Health Net Q3 2007 Earnings Call Transcript

Health Net, Inc. (HNT)

Q3 2007 Earnings Call

November 1, 2007 11:00 am ET

Executives

David Olson - SVP of Corporate Communications

Jay Gellert - President and CEO

Jim Woys - Interim CFO and President of Government and Specialty Services

Analysts

Carl McDonald - CIBC

Joseph France - Banc of America Securities

John Rex - Bear Stearns

Scott Fidel - Deutsche Bank

Will Georges - JP Morgan

Josh Raskin - Lehman Brothers

Justin Lake - UBS

Matthew Borsch - Goldman Sachs

Christine Arnold - Morgan Stanley

Tom Carroll - Stifel Nicolaus

Presentation

Operator

Good day, everyone, and welcome to this Health Net, Inc. Third Quarter Conference Call. Today's call is being recorded.

At this time, I'd like to turn the conferences over to the Investor Relations Officer, Mr. David Olson. Please go ahead, sir.

David Olson

Thank you very much, operator, and good morning, everyone.

During this call, we will make forward-looking statements that are subject to certain risks and uncertainties. Risk factors that may impact those statements and could cause actual future results to differ materially from currently expected results are described in our filings with the SEC as well as the cautionary statements in our press release issued in advance of this call.

In addition today's press release makes and the comments on this call will make reference to certain measurements that are not calculated and presented in accordance with GAAP. I should note that today's press release, which is available on the company's website, includes an income statement reconciliation that is non-GAAP.

In addition, we included a supplemental schedule showing a breakout of reserves and healthcare costs for Capitation Provider settlements and the impact the Part D. These supplemental items provide the basis for discussion of operating metrics excluding the third quarter charges, and discussion of days claims payable excluding the costs noted about.

Let me now turn the call over to our CEO, Jay Gellert.

Jay Gellert

Thank you, David, and thank you for joining us this morning for a review of our third quarter 2007 results, which includes the full effect of nearly $300 million in charges. These charges were incurred as a result of the company reaching an agreement in principle to settle three national class action lawsuits and accounting for projected liabilities arising out of related regulatory issues and certain other immaterial lawsuits.

We know the size of these charges is probably surprising to many of you. First and foremost, it was important for the company to put these matters behind us. They were proving to be and were likely to remain distractions for management. We have great opportunity in all our lines of business.

We want to be able to concentrate fully on these opportunities, not on litigation, that covers issues dating back as much as 12 years. The lawsuit center on certain out-of-network claims payment practices for the period between 1999 and this year. We don't want to get into too much detail now as we are still finalizing the settlement agreement.

It's important to put the $201 million portion of the charge that has been allocated to health plan services in context. It represents just three tenth of 1% of total commercial healthcare expenses over that period. As a result of the charges, we can lose money in the quarter. Without the charges we hit the $0.99 consensus

Our concern that we know could develop as a result of the charges centers around cash. The cash flow adjusted for timing differences in the quarter was strong. We have cash on hand, a currently untapped $900 million credit line, so we can meet the requirements in settlements and continue with share repurchase. In addition, our debt to total capital remains quite low.

To underscore our confidence, our Board authorized an additional $250 million in share repurchase authority. We remain committed to share repurchases as we believe that it is one of the best ways to improve shareholder value and enhance return on equity. Including the additional $250 million in newly authorized repurchase authority, we have approximately $346 million in remaining authority.

Now I'd like to review our strong operating results for the quarter. These results reflect our strategy of growing the small group, individual and mid-market, and managing general and administrative expenses. In addition to our continued focus on our strategy, our diversified business portfolio and share repurchase program position us for further growth and margin expansion for the remainder of 2007 and in 2008.

Excluding the impact of the charges, key operating results in the third quarter include the following. Our continued focus on our strategy of growing mid, small group and individual membership resulted in an increase in the commercial, small group and individual segment of 83,000 members or 12.1% compared to the third quarter of last year

Medicare Advantage membership grew by 21.3% to 239,000 members compared to the third quarter of '06 and by 1.3% sequentially. And PDP membership grew by 24.1% compared to the third quarter of '06 and by almost 5% sequentially. We are very confident about next year in PDP also.

Commercial enrollment, including both at-risk and ASO membership, decreased by 28,000 members or 1.2% compared to September 30th, 2006. As many of you know, we've lapsed several unprofitable large group commercial accounts this year as part of our strategy.

As a result of our continued pricing discipline, commercial large group membership decreased by 91,000 members from September 30th, '06. Sequentially, commercial large group decreased by 26,000 members or 1.8% as we lapsed one large Northern California account with 28,000 commercial members. We expect to continue to see some attrition in the commercial large group, both risk and ASO, in the remainder of '07. We think we're just about over it, and that overtime the rate of lapse just will decrease.

In addition, we're beginning to see some attractive large group opportunity. We landed two commercial large group accounts with January 1 effective date. Given this, we expect our January 1 enrollment to be higher than yearend '07, marking the first sequential January 1 growth for us in several years. We intend to update you on the 2008 RFP activity at next Friday's Investor Day in New York City.

During the third quarter, we had strong commercial sales of more than 135,000 new members, including nearly 60,000 members from the California Farm Bureau which selective Heath Net as its help plan. This is the sixth consecutive quarter where new sales have exceeded at least 50,000 members.

Growth in both Medicare Advantage and PDP exceeded our '07 guidance of 15% to 20%. Year-to-date, Medicare Advantage has grown 20% and PDP has grown 24%. 2008 looks very encouraging for both of these programs. Again, we intend to provide more color on this at next week's Investor Day.

The commercial premium yield compared to healthcare cost trend was positive in the third quarter of '07 excluding the charges. Obviously, it was upside down including the charges. We'll have to keep the relationship right side up in Q4 next year. It's a critical part of our improved margin story.

We've been holding the line on pricing. It's still growing thanks to new products and improving relationships with our distribution system. We continue to expect our full year '07 premium yield to be approximately 9%, which includes the second quarter '07 acquisition of the Guardian 50% in Healthcare Solutions. Excluding the impact of the charges, we expect the healthcare cost trend to be 30 to 50 basis points less than premium yield this year.

With regard to Medicaid, I would like to make a few comments. We continue to do well in Medi-Cal, the Medicaid program in California. As expected, we did not get a rate increase in October, although we did receive one last January. Membership in Medi-Cal was down slightly, as the state has been cleaning up its role.

Medicaid in New Jersey is performing well. In Connecticut, we continue to evaluate the program and are in discussions with the State of Connecticut about what will work for all parties, including the state and the beneficiary. We hope to have more on this next week at Investor Day.

Three final comments before I turn the call over to Jim. First, health reform in California, the special session is still open. Unfortunately, the governor, key legislative members and their staff have been diverted by the fires. We expect the process to pick up again in the next few weeks and believe that all parties, including labor, are looking for a set of proposals on which everyone can agree.

Second, we will be hosting our Annual Investor Day next Friday, November 9th, in New York City. We will give you much more detail on each of our lines of business and more specific guidance for '08 at that time. We look forward to seeing you there.

Finally, I would like to welcome Joe Capezza to Health Net as our Chief Financial Officer. Joe most recently served as CFO at Harvard Pilgrim and has a wealth of experience in the healthcare industry. He is on the call today, but we won't make him answer any questions.

Before I turn the call over to Jim, I would like to recognize him for his incredible work over the course of the last year. Most of you on the phone have commented to me about how credible and effective he has been in the CFO role. His work has added great value to our company. The only thing I can say about him he is even a better operator than a financial officer and moving them back into key operating role will enhance the company. So I thank him and I think all of us thank him for his incredible work, and we look forward on to working with Joe in his new role.

I would like to now turn the call over to Jim. Jim?

Jim Woys

Thank you, Jay, and good morning, everyone. There are four key objectives I would like to accomplish with my comments this morning. First, let me give you additional details on the charge we are taking this quarter, so you can fully understand the character and component of the charge and how they impact the income statement, the balance sheet, and going forward, cash flow.

Second, I want to spend the majority of my time on our solid operating performance in the third quarter and health plans and in TRICARE, excluding the charge. Third, I will spend a brief moment updating you on the TRICARE reprocurement. And finally, I will speak to you on Q4 expectations, our preliminary 2008 outlook and our upcoming Investor Day.

Let me spend a few moments now on the charge. We noticed the magnitude of this charge was surprising, but it was important for us to put this behind us and move forward to capitalize on all of our future opportunities. The $296.8 million pretax number, including number of items related to the impending settlement of the class-action lawsuits, the regulatory issues and some other in material lawsuits.

The charge included a fund for disbursements to affected members and a fund for specific claims that members may resubmit. It covers attorney's fees, both the plaintiff and ours. It also covers the remediation of claims that the State of New Jersey Department of Banking and Insurance had determined that we paid improperly and a fine we expect to pay to New Jersey and amounts related to our estimated liability for a few non-material lawsuits.

Most of these issues revolve around our out-of-network claims payment methods and cover a 12-year period. We have made operational changes, and we continue to work very hard to meet the needs of our members, our providers and our regulators. The charges do make the quarter more complex.

On a GAAP basis, we incurred a net loss of $104 million. In addition to the pre-tax charges, we also wrote-off a $26 million differed tax asset as a consequence of the charge. Overall, excluding the effect of the charge, we met the first call consensus EPS of $0.99 per diluted share with a fully diluted share count at a 113.5 million shares.

Given the complexity, we included a table with the release that reconciles the income statement to the three cost categories where the charge has hit, Healtcare cost, G&A expenses and the tax write-off. The table shows you how to get to the $0.99 in diluted per share earnings for the quarter. Read the back out the two components of the charge and use a 36% tax rate and approximately 113.5 million diluted shares. The tax rate is consistent with our prior guidance.

The remaining of my comments about the performance of the company for the third quarter will all be reflective of our performance without the effect of the charges.

So let me now turn to our solid third quarter performance. Total revenues rose by 11.8% in the third quarter to $3.6 billion from $3.2 billion in the third quarter of 2006 helped in part by one full quarter of 100% contribution from our Healthcare Solutions small group enrollment in the Northeast. Health plan services premium revenues increased 11.7% to $2.9 billion in the third quarter compared to $2.6 billion in the third quarter of 2006.

Government contracts revenues increased 14.2% as expected in the third quarter of 2007 to $660.4 million from $578.5 million in the third quarter of 2006. The quarter-over-quarter increases in revenue were driven by higher expected healthcare costs in Q3 of '07 and a lower cost in revenue experienced in Q3 of 2006. We continue to expect that total consolidated revenues to be greater than $14 billion for the full year of 2007. As you can see, our topline continues to be very solid.

Total health plan enrollment increased 29,000 sequentially and 67,000 new members year-over-year. As Jay mentioned, these enrollment gains were primarily driven by strong growth at small group and individual, which showed increases of 51,000 new members sequentially and 83,000 members or 12.1% increases year-over-year

We continued our strong growth in our Medicare products. For MA, we grew 3,000 new members sequentially and over 42,000 or 21.3% increase year-over-year. For our PDP standalone business, membership grew 17,000 new members sequentially and over 24% or 71,000 members year-over-year. These membership gains and these targeted segments continue to reinforce our strategy around gross margin expansion and reduce our reliance on lower margin large group business.

Let me now turn your attention to yields. Our commercial yield continues to strengthen in line with our targeted segment strategy. Commercial yield was up 10.3%. This included the full impact of the Healthcare Solutions membership for the entire three quarter in the Northeast, right in line with our previous guidance.

Commercial healthcare costs rose 9.7% in the third quarter, also including the full impact for the quarter of the Healthcare Solutions membership, providing a positive spread for the quarter of 60 basis points. Again, this affirmed our commercial mix strategy and demonstrates our ongoing pricing discipline.

We continue to see moderate trends in commercial healthcare products though our results are influenced by the Healthcare Solutions membership. Excluding the Healthcare Solutions or Guardian impact, healthcare costs for physicians and hospital are up in the mid single digit digits and pharmacy in the low single digits. This is consistent with our view that commercial trends are moderate.

At present, we expect these moderate trends to continue in the next year. These moderate trends had obviously influenced our medical cost ratios. The overall health plan MCR in the quarter was flat with the prior year but better by 180 basis points sequentially.

Commercial MCR came in at 82.7%, 50 basis point better than the prior year and 180 basis point better sequentially. The year-over-year improvement was due to the shift in business mix, while a sequential improvement is consistent with the seasonal patterns and was helped by having a full quarter of the Healthcare Solutions small group book.

Both Medicare and Medicaid MCRs were higher than prior year in the quarter. This was anticipated due to our better than expected performance last year in Medicare and a slightly more challenging Medicaid environment, especially in Connecticut.

Our government contract activity, which includes our TRICARE contract, our Veterans Affairs businesses and MHNs continued expansion of providing behavioral health and life accounting service to DoD, had another outstanding quarter. The cost ratio at 92.9% was flat with June 2007 quarter and just a bit better than last year.

We are now in the fourth year of our five-year TRICARE contract and performance continues to be solid. Both our customer and our beneficiaries are clearly benefiting from the overall moderation in healthcare costs. We're also getting some incremental gains from the ongoing positive development from prior years in the contract. These benefits should continue in the fourth quarter, but we would expect them to start to moderate as we move in the next year.

Couple other P&L items that they're mentioning. Selling costs were up 40 basis point sequentially and 70 basis points year-over-year. The increase sequentially is primarily due to the addition of the California Farm Bureau book of business on July 1st, and a continued mix shift from larger group non-commission business to the individual and small group commission-based business. The year-over-year increase reflects these changes along with the addition of the 100% of the Guardian book included this year.

Investment income was up a bit sequentially, thanks to the uptick in short rates during the quarter. Depreciation was up as we've increased our IT investments in recent periods. Finally, on the P&L, amortization rose, recording a full quarter of a Guardian intangible. Expect this quarterly amortization level to be consistent going forward.

Let's now take a look at the balance sheet. It continues to be solid. Debt to total capital is a low 18.5%. We had about $80 million in cash at the parent at quarter end. We can easily fund the changes as we continue to have a strong cash flow. We have not used any of our $900 million credit line.

Clearly, the balance sheet can easily handle in more leverage while still being under our targeted 30%. Days claims payable on a GAAP basis, we're down by six-tenth of a day year-over-year and slightly up by two-tenth of a day sequentially. And adjusted reserves are sound.

We always include a supplemental DCP table to back out capitation, Part D, and this quarter, the charges. On that basis, DCP is about the same, down by a half day year-over-year and down six-tenth of a day sequentially. These minimum changes are very reassuring.

As you have all seen, most of the managed care companies received a late CMS payment. We did too and a late payment for our Medi-Cal book, causing operating cash to be negative by about 130 million in the quarter. Adding back the two late payments, it would have caused cash to be positive by over $200 million.

Depending on the progress of various matters covered by the charges, we could be required to make a large payment in the forth quarter. If that occurs, it will impact operating cash flow.

We are putting our cash to good use. We continue to repurchase stock. In the third quarter, we purchased 2.609 million shares at an average price of $52.94. In addition, we bought back over 353,000 shares in the month of October.

From November 2006, when we restarted our repurchase program through yesterday, we have bought back over 9.8 million shares at an average price of just over $49. Our remaining authorization, as Jay mentioned, is about $346 million after the recent board action. So we have plenty of room to be active going forward.

We have issued guidance in the release for a $10 in per diluted share earnings for the fourth quarter. That would get us to our $3.56 guidance for the full year. We continue to believe that our annual 15% earnings growth goal is attainable. We will provide more detail on our 2008 enrollment outlook, premiums, Medicare and TRICARE next week at Investor Day.

Right now, it looks like more the same with a strong Medicare growth. Improving commercial mix and continued margin improvement are the hallmarks of our story.

Let me close with just a few thoughts about the TRICARE reprocurement process. We don’t much more information today than we had when I spoke to you on the second quarter close except that we are still awaiting the issuance of the final RFP.

Based on past experience and the best available timing information received from DoD, we expect that a formal RFP will be released some time after Thanksgiving. If this does occur, then bids for the three regions would probably do in early 2008.

Given that schedule, the awards have to be made prior to May or June of next year for the contracts to be implemented on April 1st, 2009, the expiration of our current contract. Based on past experience, this continues to be an extremely tight schedule.

We are actively engaged in the process and have been preparing for the RFP response for the past 18 months. Based on the draft, it has been released. The basic geographies, statement of work activities are very similar to our current contract. Given that a formal RFP has not been issued, timing is still very uncertain.

As you are aware, the National Defense Authorization Act for 2007 does provide DoD with the authority to extend the current contracts for two additional years, one year at a time. Given our long, positive experience with TRICARE, we're confident that we'll be very competitive and expect to continue to be a primary contractor for DoD for many years to come.

We have an excellent partnership with our customer, and we are proud to be supporting the needs of the government and most importantly the healthcare needs of the military family.

With that, let me conclude by thanking all of you for your support during my tenure as Interim CFO. I especially want to thank the financial team here at Health Net. They have done an outstanding job and supported me for the past year. Thank you. I have enjoyed it.

I happily turn the reins over to Joe Capezza, our new CFO. During the past few months, I've gotten to know Joe personally and professionally. I am confident Joe will be a positive influence for our company and add real value for our shareholders, and more importantly, a trusted team member. I'll still be here, and I look forward to seeing all of you at Investor Day next week.

Thank you again. Operator, we can now turn it over to Q&A.

Question-and-Answer Session

Operator

Thank you. (Operators Instructions)

And we'll take our first question from Carl McDonald from CIBC. Please go ahead.

Carl McDonald - CIBC

Thank you. First question,. I just wanted an update on the competitive environment of California. I know the pricing situation was fairly favorable for most of 2007, relative to some increased competition in the prior year. So, as you get through the open enrollment season now, what are you seeing from a pricing perspective?

Jay Gellert

We believe that the pricing environment has stayed consistent with earlier this year and is stable by comparison to prior years.

Carl McDonald - CIBC

Okay. So no one out there is being terribly aggressive on a regular basis?

Jay Gellert

I think everyone's pricing sounds alike.

Carl McDonald - CIBC

Okay. And then on the TRICARE extension,..I know DoD has the ability to extend it for another year, and do that two times. Is that an all or nothing proposition, meaning could they come to you and say, “…the contract has expired on April 1^st; we want you to stick around for three more months…”, or does it have to be a year that's the only choice?

Jim Woys

There is a provision in the contract that allows the government to extend our contract one month at a time for up to six months. But that becomes a pretty difficult situation about how to negotiate that one month's time. But it is possible….

Carl McDonald - CIBC

Got it.

Jim Woys

…though we have not seen that exercised over in the past.

Carl McDonald - CIBC

And then, last one, really quick, I know you're going to give more details next week, but Medicare enrollment--directionally should we look for more growth in 2008 than we've seen in 2007?

Jay Gellert

At least similar growth. We'll be having more details next week.

Carl McDonald - CIBC

Okay. Thank you.

Operator

And we'll take our next question from Joseph France with Banc of America Securities.

Joseph France - Banc of America Securities

Thank you very much. I had just two quick questions. One is, what was the 9,000 life drop in the commercial side in Connecticut in the quarter?

Jay Gellert

It was primarily attrition kind of across the board. It was not any large accounts. There was some high more aggressive, more conservative pricing than we have in some places. So it was nothing specific.

Joseph France - Banc of America Securities

And have you taken an early look at large group enrollment in '08, give us some guidance for what that might look like in January?

Jay Gellert

Yes. The large group enrollment in January will be up and we'll have specific details on that next week.

Joseph France - Banc of America Securities

Thanks, Jay.

Jay Gellert

Thanks.

Operator

And we'll take our next question with John Rex with Bear Stearns. Please go ahead.

John Rex - Bear Stearns

Thanks. First question just on TRICARE, the book continues to outperform considerably every quarter and I record you are saying it's going to come down and it doesn't. Can you just through again why it's going to go down in the 1Q '07, what are your elements that would take it down from this run rate that appear to be sustainable?

Jay Gellert

Yes. Again, if we look at the TRICARE option periods, the option period ends in March for option period four. Again, the cost ratio, let me just remind everybody, the cost ratio that we look at not just includes TRICARE, but includes our business with the BA. And it also includes a growing piece of business that MHN is doing, providing behavioral and life counseling services to DoD. So that is adding a little bit to the margin and causing that ratio to look little more favorable than just the TRICARE contract.

On the TRICARE contract side, again, in option period four we're starting to see little favorable results as a result of healthcare cost. We've also continued to sort of cleanup the prior option period and seen the favorable results and kind of closing down the favorable adjustments from the prior option period. So we would expect that through Q4 that will probably look pretty close to what we look like today, and then it will start tailing off because option period five will start.

Unless we see some real favorable changes in where we're at in option period four, we wouldn't expect any sort of retroactive adjustments there. We are in the midst of negotiating option period five with the government right now. And at this time, we wouldn't know whether that would be anything that would cause us to be favorable or less favorable based upon negotiating the target healthcare cost.

John Rex - Bear Stearns

So should gross profit dollars kind of drop, so you've been running in the mid-40s and kind of signaling that ultimately that should return into the 30s? I mean, should that be dropping back into the mid 30s as you go into 2Q next year? Is that your expectation?

Jay Gellert

We'll give you more guidance next week at Investor Day. But I think that is directionally correct.

John Rex - Bear Stearns

Okay. And then a follow-up on your component cost trend comments. You talked about inpatient in mid single-digit, which would compare to the 9% trend you were talking about in the first half of '07. Just wondering if you could help us understand what cause such a big drop in inpatient trend.

Jay Gellert

Well, part of it is the result of the mix change. As you can see that with more of the nationwide business and the full Guardian business that it's a mix that has lower inpatient trend, but we're also seeing even when you gross it up in same store, probably 200 basis point kind of slowdown in the hospital trends.

John Rex - Bear Stearns

Is that all about bed debts?

Jay Gellert

It's utilization, but also even some unit cost. But that's always been leading us and that's always been in the double-digit region. And that's starting to come into the high single.

John Rex - Bear Stearns

But we can think about ex-Guardian and kind of if there are impacts, we can take about 200 basis point deceleration from kind of where you were in the first half?

Jay Gellert

Yes.

John Rex - Bear Stearns

Okay. And then just a last thing, just a little more clarity on the selling cost. I just want to make sure I understand as far as we think about it going forward. The commentary in the release seemed to indicate that it had a lot to do with strengthening partnerships with agents and brokers.

So I kind of took that to mean there was some kind of increase in commission that you are embedding in. But then the commentary you went through on the call seemed to attribute it all to the Guardian and the Farm Bureau. So I just want to make sure I understand the components and kind of run rate to think about and what was driving this?

Jay Gellert

The second explanation, the one given on the call is the correct interpretation. So it's primarily the fact that in the case of Farm Bureau business, we had 50,000 from brokered lives, and they basically replaced that one large account we talked about, which wasn't brokered.

And then the full Guardian -- and there was reconciliation of a couple of million dollars that's one time in terms of that selling cost accounts. So it's ongoing with the exception of that reconciliation.

John Rex - Bear Stearns

Okay. This is the right run rate. And it's not so much about just that you changed your commission structure then?

Jay Gellert

No. It in fact -- the 12.1% we talked about in terms of the growth in that segment is commissioned business, and it replaced the non-commission business.

John Rex - Bear Stearns

Great. Thank you

Operator

And we'll take our next question from Scott Fidel with Deutsche Bank. Please go ahead.

Scott Fidel - Deutsche Bank

Thanks. Good morning. First question, just if can you give an update around the California fires and just interested if you all see any impact around 4Q around cost trends in terms of thinking? Do you think they might come in a bit abnormally low in 4Q, just given maybe a drop in utilization there or have you seen pretty consistent trend there, just some thoughts on that?

Jay Gellert

Yes. I think it's too early to really tell on the implications. At this point, you know, it was in many ways kind of I think well intent, a relatively brief interruption. So at this point, we are not anticipating any change.

Also, in our case, you have to bear in mind that a lot our physician costs are capitated. So they would not be affected by those circumstances. And it's not our anticipation that hospitalization for example would be effective by that at this time. So we are operating on the assumption that, you know, it's conceivable, that we could see some effect, but we are not counting on it.

Scott Fidel - Deutsche Bank

Okay. And then just to follow up on the question around just price competition, and you talked about California. Just give us an update on what you are seeing in the Northeast markets as folks are pricing for 2008, maybe breakout New York, New Jersey and Connecticut.

Jay Gellert

I think everyone has indicated that New Jersey is a competitive environment, and we don't see any change in that. We see New York as fairly stable. To Joe France's earlier question, there were some instances where people are making some "competitive forays" in Connecticut. And we're maintaining our pricing discipline, but we don't see those as long-term or disruptive. So I guess overall, it's pretty much the same as it's been.

Scott Fidel - Deutsche Bank

Okay. And Jay, just on New Jersey, is it Horizon that you are seeing driving the competition there or any changes from any other public competitors?

Jay Gellert

Well, we are really careful not to specifically highlight companies. But I would say that it's more of the non-profit competitors in the forefront.

Scott Fidel - Deutsche Bank

Okay. And then just a last question, just do you have what the Medicaid and Medicare MLRs were in the third quarter relative to the third quarter of last year?

Jay Gellert

I think David will follow up with you if that's okay.

Scott Fidel - Deutsche Bank

All right.

Jay Gellert

Take it.

Scott Fidel - Deutsche Bank

Or do you want to just give it?

David Olson

Yes, I will just give it to you.

Scott Fidel - Deutsche Bank

Just give it.

Jay Gellert

Okay. We are going to give it.

David Olson

So just going through, in the commercial MCR was 82.7%. Our MA Medicare MCR was 86.1%. Our PDP MCR was 67.1%. Our Medicaid MCR was 82.1%. And the total MCR for our health plan business is 82.9.

Scott Fidel - Deutsche Bank

Great. Helpful. Okay. Thank you.

David Olson

And the commercial excludes all the charges. All the charges were allotted to the commercial line.

Scott Fidel - Deutsche Bank

Okay.

Operator

(Operators Instructions)

We'll take our next question from Will Georges with JP Morgan. Please go ahead.

Will Georges - JP Morgan

Thanks. Good morning. I am wondering if you could just help out with some still high level metrics around your '08 guidance. Just in terms of the revenue line, because you talk about yields remaining essentially stable with '07. Is that correct?

Jay Gellert

No, I think we indicated we'd be right side up in '08.

Will Georges - JP Morgan

Okay. And how about as far as membership is concerned? I am assuming that the membership acceleration that you have experienced will continue.

Jay Gellert

I think that we anticipate that membership acceleration on commercial side will be close a little as for our plans dealt around that we continue to see the Medicare increases that we've seen. And then Medicaid, there may still be some culling, but basically stable.

Will Georges - JP Morgan

Okay. And then as we lump all of those factors together, how do you see the topline growing in 2008, high single…

Jay Gellert

No. We see the topline in the 10 to low teens range.

Will Georges - JP Morgan

10 to low teens, okay. And then just a quick question. Looking at prior period development, I think that, if I'm doing the math right, this is the second quarter where you've shown some modest negative PPD. I am wondering can you give us a little bit of color around what's going on.

Jay Gellert

Yeah. As we indicated in the last quarter, we're cleaning up some of the old accounts that we dropped, 11 and 71. And so there is a little bit of that activity in there, but it's very minimal in Q3.

Will Georges - JP Morgan

And should we expect that to dissipate then in the fourth quarter?

Jay Gellert

Yes.

Will Georges - JP Morgan

Okay, great. Thanks very much.

Operator

Thank you. And we'll take our next question with Josh Raskin with Lehman Brothers. Please go ahead.

Josh Raskin - Lehman Brothers

Hi, thanks. First question just on the charge, I think Jim you mentioned as a potential count in the fourth quarter, but what are the total cash portion to that?

Jim Woys

The after-tax numbers is just rough $200 million.

Josh Raskin - Lehman Brothers

Okay. So that's all the cash balance.

Jim Woys

Yes. And it will be paid down over different periods.

Josh Raskin - Lehman Brothers

Okay. That's helpful. And then second question just on the Guardian relationship, any way to give an impact? What was the sort of basis point impact on the yield and the cost from Guardian?

Jay Gellert

Yeah. I don't think we have it exactly here. We can get that to you, but it had a significant effect.

Josh Raskin - Lehman Brothers

Okay.

Jay Gellert

Yeah. Let us get it to you, so we give you the exact numbers.

Josh Raskin - Lehman Brothers

Okay, I'll get that off. Okay, I'm off. Thanks.

Operator

And we'll take our next question with Justin Lake with UBS. Please go ahead.

Justin Lake - UBS

Thanks. Just a quick follow-up on TRICARE, you mentioned there were some prior year development in TRICARE throwing up some cost, can you tell us how much of that contributed to the quarter?

Jim Woys

It contributed -- I have the exact number -- it was around $10 million.

Justin Lake - UBS

$10 million, okay. So when we think about the run rate for the fourth quarter, should we expect that kind of contribution again in the fourth quarter?

Jim Woys

At this point, I think it will be less than that.

Justin Lake - UBS

Okay. And I know the official RFP has not come out yet, but the RFI looks like there might be some significant changes in the structure of a contract, basically moving it from looking more like a risk contract to more like an ASO contract.

I'm sure you've had some commentary around that, I guess moving into an ASO contract, and then also looks like the cash requirements on that contract, as far as moving from payments. I think the government pays you within the five days to moving it's out to 25 to 30, which would be significantly detrimental from a cash flow standpoint.

Can you tell us in what kind of feedback you've given the government and how responsible they've been to those?

Jim Woys

Well, we've made comments on all those financial issues around the model to our customer. And the way that we do that, you have to submit those issues and comments directly to the customers via the website. There has been, because of the pyramid and the sensitive nature that the government doesn't respond back to us, so we don't know what they have taken into account.

I believe probably other companies within the industry will probably make some more comments. So we are sort of anxiously awaiting what the final RFP would look like subject to probably the hundreds, maybe thousands of comments that the government receives concerning what the draft RFI look like and would expect that the final RFP would make some changes.

I can't comment on what they will make, but the reason I weigh the industry performance was for things like that to understand what the impact to beat the industry and how will it impact competition. So I would expect that some of those set draft RFI would change when the final RFP comes up that we have no really insight into what it will look like.

Justin Lake - UBS

Are those changes something that the governments ever tried to make in the pastor the military's tried to make as far as taking away some of the risk sharing and things like that?

Jim Woys

I think over the history of the program, over the last 20 years, has been -- the TRICARE business has been reprocured four times in that period. There has been -- we have seen historically a draft RFP or an RFI that has come out that has got the industry common and there has been historically changes, even material changes made during that common period that then turned into a more like a contractor-friendly RFP.

So they have tried to make similar sort of adjustments in past and even the past, even more radical than this. And they have adjusted it, you know, in the other direction.

But again, I think this is -- our customer is out there trying to figure out what to do to best manage their program. You know, we will try to give comments about what's best what we think for industry. But it at the end of the day, we are going to support our customer, and we are going to continue to meet this business end and be successful in the reprocurement.

Justin Lake - UBS

That's helpful. Just two other quick questions. One, on the commercial membership, can you tell us if -- and obviously, you have a big win with the Farm Bureau. Can you tell us if there are any offsetting losses in the individual and small group?

Jay Gellert

No

Justin Lake - UBS

There weren't. So what if -- we've looked at, it would seem that the individual and small group was down ex that Slate win. Is there anything in particular given that you can't seek momentum there sequentially?

Jay Gellert

Yes, the small group and individual is sequentially up 51,000 members.

Justin Lake - UBS

Sure

Jay Gellert

So it's down by about 3,000 in Connecticut and New Jersey. So when you put it together, I think that Farm Bureau really came in it like 57 or 58. So I think it pretty much balances out.

Justin Lake - UBS

Okay. So California ex-Farm Bureau was relatively flat this quarter?

Jay Gellert

Yes, in fact, it's up 52,000 members. I mean it was relatively flat as compared to Farm Bureau.

Justin Lake - UBS

Okay. And last question just on the EPS target reaffirming at 15%. Does that include or exclude capital reinvestment, share repurchases or so?

Jay Gellert

Yes. We'll talk about it more on Investor Day, but we do anticipate making some share repurchases, as we said.

Justin Lake - UBS

Okay. Great. Thank you

Operator

And we'll take our next question from Matthew Borsch with Goldman Sachs. Please go ahead

Matthew Borsch - Goldman Sachs

Yes. If I could ask a question just on your outlook for Medicare profit margins, just directionally do you expect Medicare advantage and Medicare drug plan margins to be moving up going into next year?

Jay Gellert

No.

Matthew Borsch - Goldman Sachs

No. Okay. Down?

Jay Gellert

Maybe down slightly, but in the range of flat-to-down maybe a little.

Matthew Borsch - Goldman Sachs

And commercial will be going up?

Jay Gellert

Yes.

Matthew Borsch - Goldman Sachs

Okay. And what -- in Connecticut Medicaid, have you been approached by the State regarding potentially assuming enrollment from another plan?

Jay Gellert

We have enough trouble with our own enrollment.

Matthew Borsch - Goldman Sachs

Okay. Fair enough. And what are you seeing from some of your employer customers if you can generalize a trend in terms of benefit buy-downs, cost shifting going into next year, you know, relative maybe the trend in the last couple of years? Any changes there?

Jay Gellert

We are not -- we are seeing a stable to a little bit, even less progressive just going in to this year.

Matthew Borsch - Goldman Sachs

Okay. And last question here. Can you comment on any of the other components of medical cost trend? There was interesting commentary on in-patient, but may be on the same-store basis, is any thing else up or down relative to your last view on it?

Jay Gellert

Well, we have consistently had good pharmaceutical results, and they continue. Division trend is maybe flat to up a little bit, but not significant.

Matthew Borsch - Goldman Sachs

Okay. Okay. Got it. Okay. Thank you.

Operator

(Operators Instructions)

We will take our next question with Christine Arnold with Morgan Stanley. Please go ahead.

Christine Arnold - Morgan Stanley

Thank you. Good afternoon. The commercial NOI, you said it was going to be kind of right size up. Should we think 30 to 50 basis points, which has been kind of your historically your view of target?

Jay Gellert

Yes.

Christine Arnold - Morgan Stanley

Okay. And then on…

Jay Gellert

It's good morning still. It's good morning here. It's good morning where you are.

Christine Arnold - Morgan Stanley

Sorry. Moving forward in the day. On TRICARE, in terms of your guidance is to kind of expect cover loss ratio to go up next year, because you are not anticipating the same kind of positive development. But given what you're seeing on hospital costs, this year they came down through this year, are you building in conservatism in your TRICARE expectations or is there something offsetting what would intuitively result in more positive development next year?

Jay Gellert

Yes, hi, Christine. The issue around TRICARE is a little bit around the commercial side. We are in mid-negotiations with our customer about what the target healthcare cost would look like in option period five. In doing so, both our customer and us lay out all of the best information available.

So that gets taken into account as we see mitigation of the hospital trends or physician trends or ancillary or pharmacy. Whatever that's included is laid out in front of our customer, and we negotiate what we think the most reasonable sort of where the trend would be, including all components going forward starting April 1st of next year.

Christine Arnold - Morgan Stanley

So are you anticipating kind of a lower margin for option period five offsetting positive development? Is that what I am hearing?

Jay Gellert

Well, what I said is that the option period five, we would expect as we move into next year with no other information and the best information we used in negotiating with our customer is that we would expect we would hit the healthcare cost target, which would be about 5.5% margin on our TRICARE business. And right now, we're experiencing higher net because of the favorable development.

Christine Arnold - Morgan Stanley

Okay. So you are saying that your negotiations for period five include the fact that cost trends have been lower.

Jay Gellert

Yes, that's correct.

Christine Arnold - Morgan Stanley

And so we would expect option period five margin to be lower. And then whatever we get in positive developments extern over that.

Jay Gellert

That's correct.

Christine Arnold - Morgan Stanley

Okay. So the period five margin will be lower and offset positive development. And then a final question, did you say you have some one-time selling cost in the quarter and were there any transitional G&A costs to go away related to the full taking on of Guardian?

Jay Gellert

Well, with regard to the part-time selling cost, a couple of $3 million, so they really kind of relatively material. But they are one-time. With regard to Guardian, you know, I think that we don't anticipate seeing any significant change in the SG&A and going into next year.

Christine Arnold - Morgan Stanley

Okay. And assuming it was selling, correct?

Jay Gellert

What? Yes, it was.

Christine Arnold - Morgan Stanley

Perfect. Thank you.

Operator

And we'll take our next question from Tom Carroll with Stifel Nicolaus. Please go ahead.

Tom Carroll - Stifel Nicolaus

Hi. Good morning. A quick question on the litigation or the settlement again and your continuing litigations in some other areas, excluding everything that has been highlighted today, of the litigation items that are remaining out there outstanding, I guess two numbers I am looking for. How much could go against the company? So may be a worst case scenario, a dollar number?

And then how much has currently been reserved of that dollar amount? So for example, in the AmCare co-litigation, it looks like I guess the worst case number would be like $109 million and you've reserved in the neighborhood of like $16 million. Can you maybe give us some more color on that?

Jay Gellert

You know, with regard to the litigation, we really work hard to make expenses disclosures in the Qs and Ks. And I think it's best that we have our comment to those disclosures.

Tom Carroll - Stifel Nicolaus

Okay. That's fine. That's very good. We have been looking at those. I appreciate them. And the secondly, I guess following on Christine's question on TRICARE as well as John's, would you say that your positive cost ratio experience this quarter in TRICARE was unexpected?

Jay Gellert

Not particularly. I think we -- it is little higher than expected, primarily because we did see some nice improvements. And again, it's not just a TRICARE. Again, it's again the cost ratio, which includes the business that we are doing through MHN, which has some really nice improvement there.

We've got a nice contract of DoD to do family life counseling with MHN, and that is growing just about everyday and servicing the needs of the military family there and the returning of warriors. So that's a piece of that, and that's probably is about 90 bips for the quarter. It was probably a little better than we expected other than, you know, the positive development of sort of prior periods or prior contract periods. We knew some of that was going to happen maybe a little better than we expected. But it's fairly on line with our expectations.

Tom Carroll - Stifel Nicolaus

Okay. So I guess my thought was your prior expectations were for it to be ticking up in third and fourth quarter.

Jay Gellert

Yes, I think the mental health is really what is driving it, the positive surprise, which I think we anticipate to be ongoing.

Tom Carroll - Stifel Nicolaus

Okay. Thank you.

Operator

And that does conclude our question-and-answer session. I would like to turn it back over management for any additional or closing remarks.

David Olson

Thank you very much. Here, we want just to remind you all, next Friday, November 9th, we are having our Annual Investor Day at the Millennium Hotel in New York. If you haven't responded yet, please do so as soon as possible to us. The phone numbers and email addresses are on the press release. So let us know quickly if you are going to make it, and we look forward to seeing all of you next week in New York.

Jay Gellert

Tickets are going fast.

David Olson

Yes.

Jay Gellert

Thank you.

Operator

Once again, ladies and gentlemen, this will conclude today's conference. We thank you for your participation. You may now disconnect.

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