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Magellan Health Services (NASDAQ:MGLN)

Q3 2007 Earnings Call

November 02, 2007 9:30 am ET

Executives

Melissa Rose - Senior Vice President of Financial Planning and Investor Relations

Steve Shulman - Chairman and Chief Executive Officer

Rene Lerer - President and Chief Operating Officer

Mark Demilio - Chief Financial Officer

Analysts

Josh Raskin - Lehman Brothers

Michael Glynn - Credit Suisse

Melissa Jaffe - Merrill Lynch

Michael Yuan - Banc of America Securities

Brian - Raymond James

Operator

Ladies and Gentlemen, thank you for standing by. At this time all participants are in a listen only mode (Operator Instructions). Today's conference is being recorded. If anyone has any objections they may disconnect at this time.

I would like to introduce Miss Melissa Rose, Senior Vice President of Financial Planning and Investor Relations. You may begin.

Melissa Rose

Thank you. Good morning and welcome to Magellan's Third Quarter 2007 Earnings Conference Call. This is Melissa Rose, Senior Vice President Investor Relations for Magellan Health Services. And here with me today are Magellan's Chairman and CEO, Steve Shulman, our President and Chief Operating Officer, Rene Lerer, and our Chief Financial Officer, Mark Demilio. They will discuss the financial and operational results of our third quarter ending September 30, 2007

Certain of the statements made during this conference call are forward-looking statements contemplated under the Private Securities Litigation Reform Act of 1995. These forward-looking statements are subject to known and unknown uncertainties and risks, which could cause actual results to differ materially from those discussed.

These forward-looking statements are qualified in their entirety by the complete discussion of the risks set forth in the caption risk factors in Magellan's annual report on Form 10-K for the year ended December 31, 2006, which was filed with the Securities Exchange Commission on February 28, 2007 and also discussed in the 10-Q that we filed with the SEC later today.

Also please note that in this call we refer to segment profit. A reconciliation of the segment profit is the most directly comparable GAAP financial measure. Please see our form 10-Q for the quarter ended September 30, 2007, which you will be able to fine on our website under magellanhealth.com investor info.

I will turn the call over now to our Chairman and CEO Steve Shulman. Thank you.

Steven Schulman

Good morning everyone and thank you for joining us today. As you saw the press release issued this morning, we produced $57.4 million in segment profit in the third quarter ending September 30, 2007. Based on the strong quarter, we are raising our guidance to $215 million to $225 million of segment profit, for 2007 from $180 million to $200 million.

The two primary items driving the stronger than projected third quarter results include $6 million of favorable pride period care development primarily in our health plan segment, of the of which $4.9 million related to 2007 and $1.1 million related to the prior year.

In addition, the quarter's financial results were more favorable than we had originally estimated due to higher than projected membership and lower than projected start up costs related to our new Maricopa County Medicaid contract.

However, we are focused on ICOR, given its continued lag versus expectations and I will discuss this more in a moment. First let me spend a few minutes updating you on the successful implementation of the Maricopa contract, which went live on September 1st. With analyzed revenue of approximately $580 million, this contract is larger than we had originally projected and it is the largest behavioral care contract carve-out in the United States for Medicaid.

The size and complexity provided a significant operational challenge for our team, given a very short implementation time line. In only 59 business days our team was challenged with building out a service center, preparing to take on 23 clinics and an urgent care center, and working with community and the new governance board to ensure a smooth transition.

I am very pleased to report that the implementation has gone quite well. Thanks to the diligent work of hundreds of Magellan employees. We implemented this contract quickly and efficiently, while at the same time keeping up our service metrics for the rest of our Magellan customers around the country.

Our success is a testament to our national scale, our very strong operational infrastructure and expertise in implementing and managing large and complex specialty managed care contracts. The local response for Magellan has been very positive and was exemplified in a guest editorial by Susan Gerard, the Director of the Arizona Health Services that appeared in the Arizona Republican on September 28.

Miss Gerard, stated in her editorial, they, being Magellan, are off to a tremendous start and we look forward to working with them in the early phases of the transition and in the implement of their contract as they work to serve the people of Arizona.

In addition to a smooth operational implementation, we are also very pleased that start up expense related to Maricopa came in lower than originally projected. In addition, operating results were better than expected due to higher than projected membership and earlier than anticipated impact from management of the contract.

As you may recall, we’d projected that the initial month of the contracted would be less profitable than the contract would be at a mature state, due to our expectation that we would not be at optimal efficiency of managing care during the early months of the contract, while we have not yet achieved run rate efficiency, we have performed better than originally projected during the start up period.

This better than previously paid operational performance for Maricopa during its start up phase is projected to continue in the fourth quarter. This combined with lower implementation costs are contributing to our increased guidance for the year. A final note on Maricopa relates to the protest. The contract award was originally protested by the two other bidders. Both protests have been dropped.

Other news in our behavior health business includes the State of Tennessee's recent announcement that it was releasing RFPs for integrated and behavioral medical behavioral bids for the east and west regions in mid to late November.

The state has not announced the award dates or start dates of the contract. We estimate, based on the time line of the previous award in the middle region that the start date would be no earlier than the fourth quarter ‘08 and very possibly not until early 2009.

We have entered into an agreement to partner with the health plan to bid on the regions. Our partner has asked we keep its identity confidential. It is important to note that we have had partnership conversations with several firms and that we have chosen our current partner based on their strong managed care and Medicaid capabilities in our confidence on their commitment to bidding on both regions in the RFP

Revenues from our current TennCare contract equals approximately $275 million, which includes approximately $19 million that we continue to manage for certain populations in the middle region, even though the rest of that has moved over to the other vendors.

The remaining $256 million represents the revenue from the east and west region. Approximately, $20 million of this revenue pertains to certain children categories in the east and the west regions, similar to those that have continued to be carved-out to Magellan in the middle region at this time. It is unclear if these categories will continue to be served by Magellan or if they will roll into the new contracts in the east and west regions.

However, based on what has occurred in the middle region with this population, we think it's likely we retain this business on a carved-out basis. Let me also give you an update on our radiology business. Why the implementation of the Maricopa Behavioral Contract has been a major event for us this summer it certainly has not been the only major implementation under way.

As we discussed in last quarter a call the CIGNA implementation began in June with seven of the 15 markets beginning June 1st, and an eighth market beginning in July. A ninth market has been implemented in September. As we stated in our last call, we expect four of the remaining markets to be implement by early 2008, with the remaining two, primarily ASO markets, being implemented sometime in 2008.

In addition, our Empire Radiology contract successfully converted to our risk contract on July 1st. Service for both the Empire and CIGNA contracts have gone very well since the implementations. Financially this quarter's care, as we had projected, was negatively impacted by the building of IB&R reserves.

While it is still too early for us to be completely be certain of the financial performance of the contracts, based on both claims and authorization data, early indications are that the overall risk radiology business is performing on track and within the range we had expected.

Given that carving out risk for these contracts is a new process for both Magellan and for our customers, we are taking some extra time to fully reconcile and analyze the initial months of claims. The process is working well and we are developing a solid foundation for future analysis.

With the implementations for these two large contracts successfully under way, we are increasing our marketing efforts and are actively pursuing new radiology management business for 2008.

Moving to specialty pharmacy, ICORE's performance this quarter has continued to lag our expectations. Our investment was predicated on ICORE's differentiated ability to bring formulary rebates to the pharmaceutical industry. As we discussed last quarter our rebate business is performing on target. However, our distribution and consulting revenues are lagging our projections.

We believe that we could successfully integrate rebates and distribution capabilities into a competitively advantaged product. Distribution continues to be impacted by slower than anticipated ramp in our new distribution contracts.

In addition, both the distribution and consulting businesses have not achieved their respective new business targets in 2007. The consulting contract has been adversely affected in part due to increased concerns for manufacturers about having consulting relationships with the same vendor, which it contracts to rebates. This is adversely impacted ICORE's consulting business.

Finally, our distribution, rebate and consulting businesses have all been adversely impacted by the restrictions on erythropoietin stimulating agents, ESA drugs, in 2007 than we had originally anticipated.

Earlier this year we had reduced provider-describing patterns for the drugs more significantly than we had previously anticipated and we are projecting further reduction in usage in the fourth quarter. As a result of these issues, we are further reducing our guidance for ICORE in 2007 and we are now projecting a segment profit of $17 million to $20 million.

Clearly, this performance is very disappointing, and unacceptable to management. Given that we have not seen the growth in ICOR business that his we had projected for 2007, we have been aggressively working on evaluating and go adjusting our strategy and tactics for growing this business, which includes going back to the roots of ICORE's historical success and focusing on the rebate market.

We remain interested in the distribution market and will be opportunistic in this area. We will continue to focus on the rebate segment of the business and tie in the distribution where appropriate and feasible.

As we move forward, we are also increasing our sales resources in the areas of distribution and consulting. This includes significantly reducing the operational responsibilities of key executives in these areas so that they can focus on business development.

With our increased resources and improved focus, we are confident that we are hitting the 2008 sales cycle with improved efficiency and focus, which will drive improved earnings growth. While the ICOR performance is disappointing, this year's overall business is thriving and we are significantly raising our 2007 guidance.

Given the strong third quarter, we are increasing it, as I said earlier to $215 million to $225 million of segment profit, including Maricopa start up in operating results. Driven by solid performance in both our behavioral and radiology businesses, we are performing in total well ahead of previous projections and we are projecting much of the strong performance to continue into the fourth quarter.

Our health plan segment has been running favorably this year due to lower than projected costs and we have projected this to continue in the fourth quarter.

In public sector, the increased membership of Maricopa and the fact that the implementation and ramp up of our managed care factors in Maricopa are proceeding faster than previously projected, which will cause this segment to perform better than previously projected. Combined, this strong performance has led us to significantly increase our guidance for the year.

Let me now turn the call over to our CFO, Mark Demilio who will walk through additional details on the third quarter financial results, our 2007 guidance and our 2008 preliminary outlook. Mark?

Mark Demilio

Thank you, Steve.

Good morning, everyone. As indicated in the press release issued this morning our segment profit for the third quarter of 2007 was $57.4 million. As Melissa stated earlier, segment profit is disclosed and defined in our quarterly reports on Form 10-Q and our annual report on Form 10-K and is equal to net revenues, less costs of care and cost of goods sold, direct service costs and other operating expenses, excluding stock compensation expense, plus equity and earnings of unconsolidated subsidiaries.

Included in the tables for our press release issued this morning and to be included in our form 10-Q to be filed later today, is the reconciliation from segment profits of a line item income from continuing operations before income impacted and minority interest. We encourage you to review such reconciliation for an understanding of how segment profit compares to that GAAP measure.

Revenues in the third quarter 2007 were $558.1million versus $429.5 million for the quarter ended September 30, 2006. The revenue increase resulted primarily from new business added the since the prior year quarter of $144.2 million, including the conversion of radiology benefits management ASO contract to a risk basis effective July 1, 2007.

Favorable specialty pharmaceutical management revenue of $24.4 million due primarily to only two months of operating results incurred in the prior year quarter. Favorable rate changes of $9.4 million, same-store membership increases of $5.2 million and other net increases of $3.4 million. These increases were partially offset by the loss of membership due to contract terminations of $58.0 million.

Net income for the third quarter of 2007 was $25.1million or $0.63 per share on a diluted basis. For the third quarter of 2006, the company's net income was $21.2 million or $0.54 cents per share on a diluted basis. As stated, segment profit was $57.4 million for the third quarter of 2007, compared to $54.6 million for the third quarter of 2006. Segment profit for the nine months ended September 30, 2007 was $157 million.

In the nine months ended September 30, 2006 segment profit was $154 million. Segment profit for the health plan segment increased by $7.8 million from the prior year. This increase is mainly due to the net favorable impact of care development between the quarters of $9.1 million, which includes favorable development in the current quarter of $5.4 million plus the unfavorable development in the prior year quarter of $3.7 million, as well as profitability from new business and same-store member increases, which increases were partially offset by the impact of contract terminations.

Current year third quarter segment profit for the employer segment is $9.4 million, which is $700,000 better than the prior year, mainly due to favorable care development in the current year quarter. Segment profit for the public sector segment is $11.8 million lower than the prior year third quarter.

This decrease is mainly due to the net impact in the current quarter of the Maricopa contract, including implementation costs, the impact of decreased membership from TennCare Middle Grand Region and other membership decreases and the impact of out of period care development with respect to the prior year quarter.

As set forth our press release this morning and as Steve just explained we have increased our fiscal 2007 guidance to a range of $215 million to $225 million of segment profit and $2.13 to $2.39 of earnings per diluted share. This shift in the range is based on the results for the nine months and the expected continuation of certain of the factors causing such results.

In particular, the improved care trend in the health plan segment, which was demonstrated by the favorable prior period development, as well as the lower care trend in the quarter and which we are now projecting to continue into the fourth quarter.

The other major factor contributing to the increase there guidance is the favorable change in our expectations for the Maricopa County contract, due to improved operating results, based primarily on higher membership and an earlier than projected impact on managing the contract, both of which impacts will continue into the fourth quarter.

And to lower estimated implementation costs substantially all of which have been incurred in the third quarter. While we did not provide individual contract profitability as we previously stated this contract has a limit on profitability, which is 4% to 5% on a tax effective basis.

The Radiology Benefits Management segment profit for the third quarter of 2007 increased by $4.1million from the third quarter of 2006 mainly due to results experienced from the two risk contracts, which were implemented since the prior quarter. As Steve discussed, the radiology segment continues to track with our expectations and the guidance we previously provided of $7 million to $12 million in segment profit for 2007.

Specialty Pharmaceutical Management segment profit was $4.6 million compared to $4.2 million in the prior year quarter. As you know, we did not acquire ICORE until July 31 of 2006 and therefore there were only two months of results for this segment in last year's segment profit.

The current year results were negatively impacted compared to the prior year by the reduction in distribution rebate and the consulting revenue from the ESA drug class and the reduction in consulting revenue from certain drug manufacturers that if determined did not continue with rebate and consulting arrangements with the same vendor.

As Steve mentioned, due to these factors and the lower than expected growth, we are reducing our previous estimate of segment profit for this segment in 2007. We now expect this segment to generate $17 million to $20 million of segment profit in 2007.

Corporate and administrative costs, excluding stock compensation expense for the third quarter were $1.6 million less than the third quarter of 2007, primarily due to a decrease in fixed asset disposals of $1 million from the prior year quarter and other net decreases of $600,000.

The total direct service and operating expenses, excluding stock compensation expense were 16.9% of revenue in the current year quarter compared to 20.4% in last year's quarter. This decrease is primarily due to our ability to leverage our operating and corporate infrastructure, as we added the Radiology Management and Specialty Pharmaceutical segments and the additional revenue provided by the Maricopa contract.

In the third quarter of 2007, we recognized $8.2 million of stock compensation expense in the prior year quarter we recognized $8.9 million of such expense. The decrease is mainly due to stock options issued to management upon emergence from bankruptcy, which were fully expensed prior to the current year quarter, which was partially offset by a full quarter of expense for the restricted stock issued to management of ICOR prior to acquisition on July 31, 2006.

Depreciation and amortization expense was $14.4 million for the third quarter of ‘07 compared to $13.1 million in the prior year period. The increase is primarily due to current year capital expenditures as well as a full quarter depreciation of assets acquired in the ICOR acquisition.

Interest expense was $1.6 million for the third quarter of '07, which is down slightly from $1.8 million in the last year's third quarter due to the scheduled debt payments we have made since last year's third quarter. Interest income was $6.4 million for the current year quarter, compared to $3.4 million for the prior year quarter and this increase is mainly due to increases in yields on invested balances and an increase in average invested balances.

The effective income tax rate for the nine months ending September 30, 2007 was 40%. As, the effective income tax rate varies from federal, state statutory income tax rate primarily due to state income taxes and to permanent difference between book and tax income. Our effective rate will vary from period to period depending upon the amount of permanent to book to tax differences realized during the period.

Our effective rate for the nine months reflects our anticipated effective rate for the full year of 2007. So our estimated rate of 40% has decreased from our previous estimate of 42% due to clarification of certain tax positions on 2006 state tax returns that were filed during the third quarter. Our effective rate for the third quarter was 37%, which reflects the impact of changing our estimates for the year from 42% to 40%.

Turning to cash flow and balance sheet highlights, our cash flow from operations for the nine months ended September 30, 2007 was $152.5 million, which was $20.6 million higher than the prior year period. The variance relates primarily to lower payments associated with claims run out for terminated contracts, with prior period and current period run out payments of $23.5 million and $8.1million respectively.

In addition, the current year period was positively impacted by the build-up of IB& R associated with the new risk radiology business. Partially offsetting these positive items is the company's funding of $15 million relating to the initial capitalization of the regulated subsidiary that is responsible for managing the Maricopa County contract.

The company will make an additional capital contribution to such subsidiary in the fourth quarter with such additional amount estimated to be $30 million. In total the Maricopa regulatory cash requirements are estimated to be $5 million higher than what was discussed during last quarter's call. With such increase driven by the size of the contract being larger than estimated as previously discussed.

Also, during the fort quarter, the company will make an estimated payment of $13 million to the previous unit quarters of ICOR. This payment relates to a final settlement of working capital pursuant to the purchase agreement.

As of September 30, 2007, our unrestricted cash in investments totaled $300.3 million, which balance consists of $278.5 of unrestricted cash and $21.8 million of unrestricted short-term investments. Approximately $60 million of the total unrestricted cash in investments at September 30 was held at regulated subsidiaries.

We are projecting cash flow from operations for the year of $175 million to $205 million and net cash flow of $105 million to $135 million, which amounts are higher than discussed last quarter, principally due to the increase in our segment profit guidance. In total, we expect our capital expenditures for the year to be approximately $42 million to $52 million, $32 million of which were incurred through September 30, 2007.

Based on this cash flow projection, our unrestricted cash and investments balance at year-end is expected to be $290 million to $320 million. Again this cash amount includes unrestricted cash at regulated subsidiaries.

As of September 30, 2007, total long-term debt was $21.5 million, including the current portion of such debt of $20.2 million. The total debt consists of $18.1million of term loans under our credit facility, and $2.7 million of capital lease obligations.

Before I turn the call back to Steve, I would like to briefly comment on our outlook for 2008. As, we will provide 2008 guidance in December as we typically do every year. However, we wanted to let you know our preliminary thoughts on 2008 based on our forecast and go budgeting process to date. While this process is not yet complete, we have estimated the impact of the several factors that will affect 2008.

As set forth in the press release, these major factors include new business, including the impact of a full year of the results of the risk radiology, Maricopa County and other contracts implemented in 2007, as well as sold and unsold new business to be implemented in 2008.

Terminated contracts, including the Anthem and TennCare Middle Region contracts, which terminated as of March 31, 2007 and the Empire Behavioral and Blue Cross Blue Shield of Massachusetts contracts that will terminate as of January 1, 2008 as we previously announced, and the rate adjustments for 2008 with respect to behavioral business.

Some of these rate adjustments are the result of next year's rates reflecting the lower care trend, while the rates this year were set based on an assumption of a higher care trend than ultimately experienced. Other rate adjustments, such as the case with a recent rate change in our TennCare contracts are a reduction in margin.

We estimate at this point that the netted impact of these and other factors is that our 2008 segment profit will be slightly less than our expected segment profit for 2007. We will provide more detail on these factors and on you are on estimate of 2008-segment profit when we provide our guidance in December.

At this point I would like to turn the call back over to Steve. Steve.

Steven Schulman

Thanks, Mark. Before we close today, I want to spend a few minutes discussing our strategy and updating you on our current position on our capital deployment initiatives. Our strategy for the past several years, as well as today, is to leverage Magellan's strong and efficient platform by accelerating growth organically and through acquisitions to supplement our more mature business lines.

Our flat platform is comprised of our operational infrastructure, customer base, management team and balance sheet. Our focus is on growth by expanding our existing markets as well as entering into new, high growth areas of healthcare with the goal of accelerating our overall growth rate.

When possible, as in NIA's case, we have successfully integrated their total infrastructure. That is, their IT, customer service, claims, financial, HR, legal etcetera, on to our existing platform. Therefore the integration work is complete and on the Magellan existing infrastructure.

In ICOR's case, we have integrated their IT, finance, HR, legal, but not their operational functions, due to the difference in their business. Therefore, these integrations are by and large complete, and there is platform capacity to add additional lines of business without straining the existing platform and the management team or distracting other lines of business.

Sound acquisitions are a fundamental component to our growth strategy. As, we look at future acquisition opportunities; we will look at acquisitions that would add to our competitive strengths in areas of healthcare where we currently operate. And in addition we will continue to look for new areas of healthcare that would add new products to our current offerings.

When identifying new markets in healthcare, we continue to look for areas that meet the following investment criteria that we have stated over the last three or four years, markets that represent a meaningful portion of the healthcare dollar, markets where costs are growing at a faster rate than other healthcare expenses, areas where costs are separable from other medical costs and are measurable, areas where we can demonstrate value through improved outcomes and reduced cost.

Over the long-term, we believe this strategy of expanding into new markets will create significant shareholder value. Since our last earnings call, certain shareholders have expressed to our Board of Directors their desire for us to implement a share repurchase or dividend. We take this feedback very seriously.

By way of history, the Board has reviewed balance sheet and shareholder value optimization at every board meeting in 2007. The Board held its regularly scheduled quarterly meeting last week and as a standard in these meetings the Board considered various capital deployment alternatives.

The conversation included a discussion of various strategies, including share repurchase and or dividend. In addition, the Board reviewed acquisition opportunities. The key objective is to balance the acquisition opportunities with alternative capital uses.

A recent critical environmental factor that was considered was the so-called credit crunch during this past summer and its changes in the costs of debt, the value of our cash and the resulting repositioning of strategic buyers versus financial buyers.

Given that acquisitions are key to Magellan's strategy, the Board unanimously and firmly believes that diverse identifying our platform remains the economic and long-term strategic use of capital.

They further evaluated various options in combinations. For example a buy back and the pursuit of acquisitions are not entirely mutually exclusive. Given a very active acquisition pipeline of opportunity, the Board has decided not to institute a share repurchase or dividend at this time.

Let me emphasize two things, first, the Board has actively considered our shareholders input and has given serious consideration. However when considering the breadth of the opportunities in front of the company, including possible acquisition targets the Board believes that is not prudent to implement a share repurchase or dividend at this time.

Second, the Board will reconsider this matter at all future meetings. This discussion is not off the table and will never be off the table. It is simply been determined that at this point in time, based on acquisition opportunities, the value of cash the cost of debt, et cetera, a share repurchase or dividend is not being affected.

In closing, let me take a moment to comment on Mark's earlier discussion of 2008 guidance. As Mark stated, we are currently projecting the 2008 segment profit will be down slightly from the new increased 2007 guidance. We are still in the midst of our budget process.

So let me please emphasize this is a preliminary estimate at this time. Our next call will be about our 2008 guidance, which we expect will be during the second week in December as we have done in previous years. At that time we will be issuing full guidance for 2008 including guidance by segment EPS cash flow, et cetera.

Thank you for joining us today. Let me now turn the call over to the operator for questions and answers. Thank you all for listening.

Questions-and-Answer Session

Operator

(Operator Instructions) Josh Raskin of Lehman Brothers, you may ask your question.

Josh Raskin - Lehman Brothers

Hi. Thanks. Good morning. Two quick questions. One, could you give an update, I apologize if I missed it early on, I jumped on when you were talking about Maricopa. Sounds like higher membership. Could you give an update on the expected revenue run rate on an annual basis there?

Steven Schulman

Yes, we shared it. Josh said earlier $580 million. Higher than we originally expected, but the membership is up.

Josh Raskin - Lehman Brothers

Okay. And on the margin side, I know you guys are capped at 4% to 5%. That's post, that's after taxes. Would you expect to be sort of this that run rate for the full fiscal year of '08 at this point? It sounds like you know you feel like you are getting better margins at this point already.

Steven Schulman

Let me not comment on that. We have said there is a range. We knew what the cap was. We expected the consider to mature over time and we are doing better than we expected early on in terms of our managed care impact versus the previous incumbent.

But it is too early for us to definitively say where we are going to be we have had a month into the contract.

Josh Raskin - Lehman Brothers

Yes, that's fair. And then let me play I guess, devil's advocate. You spoke of the impact of the credit crunch on your throughout processes around the repurchase and certainly understand the ability of others in terms of raising debt et cetera two acquisitions will help you competitively in the M&A front.

But if you look back and you have done two significant deals one of them has been very, very successful, the radiology side, but ICORE certainly lacking the previous expectations. I'm curious; do you take into effect, the inherent risk in acquisitions?

Has the ICORE business sort changed your mind frame in terms of the relative attractiveness of other capital deployment areas?

Steven Schulman

Well, it's a fair question. Certainly let me just back up and say what we are seeing in the marketplace, not only the value of our cash is higher, the costs of the debt is higher. But we are seeing a return to normal patterns, because the cost of capital to financial buyers has increase in their ability to leverage the company as much as they could with no covenants has decreased.

And therefore, we are returning to kind of a status quo anti, where strategic buyers have historically had a competitive advantage over financial buyers due to synergies and leverage, which was not the case over the last two or three frothy years.

And so, we see our opportunities in the competitive bidding and the pricing being better. We certainly do an evaluation every quarter on the returns and investment what are our assumptions et cetera. From an operational basis as I mentioned, we have integrated those companies.

Our ability to do that and our operation efficiency has been all demonstrated. And I want to make sure it is not a distraction because of the way we have organized our lines of business, everybody leverages that common platform as much as we can. Then mostly what the SBU heads are doing is product development, initiative, sales initiatives, account management initiatives, et cetera, et cetera.

We certainly take into account ICORE's performance to date. But I must tell you, we were challenged early on in NIA's performance and that thing has rocketed beyond our expectations, we have increased the company five fold.

So, we acknowledge their issues at ICORE maybe re-evaluating our tactics to the market we package from the historical strength, which are rebates only to move into distribution to get a bigger piece of the market.

Maybe that thinking was premature. We are not certain yet. But we are re-evaluating our tactics in the market. But we are confident we are in the right place at the right time with the right management team. But trust me, we are working it very hard. We do put always the inherent risks and discounts on acquisitions when we take that into account.

But net-net without the benefit of 20-20 hindsight, we think the cash is so valuable right now and the opportunities are reasonable that we are holding where we are right now. And as I said every quarter reevaluated and these are not mutually exclusive options, but that is where we are today.

Josh Raskin - Lehman Brothers

That's fair, and the last quick question is for Mark. Could you review the balance of favorable development that were booked in the current quarter? I heard a number for the health plan. I think it was $5.4 million. I want to see what the other areas were up in behavioral.

Mark Demilio

Sure, Josh. The favorable in the health plan was the $5.4 million of which 4.5 related to current year prior quarters. The employer segment had a positive of $600,000. And then the public sector segment had a slightly negative $1.2 million negative or unfavorable development.

A lot of the public sector development was on contracts for, which there is minimum care requirements. There is revenue attached to that of about $1 million.

Josh Raskin - Lehman Brothers

Got you.

Mark Demilio

It pretty much netted out.

Josh Raskin - Lehman Brothers

It looked like there was really only $1 million that was out of period, i.e. relate to 2006 or before?

Mark Demilio

Yes, that's right.

Josh Raskin - Lehman Brothers

Okay. Perfect. Thanks.

Operator

Michael Glynn from Credit Suisse, you may ask your question.

Michael Glynn - Credit Suisse

Thank you. Nice quarter, guys. A question following up on Josh's question there with the cost of care ratios. Looking at the adjusted ratios, with the favorable development, over the last few quarters, looks like it's gone from, in the health plan segment, 60% level and now adjusted all the way down to 57%, which maybe looks more like historical levels.

So, have we kind of hit a new run rate level, where it is well below 60%, say around 57% now? And then I guess looking out to 2008; I assume you are already contracted with the health plans. And now the trends are coming in a little better than expected. We should be able to see this flow through to 2008.

Mark Demilio

As to your first question, Michael. I think the actual percentage is higher than what you are saying. I think without adjusting we are at 66%. You have to add back care for the favorable development. It should be higher than 66% when you do that adjustment.

Michael Glynn - Credit Suisse

Okay.

Mark Demilio

First of all the calculations, but secondly as to whether that's the run rate or not. As I said as we look preliminarily add 2008 and review the rate adjustments that have been going on in health plan, we also expect that to be higher in 2008. We had rates in '07 that were based on an expected trend of 6% to 8%.

And the trend is actually coming in lower than that. So, we are seeing better margins this year than we would have expected from that rate setting. As we set rates for 2008, we are now setting it on that lower trend. So the margin should be more of what we expect it to be this year. And so, that would be lower than what it is this year.

Michael Glynn - Credit Suisse

Okay, so the contracting already went on the assumption of the lower trends? That is what I was getting at.

Mark Demilio

Yes. Some of the ones that have occurred and then the expectation of the ones that have not yet completed is based on the assumption of the lower trend.

Michael Glynn - Credit Suisse

Okay. Then over to capital deployment. Given the credit market, it seems like the strategy to hold off on the share repurchase and dividend is really playing out nicely. Given that, and given that you continue to hold on to a large cash balance. Should, we assume that you guys are far along with potential acquisition?

Steven Schulman

No. We are in various stages with a number of opportunities but even if you assume we are far along, it doesn't mean we are going to get it done. So I wouldn't assume anything imminent it's a lumpy issue. We had said, before we did the last two for about $330 million, we had looked at $2 billion of deals we were far along in.

So, I wouldn't read into that and clearly as we continue to build up cash, what happens to the credit markets, we are going to constantly re-evaluate the balance. But I appreciate your statement, because I think we were strong in July, after what happened in August, we are in a better position to be quite opportunistic and aggressive.

Michael Glynn - Credit Suisse

Agreed. Agreed. And then last quickly I was intrigued by your comments on the ICORE segment hitting the '08 sales cycle with some of the re-restructuring for lack of a better term that you talked about that suggests your strategy will be able to hit '08 sales cycle? We are not already through that?

Rene Lerer

Hi this is Rene. The sales cycle for specialty deals primarily with health plan, so it is not a January date implementation times for ICORE, particularly on the rebate side is reasonably short. So we believe there is still significant opportunity for us to hit the sales prospects for a 2008 implementation. Obviously January is a bit early, but we think throughout the course of 2008 we have opportunities for increased sales with all the lines within ICORE.

Michael Glynn - Credit Suisse

Great. Thank you.

Operator

Melissa Jaffe, of Merrill Lynch, you may ask your question.

Melissa Jaffe - Merrill Lynch

Hi, guys.

Steven Schulman

Good morning.

Melissa Jaffe - Merrill Lynch

Medicaid behavioral, recognizing you are busy ramping up Maricopa and you want to get that right, do you still see Medicaid behavioral as a meaningful growth driver longer term? And then also, can you give us a way to sort of size that potential market? And you know, just given all the different arrangements that the states have?

Steven Schulman

Yes, let me start off. But, in terms of long-term to answer your question. Absolutely, that market still is immature, evasive, behavioral managed care. We look at we changed about a year and a half ago, two years ago we put a tremendous amount of resources in there, because we had lost 12 opportunities in a row.

We had the wrong team and the wrong set of resources, as you know. We have really been hitting the ball out of the park in terms of we won four or five regions in Florida, we won a number of regions in the Midwest. We also changed our tactics on distribution channels.

We went after not only carve-outs directly with states but have won a number of opportunities as the subcontractor for health plans who don't have a strong behavioral Medicaid area of expertise and that's opened up opportunities over the short-term Maricopa was the big event. We have to digest that. Over the long-term the market will be quite strong

The point we look at, I'll give you specific numbers off line but in the commercial world behavioral world behavioral health is 2% to 3%, in Medicaid it is closer to 10%, given the nature of the people, a lot of it is, people with behavioral illness cannot work and therefore it is causes them to enter into Medicaid with a much bigger percentage.

And you guys know the total dollars in Medicaid, I would say 10% of that is our market and discount it for penetration assumptions.

Melissa Jaffe - Merrill Lynch

Okay. Thanks.

Operator

Michael Yuan, of Banc of America you may ask your question.

Michael Yuan - Banc of America Securities

Hi good morning guys I just had a question on TennCare. I know the Middle Region where you partnered with Blue Cross, Blue Shield, you basically won on every metric except costs and that is because they weren't willing to bid on a risk basis.

With your new partner I know you are not discussing or disclosing the name. Would you tell us whether they are willing to bid on full risk or not?

Mark Demilio

We’ve obviously as Steve talked about during his remarks, we have talked to lots of different partners and obviously, we are intimately knowledgeable and familiar with what happened in the Middle. So honestly, it is not fair for us to except comment on how a partner would bid or would thought bid.

But it was clear to us what happened the first time around and what it takes to win and what we need to do. But let's leave it at that. I think we are all very aware of what happened and why, and we took that into account as we chose a partner.

Michael Yuan - Banc of America Securities

Great. Thank you.

Operator

Michael Baker of Raymond James you may ask your question.

Brian - Raymond James

This is Brian, in for Mike. I appreciate the detail on '08, guys. I just had a clarification question. You mentioned the segment profit for '08 should be a little softer versus '07. I was wondering to what extend you have included the TennCare, are the east and west regions in on that?

Mark Demilio

Yes, we have assumed we will retain both of those for the full year in that general guidance outlook that we gave.

Steven Schulman

In the form that we have today.

Mark Demilio

In the form that we have today, so we have assumed no change in '08.

Brian - Raymond James

Okay thank you.

Operator

At this time there are no further questions.

Steven Schulman

Great. I want to we are pretty proud we had a great quarter. Implementations are going well. We understand where there are operating deficiencies and we are quite focused on those and I appreciate everyone's interest on our balance sheet optimization. I know there are lots different points of view and we are aggressively evaluate it go constantly.

Thank you for that. Thank you for your continued interest in Magellan and we look forward in chatting with you in December when we talk about 2008 guidance. Have a nice weekend.

Operator

Thank you for your participation. Your call has concluded. You may disconnect at this time.

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Source: Magellan Health Services Q3 2007 Earnings Call Transcript
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