveany. We're certainly not aware of anything now.

Charles Boorady -Citigroup

Are there open lines of communication with CMS on this? Irecognize you wouldn't be able to share with us the specifics, the warrantswere sealed but are they -- is there an open line of communication, given themagnitude of what's happened there?

Herbert Fritch

I'm not totally sure CMS is even aware of all the issues butwe're asking everybody we can what's going on and not getting many answers yetfrom anybody.

Charles Boorady -Citigroup

Okay. All right. Well, thanks very much and congrats on thequarter.

Operator

Thank you. We are going next to Josh Raskin of LehmanBrothers.

Josh Raskin - LehmanBrothers

Hi. Thanks. Good morning. First question just on, as wethink about 2008 membership growth, and if I look back over the MedicareAdvantage membership growth. If we look back over the last couple of years, youguys have added organic growth somewhere in the 12 to 14,000 life range.

And I think that was a little bit below what you guys sortof hoped would run at. Different reasons for different years, but I'm curious,as you think about '08, what are some of the pluses and minuses? How do youthink about sort of that low-teen thousands of growth rate in terms ofmembership for '08?

Herbert Fritch

I think, in general, and we'll sharpen our pencils a bit aswe do 2008 guidance but in general, Josh, I mentioned we emphasize for '08 moreprofitability and margins and a little less membership in a couple of respects,especially in Alabama and Tennessee and drop some unprofitable members invarious products and counties. Not a huge amount, but in general, I think,while we're optimistic we can see EBITDA growth.

I think membership growth might be a little bit down fromprior years.

Josh Raskin - LehmanBrothers

Okay. And that's sort of the respite better retention andsome of this did roll out, is that a way to think about it?

Herbert Fritch

Yes. You know, we may well see a little different pattern, Ithink the things we did may actually reduce the January enrollment just basedon transition, you know, going -- dropping a few members.

The sniff products are likely to be more lock-in relatedwhen we see that growth so it'll be the growth could be a little more evenlyspread throughout the year as opposed to front ended the way it's beenhistorically.

Josh Raskin - LehmanBrothers

Okay.

Kevin McNamara

Josh, better retention could potentially change that picturebut we're not banking on that. We're not planning for a significantdeterioration in attrition rates but we're certainly not planning forsignificant improvement, although we've committed a lot of resources to thatarea.

Josh Raskin - LehmanBrothers

Okay. I think, I get the color that you guys are talkingabout. And then, Kevin just a quick balance sheet account question for you. Thetwo liability line items that I'm just curious on, the funds held for thebenefit of members and then the risk corridor at CMS, I think I understand therisk corridors?

But could you just help me understand which buckets line upwith sort of what the way CMS thinks of it? They think of it in sort of threebuckets and you guys have it in two liability accounts, I'm just trying toreconcile those two.

Kevin McNamara

Yes. Once you've got, Josh and I guess, the basis of yourquestion is where is the $103 million coming from?

Josh Raskin - LehmanBrothers

Yes.

Kevin McNamara

When you get the 10-Q you'll have a very detailed it showsyou exactly where it's coming from. But in a nutshell basically the funds heldfor the most part is an in and out calculation. So a part of it comes out ofthat funds-held account but you're continually replenishing it during the year.

So, the $103 is going to become -- is going to come partlyout of funds held, partly out of risk corridor. I believe the risk corridornumber of that $103 is all but $9 or $10 million goes out.

Herbert Fritch

If you subtract 34 from that the balance comes out here.

Kevin McNamara

If you take, I just got the answer. If you take the $103million.

Josh Raskin - LehmanBrothers

Yes.

Kevin McNamara

Subtract the $34 million risk corridor that's on the balancesheet in the current liabilities.

Josh Raskin - LehmanBrothers

Yes.

Kevin McNamara

The rest comes out of the funds held account.

Josh Raskin - LehmanBrothers

Okay.

Kevin McNamara

So, the long-term portion of the risk corridor relates to2007 because you'll obviously settle that later on in 2008.

Josh Raskin - LehmanBrothers

And then, I guess, just. Okay. So that's helpful from anumerical standpoint. But coming back to the business, the risk corridors theremaining portion of that $70-ish million or so that is a function of youroperations around the PDP -- around the Part D program coming in better thanexpected. That's just simply we've done better we owe part of it back to thegovernment.

Kevin McNamara

That's the risk corridor piece, correct.

Josh Raskin - LehmanBrothers

Okay.

Kevin McNamara

What's in the funds held account is really just the positiveaccounting where you receive advance payments from CMS for low income subsidyand reinsurance and then you charge amounts against that as they're incurred.

None of those dollars ever go through P&L and so youjust get a residual balance that sits on the balance sheet and continuallymoves.

Josh Raskin - LehmanBrothers

Okay.

Herbert Fritch

Those are components that we're not at risk for, so if theutilization is lower we have to give the money back, if it's higher we actuallyget reimbursed for that. And it covers the cost sharing of low-income membersand then a reinsurance component that CMS rakes the risk for.

Josh Raskin - LehmanBrothers

Right. I guess.

Herbert Fritch

They front you the money so you can pay your clients.

Josh Raskin - LehmanBrothers

Right. Which certainly I understand, I was just trying toget at with a P&L impact we can take a look at the risk corridor balancesheet item, that's the one that really?

Herbert Fritch

That's correct. All the funds held activity is staying awayfrom the P&L.

Josh Raskin - LehmanBrothers

Yes. Okay. Perfect. Thank you very much.

Operator

(Operator Instructions) We’ll go to Michael Baker, RaymondJames.

Michael Baker -Raymond James and Associates

Yes. Just a follow-up. I was wondering if you could updateus in terms of your plans for leadership in the marketing area given Craig'sdeparture earlier this year?

Herbert Fritch

We have just recently hired someone here at corporate whowas working with Craig for continuity's sake and I don't know that I'd term[Michael Pensley] his name, him as Craig's replacement necessarily butcertainly in the short term for this open enrollment period he's working withCraig.

Michael Baker -Raymond James and Associates

Thanks.

Operator

Thank you. And with no further questions, I'd like to turnthe conference back over for any additional or closing remarks to Mr. HerbertFritch.

Herbert Fritch

Well, thanks. We appreciate your interest and look forwardto talking to you again and seeing you down in Miami for Investor Day.

Operator

Thank you for your participation. That does conclude today'sconference. You may disconnect at this time.

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