Coventry Health Care, Inc. Q1 2008 Earnings Call Transcript

Coventry Health Care Inc. (CVH)

Q1 FY08 Earnings Call

April 25, 2008, 8:30 AM ET

Executives

Drew Asher - Sr. VP, Corporate Finance

Dale B. Wolf - CEO

Shawn M. Guertin - EVP and CFO

Analysts

Charles Boorady - Citigroup

Justin Lake - UBS

Joshua Raskin - Lehman Brothers

Matthew Borsch - Goldman Sachs

Scott Fidel - Deutsche Bank

Doug Simpson - Merrill Lynch

Carl McDonald - Oppenheimer & Co.

John Rex - Bear Stearns

Matt Perry - Wachovia

Michael Baker - Raymond James

Presentation

Operator

Good morning and welcome to Coventry Health Care's First Quarter 2008 Earnings Conference Call. Today's conference is being recorded and all participants are in a listen-only mode. Today's call will begin with opening remarks by the Chief Executive Officer of Coventry Health Care, Mr. Dale Wolf, after a brief forward-looking statement read by Drew Asher. Please go ahead, Drew.

Drew Asher - Senior Vice President, Corporate Finance

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

Dale B. Wolf - Chief Executive Officer

Good morning, everybody. As you've seen this morning, we reported operating revenues of $2.94 billion for the first quarter, up over 30% from the previous year, and net income of $125 million, up 6.6% from the prior quarter. It was, in every respect, a steady-as-she-goes outcome. Our overall results were entirely consistent with the revised guidance given at the beginning of March, and our guidance for the remainder of the year is totally unchanged. More importantly, our business fundamental operations are right on track.

The highlights for the year, we projected last fall: growth in small group, growth in individual, growth in Medicare, and growth in workers' comp are all working. As witnessed by the 31.5% revenue growth, we have a diversified growth platform unmatched in the industry. Shawn will elaborate further on some of the specifics behind these results.

I want to confine my comments this morning to a few select topics, including a couple of operational updates I need to provide, and then some thoughts on current industry dynamics. First, on the operational side, contrary to my expectation, we've not yet concluded our process around our pharmacy plans for 2009. I assume most of you know but by way of background, Coventry has long employed a mixed model relative to its pharmacy operations.

For the last number of years, our outsource partner for claims processing, customer service, mail and specialty has been Caremark. Our current contract expires with respect to our Part D product at the end of 2008 and our commercial business at the end of 2009. There has been great interest in what our plans would be relative to this relationship. Over the last number of months, we've been evaluating a range of possibilities for this part of our operations, and that evaluation remains ongoing. I had thought we would have this wrapped up now, but this is clearly not the case. This will be a second-quarter decision. And I really can't share any more about this or a likely result at this point except to say that we are cautiously optimistic about the opportunity presented by any new contract we enter into. As soon as we reach a conclusion, we will let you know, as appropriate.

Secondly, I plan to talk a little about the Tennessee Medicaid results, ideally with a different spin. To no one's surprise, we were extremely disappointed at not being selected by the state of Tennessee. I had committed to you we would leave no stone unturned in our efforts to improve our presentation of our capabilities. Notwithstanding the result, I'm convinced that our team did exactly that. I'm very proud of their efforts and commitment to make us a winning bidder and as always, we will use this as an opportunity to learn how we can show better in the future and to strengthen our resolve to accomplish a different result.

Now, let me turn to industry dynamics. First, let me remind you that this has been, is and will continue to be, for the best operators, a terrific business. So, why so confident, at least with respect to Coventry? First, we have the operational controls, low-cost position, financial discipline and organizational backbone to continue to grow operating earnings in our core commercial business.

We've said for the last three years that the core operating growth rate in a purely commercial business was not as high as some were suggesting. We took some flak for that. But more recently, the reality of that seems to have become more evident. But that is away different from an underwriting cycle. Underwriting cycles are also not caused by variations in medical cost trends. Variations in medical cost trends generally do not happen quickly and given the progress in analytics within the industry, will be pretty closely anticipated in pricing. That doesn't suggest we will never make a mistake and miss it a little, but that's far from an underwriting cycle.

Underwriting cycles are caused solely by lack of pricing discipline, either consciously, which I actually think is less common, or unconsciously, through lack of financial control. This isn't a new topic either. We've been, for many years, answering the question of whether there's an underwriting cycle. We've cited a consolidation in the industry, growth of for-profit blues, improved analytics and so on and on and on. Those reasons are as valid and real today as they have been for the last five years. It makes no economic sense to chase market share at the expense of pricing discipline.

I'm reasonably confident that that's understood across the industry, but I'm absolutely certain that it's understood at Coventry. So don't look for the operating margins of our commercial operations to fall off the table. They won't. If we have to shrink a little, which we don't think we will do, but we will, we will not sacrifice margin at the expense of market share, and that is the only thing that causes an underwriting cycle.

The next important topic, although somewhat less top-of-mind during the last eight weeks, is the prospect for Medicare. Obviously, that business has been an important driver, both for the industry and Coventry, for the last couple of years. To no one's surprise, this is a highly politically charged issue and will be at the forefront of publicity for the coming months and years. We expect there to be headline noise, we expect the program to undergo some change. But fundamentally, private options in Medicare make infinite sense for and are appreciated by seniors, as evidenced by the nearly 10 million seniors now enrolled in Medicare Advantage.

At Coventry, Medicare revenue now exceeds 30% of the company's revenue. We are committed to this business for the long run, and most importantly, as in all our businesses, committed to be a low-cost provider of these products and services to seniors. Wherever the twists and turns go as a low-cost provider, we will be competitively advantaged, both as to growth and/or profitability.

Given the demographics and product appeal to seniors, we fully expect, notwithstanding the bumps in the road, that Medicare will be an important part of our company's strategy going forward and an above-average growth engine for the foreseeable future. Of course, we're pushing on the rest of our growth opportunities as well. You've heard them before. Our new market initiative is actually picking up steam. Our individual business continues to hum. Our small business grew in excess of 2% in the first quarter and we will have life and dental products in the market before the end of the year.

You put all these together and you have a strategically sound, competitively advantaged operating platform for the future. It's one that we have no less confidence in and see no differently than we did on January 11, when our stock was nearly 45% higher than it is today. I'm afraid the market has confused business fundamentals with executional missteps.

Now let me turn the call over to Shawn for some more financial commentary.

Shawn M. Guertin - Executive Vice President and Chief Financial Officer

Thanks, Dale. Good morning, everyone. You know, the simplest and most concise way to summarize my commentary this morning is that the first quarter has played out just as we guided in mid-March and, to no surprise, our outlook for the balance of 2008 is the same as what we shared with you at that same time.

In summary, notwithstanding the isolated issues around flu and investment income, our business is on a very solid financial footing. It is fundamentally sound and well positioned for the future. Given recent events in the industry, it feels a little funny saying this but, in many ways for Coventry, this was a pretty clean and relatively quiet quarter with medical loss ratios consistent with guidance, steady days in claims payable, and strong cash flow from operations.

As has been my convention, I will start off this morning with the commercial business. Overall, our commercial business continues to perform well. From a topline perspective, overall risk membership decreased in the first quarter, consistent with our previous guidance, but again it's instructive to point out the success we continue to experience in the Small Group segment where, as Dale mentioned, membership increased by up 10,000 members in Q1, a little bit over 2%.

From a bottom-line perspective, the commercial results continue to be strong and stable as well. The commercial MLR for Q1 is 78.8%, up 40 basis points on a reported basis from the same quarter last year. However, as we've discussed previously, this increase was expected and is driven entirely by two factors -- mix of business, driven by the inclusion of Vista and Mutual of Omaha, as well as the impact of influenza-related expense in the quarter. As you will also recall, we expected the full year 2008 commercial MLR to be in the mid to high 78s, including Vista and Mutual of Omaha, so this Q1 result is also very consistent with the full year outlook.

At the risk of sounding like a broken record, I want to reiterate our views on commercial trend in pricing as well. We continue to see no evidence of an overall acceleration of cost trend in 2008 versus 2007. Our outlook remains that trend will be stable in 2008 versus 2007, in the neighborhood of 7.5%. Over a long period of time, we have exhibited an attention to detail and an unwavering discipline in the pricing arena, and to no surprise, this will not be changing. We remain firmly committed to having our commercial price increases at least equal to medical cost trends. The competitive environment is, as always, a very competitive arena. Growth is not easy to come by, but despite isolated local market skirmishes, it is still a rational environment where those that have a low-cost structure, those that are disciplined, those that are close to the details and fundamentals of the business, will succeed over the long haul.

Again, I can think of no better evidence of this in our own business than the remarkable success we have had in growing Small Group over the last year, arguably the most cost-competitive group segment, and growing this segment profitably.

Let me now turn to our Individual Consumer and Government division. As you saw in our press release, the strong topline performance of this division is continuing into 2008 with membership gains in each line of business. We've done exceedingly well on Part D membership, adding almost 150,000 members since year-end. On Medicare Advantage, our goal was to add 100,000 members this year, and with 36,000 members in the first quarter and the state of Pennsylvania account coming on in May, we are well on our way towards achieving this objective.

Bottom-line performance continues to be strong as well. Part D has come in more or less right on where we expected in Q1, as has Medicare Advantage. I won't belabor them, but similar to my remarks on commercial, there are many attributes of how we approach this business that have led to our consistent level of high-performance in this area; a single operating system and data warehouse behind our risk business; the consistency of the people and the process over time; having realistic financial expectations and guidance from year-to-year; and most importantly, an unrelenting focus on the details and fundamentals behind these products.

I would be remiss if I didn't quickly highlight the ongoing strength in operations in our specialty division. This division now houses our workers' compensation services business, our network rental business, and our recently acquired managed behavioral health business. It is often overlooked and underappreciated, as the revenue seems low in comparison to the total, as it is almost all fee revenue. However, as constituted today, this division is expected to produce somewhere between 10% and 15% of the operating EBITDA of Coventry and it's growing quite nicely as evidenced by the sequential revenue growth in Q1 2008 versus Q4 2007.

Before turning to guidance, I also want to quickly update you on free cash and capital deployment. First, let me reset the table here. We came into 2008 with about $250 million of available cash, and we expected 2008 operations to generate an additional $600 million of deployable free cash. As you saw in the press release, we closed on our managed behavioral healthcare acquisition in the quarter, and also repurchased 3.2 million shares of stock.

A simple way to think about this is that this used up all of the free cash we carried into the year. Looking forward, I intend to fulfill our previous commitment to return our debt-to-cap to approximately 30% by the end of the second quarter of 2008. And this should leave us with approximately $400 million or so for the balance of the year to deploy throughout the rest of 2008. The priorities for this free cash are unchanged. This will either go to M&A or share repurchase.

Turning now to 2008 guidance, we are affirming our earnings guidance of $4.39 to $4.50 per diluted share, an increase of 10% to 13% from 2007. The detailed components behind this guidance are unchanged from what we shared with you in mid-March. For the second quarter, we are providing initial EPS guidance of a $1.03 to a $1.04. This is a $0.22 to $0.23 increase from Q1. And as you would expect, most of this increase is driven by the improving seasonal pattern of earnings on Part D, as well as the absence of any excess flu costs in Q2.

I'd also like to give you a little more insight into the progression for the rest of the year. After Q2, we would expect the increase in earnings per share, not the absolute level, but the increase in earnings per share for each of the remaining quarters, Q3 and Q4, to be more or less the same. The result of all of this is that the current Q2 consensus is a little too high, Q3 consensus coincidentally is in the right neighborhood, and Q4 is a little too low, low by about the amount that Q2 is heavy.

In conclusion, the first quarter of 2008 was, at its core, another strong and fundamentally sound quarter for Coventry Health Care. We continue to grow revenue better than any of our peers, and our long-held principles around attention to detail, the focus on the core fundamentals of the insurance business, and unwavering price discipline continue to serve us well on the bottom line. At their heart, our businesses continue to perform at a very high-level and are fundamentally sound. We continue to feel very good about our positioning and the many different growth drivers we have at work.

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

Question and Answer

Operator

Thank you. [Operator Instructions]. We will go first to Charles Boorady with Citi.

Charles Boorady - Citigroup

Thanks. Good morning and I really appreciate the comments on the state of the industry as you see them as well. A question on Group Medicare Advantage, can you update us on how the process of enrolling the upcoming group is? Do you foresee it being postponed again, and what impact that has from a cost standpoint as you are enrolling those lives? Might you see higher admin expenses in that quarter? And then also in Group MA what the backlog looks like and if you can comment on why more employers haven't jumped on the opportunity faster?

Dale B. Wolf - Chief Executive Officer

Do you have any more you want to add to that, Charles?

Charles Boorady - Citigroup

It's all on Group MA.

Dale B. Wolf - Chief Executive Officer

Okay. Let me try to take those. First, on the enrollment of the Pennsylvania business, it's actually gone really well. I mean, I won't bore you with the details, but we've got a pretty-honed process there of account management and installation enrollment kind of stuff. ID cards are already in the hands of most if not all of the people who are to be enrolled, and I think there is near zero chance that it will be delayed again. It's going to be implemented on May 1.

In terms of expenses that might create, I don't even think you'll see a blip on the radar for that, so don't look for any. Certainly, we've spent some money, but it's more like soft dollars than hard dollars, and it's not that big a deal. In terms of -- but I do want to caution you. I don't know if Shawn wants to follow up on this. Obviously, it's a pretty big piece of business and as a group account, it should have a higher expected loss ratio than the average of our current private fee business, so just don't be surprised by that. And I'm sorry, forgot the last one.

Charles Boorady - Citigroup

That's in your guidance?

Shawn M. Guertin - Executive Vice President and Chief Financial Officer

Yes, we've worked that into the guidance, right.

Charles Boorady - Citigroup

Then also related to Group MA, just what you see is the backlog? Why more people haven't jumped on it?

Dale B. Wolf - Chief Executive Officer

I feel like a broken record on this subject, but let me just say the same answer again, which is, the backlog is enormous and the only reason that I can think of why people haven't jumped on it is, well, obviously there's an education process to go through and some of that kind of thing, but I'm speculating totally -- but some uncertainty around the political environment is the only thing I can come up with.

Charles Boorady - Citigroup

Is there a dollar amount you can put on that enormous?

Dale B. Wolf - Chief Executive Officer

No, I don't have that at my fingertips, Charles, but enormous.

Charles Boorady - Citigroup

Thanks.

Operator

We will go next to Justin Lake with UBS.

Justin Lake - UBS

Thanks. Good morning. Just a quick numbers question around the second quarter, Shawn. The progression of earnings is a little bit different this year; I think you noted it. I'm just curious, most likely I've got to think it's in the margin side. Is there any of the MLRs you want to spike out as far as being maybe a little bit different seasonality here versus last year?

Shawn M. Guertin - Executive Vice President and Chief Financial Officer

No, it's really about -- sort of the biggest driver here is the steepness of Part D. There isn't really huge swings, I would say, intrinsic in the MLR, sort of in the non-Part D. I mean, obviously, within tens of basis points, our forecasting moves them around. But when you really sort of cut through it, what you have is mainly just sort of the Part D sort of seasonal growth and then a little bit -- you get obviously we tend to have a lot of back-end SG&A spending actually in the fourth quarter related to the open enrollment next year. So when you cut through that, that's what it is.

If you can follow my explanation, which was intended to be helpful to all of you, if you think about this quarter being up $0.22, $0.23 and obviously part of that is sort of not having the flu; that would get you kind of with this quarter, Q1 to Q2, going up in the high teens. That's in the neighborhood of the right number for the rest of the year. So it's a pretty level sort of build, admittedly different than last year, but a fairly level build from quarter to quarter.

Justin Lake - UBS

Great. Just if I can ask you to comment on a couple of issues outside of what you've already done a good job on, which is in-patient medical cost trends have been discussed by a couple of folks as being a little bit higher than what they were seeing. Can you give us an idea of what you're seeing there, especially on the pricing side? And then there's been some contrasting remarks about the levels of competitiveness, especially around not-for-profit Blues, and if you can just comment on what you're seeing there, I would appreciate it. Thanks.

Dale B. Wolf - Chief Executive Officer

Actually, we have not seen the sort of market movement in in-patient trend. I know that was cited on some of the earlier calls. Having said that, what would say is I think, for a very long period of time, we have talked about the unit cost trend component on in-patient being in the mid to the high single digits. I think, in many ways, some of these explanations are kind of coming back more towards where we've been for a while. But in terms of change in that, we have not observed that in our business.

Shawn M. Guertin - Executive Vice President and Chief Financial Officer

Particularly on the utilization side, I mean [inaudible] specifically utilization patterns this year are very well controlled again.

Dale B. Wolf - Chief Executive Officer

Yes.

Justin Lake - UBS

Great. Just a comment on the not-for-profit Blue?

Dale B. Wolf - Chief Executive Officer

In the not-for-profit Blue -- I'm trying to figure out how to not sound like a broken record again, but I'm going to because it's no different than it's been for five years. In fact, as we've said before, it's better in Pennsylvania than it's been for the last three years. We get skirmishes in various markets with competitors, be they for-profit or not-for-profit, from time to time. They don't last. They are not systemic. That environment is exactly what we see in the market today.

Justin Lake - UBS

Great. Thank you very much.

Operator

We will take our next question from Joshua Raskin with Lehman Brothers.

Joshua Raskin - Lehman Brothers

Hi, thanks. Good morning. Two quick questions for you. First, the acquisitions, obviously, you completed three relatively large ones last year. Could you just walk us through the sort of systems conversion process? Obviously, that's been a topic of discussion at one of your competitors as well. I just want to get sort of the timing and how you guys have done that, understanding that you've done a dozen or more, probably 15 in the last half dozen years. So just if you could walk us through the process. And then second, Dale, I think you started to talk a little about it. On the Medicaid strategy, last quarter, you suggested you guys were putting in your best efforts and if you weren't successful in Tennessee, you would have to sort of rethink the strategy. So I'm just curious. I know it's been less than a week at this point, but what are your thoughts sort of longer-term, in terms of getting that Medicaid, as a percentage of your overall business, to your targeted goals?

Dale B. Wolf - Chief Executive Officer

Let me take the operational side of the acquisitions from last year. The two biggest pieces of that I guess would be Vista and Mutual of Omaha. We've not yet converted those two our operating platform, but we have scheduled plans to do so. And they are actually in a couple of pieces with respect to Mutual of Omaha and maybe Vista as well in two pieces. But the completion of both of those won't be until 2009. Don't put that on your list of Top 10 worries. We've done 25 of these in the last 10 years, and we got the same people doing them that have done them for most of that past 10 years, and I have a high degree of confidence that they will work really well.

Joshua Raskin - Lehman Brothers

On the Medicaid?

Dale B. Wolf - Chief Executive Officer

Oh, Medicaid, yes, I don't know what the answer is yet, Josh. As I said in my remarks, the folks did a really good job here but close on the accounts in horseshoes and hand grenades, as you well know, so we are only a day or two away from that. We don't have a complete analysis of all the details of where we fell short. If and until we go through that and get a little time to think about this, I don't have anything different to share with you.

Joshua Raskin - Lehman Brothers

I'm sorry, Dale, just to follow up on the systems for Vista and Mutual of Omaha, do you do that as a migration, or are there actual conversions that are done, sort of lump sums? I'm just curious about the process that what you guys use.

Dale B. Wolf - Chief Executive Officer

Its conversions. We convert the entire files and all of the history and everything all at once.

Shawn M. Guertin - Executive Vice President and Chief Financial Officer

And I just would add to sort of Dale's point, Josh, we really -- don't have in your head that they just sort of keep running the way they were running in the interim. For example, they, Day One, begin using our sort of IBNR models and processing controls. They are already kind of converted into our general ledger, for example. So in the interim period leading up to this, we really surround it with all of the controls and processes that we employ on our own business. And candidly, by the time they convert, not to minimize it but it becomes the formality of a system conversion as opposed to sort of a process conversion.

Joshua Raskin - Lehman Brothers

Got you. That's helpful. Thank you very much.

Operator

We will go next to Matthew Borsch with Goldman Sachs. Matthew your line is open.

Matthew Borsch - Goldman Sachs

Sorry, I had my mute on. Good morning. Dale, if I could just hit on the comments that you made -- and I appreciate your taking up the issue of the underwriting cycle directly and just to say, I agree with you on the underwriting cycle not to being driven by variations in medical cost trends, for what that's worth. Also, clearly you guys have demonstrated a very strong commitment to pricing discipline with the pressure you've faced from the Blues. But I also just wanted to ask you about, when you look at a major competitor of yours -- and I'm referring to UnitedHealth here and their view that their commercial risk pricing trend was essentially forced by the market below medical cost trend for the last two years in the sort of unintentional process at the market level -- let me put the question to you this way. If one of your market persons came to you and said look we've got a half dozen middle market accounts running at a 10% profit margin, and the price competition in the market is such that, if we want to renew them, they're going to have to be renewed at a 5% profit margin. If you put it in those terms, what do you do it in that situation?

Dale B. Wolf - Chief Executive Officer

If you take it at the micro level, we do that all of the time. You are managing a book of business in the market level. And so the market leader -- by the way, and this may be one of the distinguishing factors; our market leader cannot make that decision by themselves. So, it's why I have a high degree of confidence that we will not lose control of this that is controlled by the underwriting area, in conjunction with the markets of course. But market leaders do that all of the time. They manage a book of business. They see where their new of business is coming in, they make concessions on existing accounts if they need to and it's the right account to save them, and they get more where they can to make up the difference. And if they decide -- well, they couldn't do what you just suggested across the board, and certainly, if they did, they wouldn't earn a bonus.

Matthew Borsch - Goldman Sachs

Right. Fair enough.

Dale B. Wolf - Chief Executive Officer

Follow the money.

Matthew Borsch - Goldman Sachs

Okay. Just on a more mundane level here, so the difference between -- your seeing a pricing trend in the -- cost and pricing trend in the 7.5% range. And the income statement yield continued to be about 300 basis points below that. Could you just walk us through how much of that is from continuing benefit buy-downs and how much is product mix sort of products or geographic mix shift?

Shawn M. Guertin - Executive Vice President and Chief Financial Officer

Yes, Matt, the benefit buy down is sort of classically defined as right around 200 basis points. What I mean by that when I say classically declined, sort of the explicit movement of the employer kind of changing their plan from Plan A to Plan B. And that's fairly consistent with sort of historical activity and that where in the last few years, where we have seen sort of the downward pressure is from two other factors. The biggest one is just sort of the dynamic between the new sales coming on being in less rich benefit plan designs and therefore bringing with it lower premiums and the terminations being in richer plan designs and bringing with that higher premiums. That sort of flux in the book has been the biggest single driver to sort of take the 7.5% down into the mid to low single digits over time.

The other dynamic is a smaller piece, but that is where employers may have two benefit plans. Think about it as a high and a low. And employees themselves are sort of making the decision to in essence buy their benefits down by changing from the high to low plan. That's much smaller than the new business cancellation flux that I mentioned, but it's really those two dynamics at work that are driving the yields down.

Matthew Borsch - Goldman Sachs

Great. Thank you.

Operator

We will go next to Scott Fidel with Deutsche Bank.

Scott Fidel - Deutsche Bank

Thanks. Good morning. First question, I just wanted to go back to the conversation around the systems conversions and just really tapping into your guys' experience because you've done 25 of them. And it just seems like, so many times, we've seen companies miss around these conversions, and just first it must be clear that these are really hard. I'm just interested if you guys can help us think about where do the problems usually come from in terms of what really drives the misses around these systems conversions at competitors? How do you guys try to get in front of that proactively to avoid that?

Dale B. Wolf - Chief Executive Officer

I'm not being flipped a little bit, but since we've never had one blow up, I'm not sure what's not going right. I can tell you some of the things we do to make sure they go well. We literally have teams in our company whose sole job is system conversion. It's been three at times, it's been two at times. But anyway, we have teams of people who do systems conversions. So you have dedicated expertise. That's one thing.

A second thing is that, when you do a system conversion of one, you have to pay down the existing claim backlog to as small a level as possible so that you don't have any overhang of large backlogs of claims. So you clean it up. So this is on the operations side as opposed to the systems side. And you get it down as far as you can. Then have a disciplined process that is incredibly well tested along the way before it's put live. And then you have, sort of after the fact, you have the ops people all over it sort of making sure it worked right. And I don't know if it's any more complicated than that. I'm sure it is. But at the layman's level, those are the pieces you do.

Shawn M. Guertin - Executive Vice President and Chief Financial Officer

And again, Scott, to Dale's point, we've never had one go sideways on us, so it's hard to react but I can't -- it's very mundane, but I can't emphasize enough that, ultimately, where these things really bite companies, right, is not in service problems but as much in sort of making bad business decisions potentially on pricing or reserving because of bad info. Sort of this getting sort of our controls and going through the very sort of detailed roll-up-your-sleeve blocking and tackling, making sure you've got the dollars reconciled and understood every single month really puts a containment field around this, both before the acquisition and then even after the acquisition, to sort of know right away that things went well. So it's a big part of sort of what are the business processes that you put in place from day one and then, as Dale mentioned, all of the things that you do around the conversion process specifically.

Again, it's not something to sort of just take for granted but, guys, this should not be, as Dale said, on your Top 10 worry list.

Scott Fidel - Deutsche Bank

I appreciate the color on that. The second question, just on Medicaid and the MLR -- there actually looks like you had some nice sequential and year-over-year improvement there, and just if you could maybe spike out which markets maybe you saw improving MLR trends in Medicaid.

Shawn M. Guertin - Executive Vice President and Chief Financial Officer

It's Missouri. You know, as we've mentioned in the past, our Medicaid risk book is largely either Michigan or Missouri from quarter to quarter, and the improvement here is almost exclusively in Missouri.

Scott Fidel - Deutsche Bank

Shawn, do you think that just, for the rest of the year, it's sustainable at these levels, or should we think about it more in the typical I think 86% to 88% --?

Shawn M. Guertin - Executive Vice President and Chief Financial Officer

Yes, I think we've said, in our guidance, that we had originally thought it might be in the sort of mid to high, and we are a little more comfortable in the mid. I don't think the full year will be quite in there at the 84 and change that we just did, but I'm kind of comfortable in the mid 80s range is where this will play.

Scott Fidel - Deutsche Bank

Okay. Just one last pretty granular question, but it looks like D&A was down around 9% sequentially. You did, it looked like, reaffirm the same for the full year. I'm just wondering if there is anything worth spiking out in terms of seasonality with that, or whether we should just expect that to sort of ramp up through the course of the year.

Shawn M. Guertin - Executive Vice President and Chief Financial Officer

It will ramp as we continue to have CapEx, sort of new CapEx going in, but what you actually see there in the first quarter is there were a number of items that had three-year lives from the First Health acquisition that fell off in the first quarter. So we had incorporated that into our guidance, but that's part of the sequential move you see.

Scott Fidel - Deutsche Bank

Okay, got it. Thanks.

Operator

We will go next to Doug Simpson with Merrill Lynch.

Doug Simpson - Merrill Lynch

Hey, good morning. I was just wondering if you guys could talk about the trend stability you guys have seen for years. I remember back '04 to '06, others were talking about declining trend and you guys used to talk about relative stability in trend. And it's just been a very sort of moderate -- again, volatility in that trend, it's been very, very consistent. And I'm wondering. Following on some of the questions earlier, can you just talk to the structure that you guys have in place and how it might be different? I guess what I'm trying to get at is, is there something in your size or your sort of regional emphasis? Why do you see greater stability? And what's going on at some of the other companies that might be different?

Dale B. Wolf - Chief Executive Officer

I will take a piece of that and then Shawn can jump in. The factor, I'm sure, is the degree to which our commercial book is managed. Keep in mind we didn't come from an indemnity background, we came from an HMO background. So even the products that are no longer HMO -- and our PPO book is now bigger than our HMO book, but they have fundamental medical management that looks a heck of a lot more like an HMO than it does like an indemnity book. And so as I've talked to investors over time, they are actually surprised that we have real-time information across our entire company about like inpatient hospital base and some of that. But it all comes from a highly managed group. Back a few years, I think some will remember this. There was a move across the industry to take off some of the controls and make life easier for customers. While we certainly try to do that where we can, we were clearly out of step a few years ago with the tightness of our cost controls. It appears that some of the market is coming back to us on that, like some other things. So I really believe that's the fundamental factor, Doug. Anything else, Shawn, that you want to add?

Shawn M. Guertin - Executive Vice President and Chief Financial Officer

No. Doug, I would agree that I think what Dale articulated is really the driving factor. I would say a secondary factor, though, is I would say, as a contracting philosophy, we have actually strove for stability, and so that we'd have stability in cost and stability in price. So we have -- sometimes I think faced with decisions, we have tended to opt for the option that provided some stability in unit cost. Again, I think that's the secondary factor, but philosophically the results are consistent with sort of the intentions we have in the front end. But I think sort of the tightness of the whole process, both on the demand side and the unit cost side, is probably what goes into that more than anything else.

Dale B. Wolf - Chief Executive Officer

I'm just going to add one more at the risk of belaboring this, Doug, which is the discipline -- we talked about the discipline and process around pricing in the field. Well, there is a similar process here around contracting. And so, I think we've told everybody for a long time that the largest accounts in this company are reviewed by senior management before they go out the door. Well, the same thing is true of the contracts. And we have A list contracts and B list contracts, and those have varying levels of authority and approval.

So once again, there is a tight set of financial controls around contracts that makes sure that are unit costs don't get out of control and is also important to maintaining stability and not being surprised.

Doug Simpson - Merrill Lynch

Okay, thanks.

Operator

We will go next to Carl McDonald with Oppenheimer.

Carl McDonald - Oppenheimer & Co.

Thank you. I would be interested in your thoughts on what impact, if any, the lower interest rate environment is going to have on Blue Cross pricing for next year. Clearly, the Blue Cross plans rely on investment income for a much bigger piece of the pre-tax earnings, and that presumably is going to be down fairly substantially this year.

Dale B. Wolf - Chief Executive Officer

Yes, I mean you have, in a, way answered your own question. Investment income will clearly be down. The piece that I haven't seen much about yet, I'm sure some of you have looked at it, is the extent to which some credit problems, over and above investment income, have been experienced there, and certainly the equity market impact, I think, unlike most of the publicly traded companies, you'll find the historic Blues significantly invested in the equity markets as contracted with the rest of us, so that has to be a dampening effects. So all three of those I think are going to impact the capital position and asset portfolio of those companies way more than they do the public companies. How that translates directly, since I've never worked in one of those places, I'm not quite sure, but it clearly goes in the right direction.

Carl McDonald - Oppenheimer & Co.

Then the second question, what you just mentioned on the contracting, I'm interested in the visibility that you have on the contract pricing, particularly for the inpatient hospitals. So I guess the direct question would be, at this point in the year, what percentage of like the '09 hospital contracts do you already know? Or I guess sort of the January 1 -- just like your January 1 pricing, how much of the hospital contracts are already known versus still to be negotiated?

Dale B. Wolf - Chief Executive Officer

I don't know the exact percent, Carl, but I would venture probably a pretty educated guess that it's well into the majority of those contracts are done. You know, we tend to have fixed pricing in most of our contracts, and we tend to -- it kind of goes back to some of the other questions. We schedule these to sort of line up as best we can with pricing cycles so that we're working on them in advance of when we actually have to set price. So I would answer the question qualitatively that I think we have a very good visibility into sort of '09 unit cost changes.

Carl McDonald - Oppenheimer & Co.

Okay. Thank you.

Operator

Our next question comes from John Rex with Bear Stearns.

John Rex - Bear Stearns

Thanks. First couple of questions on membership, maybe if you take me through commercial here. So I think you would look for 1 to 2% commercial growth in '08. I want to see if you are still on board with that in light of the quarter results. Maybe give us a little color on the commercial risk book in 1Q, where you expect that to be, and also specifically the First Legacy First Health business, kind of where you ended up in mail handlers versus national accounts in 1Q?

Dale B. Wolf - Chief Executive Officer

Yes, I want to make sure I get all those right. Again, I think, on commercial risk, the decrease in the quarter wasn't a big surprise. It was pretty much expected, and I think we've talked to all of you about that probably since at least December of last year.

Again, having said that, I think, realistically and as we thought about sort of our guidance a few weeks back, I think we will probably be closer to -- sort of clawing back to breakeven by the end of the year, as opposed certainly to growing two points. Again, that's baked into our guidance that's out there. So, I would think something in that order of magnitude on risk would be in order. The one thing I would offer, in terms of thinking about that as well, is I think we had something to the tune of about 26,000 members that basically just dropped of risk and went over to ASO. So for what it's worth, I mean, there was a retention of a good chunk of those members.

Let's see. I'm pleased to tell you that on mail handlers, for the first time in my tenure here, our membership was actually up slightly in '08, and so that was some good news. As you guys know, we implemented a new value product in that. And this is really a multi-year proposition with this population because they don't move around very much from year-to-year, but I think in our initial enrollment, we got 8,000 or so members in that value product. So I'm encouraged about that going forward. Again, I don't have any expectations that this is going to kind of take off from a growth perspective, but it's certainly turned in the right direction in '08.

In national accounts, a little bit similar to my reaction to you on commercial risk, is down about the same amount. It was down last year, kind of percentage-wise. Again, that was something that we had expected and communicated over the last number of months.

John Rex - Bear Stearns

So mail handlers, what are you at now in mail handlers in terms of membership?

Dale B. Wolf - Chief Executive Officer

You know, I can get you the exact number. I think it's in the 200 and so thousand -- 218,000? Is that the number is? Yes.

John Rex - Bear Stearns

Mail handlers, 218,000?

Dale B. Wolf - Chief Executive Officer

That's subs. That's subs.

Dale B. Wolf - Chief Executive Officer

486?

Dale B. Wolf - Chief Executive Officer

486 is the member count.

John Rex - Bear Stearns

Okay. Great. So but you'd be going away from kind of the 1% to 2% that you had on your -- with your Q4 call for the '08 guidance to more -- for commercial growth to zero?

Dale B. Wolf - Chief Executive Officer

I think closer to zero is where it's a more likely target, and that's actually fairly consistent with what we have in our guidance right now.

John Rex - Bear Stearns

Okay. Good. And then just on the cost topic that you addressed, could you go through where you think you are in your component cost outlook for '08 and kind of how that compares to '07?

Dale B. Wolf - Chief Executive Officer

Yes. Again, the simple story there is that --

John Rex - Bear Stearns

Maybe you could actually give us numbers for each of the four major components?

Dale B. Wolf - Chief Executive Officer

Sure. Let me give you the numbers first. Think about inpatient as 8 to 9.

John Rex - Bear Stearns

And that's '08, right?

Dale B. Wolf - Chief Executive Officer

Yes. This is '08.

John Rex - Bear Stearns

Okay.

Dale B. Wolf - Chief Executive Officer

The outpatient, call it 7 to 10; physician, 6 to 7; Rx, 6 to 8 and all of that composites out to about 7.5. The moving parts there are -- I actually don't have the old '07 numbers, but basically physician or pharmacy is up, mainly driven by sort of the simvastatin [inaudible] activity this year. And outpatient is down a little bit and the rest of them are virtually unchanged.

John Rex - Bear Stearns

Great. Thank you.

Operator

And we will go next to Matt Perry with Wachovia.

Matt Perry - Wachovia

Hi. Good morning. First, a question on the PDP, the higher MLR you've guided to in '08, is that -- can you just clarify? Is that mostly because of the mix of new members you've added, or is that due to some benefit design changes? And if there were some benefit design changes, have they kind of come in with expectations so far?

Dale B. Wolf - Chief Executive Officer

The answer to this is Part D is coming in right where we expected it, so everything I say, use that as an umbrella. There's a few elements, though, behind your question. The biggest -- the things that sort of are driving a loss ratio higher year-over-year are, first and foremost, remember that our overall guidance for the year was that the Part D MLR would be up year-over-year. So, we had an extraordinary year in 2007, and part of the bid reset process we had guided and anticipated that the loss ratio would be higher. So just sort of the natural order of things, year-over-year the loss ratio would be higher. Specific to the first quarter was more the combination of the steepening of the slope this year because of the widening of the risk corridors that we had as well as some of the growth that we had in the low income auto-assign population. Those dynamics created a bit stronger seasonal slope than we've had in past years well. But again, the totality of what we've seen in the first quarter is almost right on it. We were very explicit with you in the fourth quarter that we expected to see 104 and we came in at 103 and change.

Matt Perry - Wachovia

Right. And then maybe just a bigger picture question I think for Dale. You guys have traditionally done pretty well in the smaller end of the market in the fully insured commercial space. I'm just wondering if you can kind of give us your current view on your relationship with those customers. I mean, are they feeling especially strained by the economy? It seems like, in general, health insurance was a product maybe getting more unaffordable every year. So I'm just wondering. If you look, as it stands now and then out over the next couple of years, how do you think about the affordability of your product and what you can do to kind of continue to add value for these customers and keep the product affordable?

Dale B. Wolf - Chief Executive Officer

There's a mix of trends there on the economic front that are impacting small business that some of them are consistent with large business and some of them aren't. Clearly, what's different about the small business market is the rate of business failure, number one, and number two, the willingness for small business owner to actually drop health care coverage as a benefit provided that is fairly impractical in the large group market. So those dynamics on terms of dropping coverage, those are not new to the economy. Those have been a dynamic that has been a headwind for the last number of years.

In terms of business failures, obviously that goes up in a period of economic downturn versus not. I will come back to the issue about sort of what we do to maintain affordability, but I'm quickly going to point out to you -- and the offset to both of those issues in small group, of course, is that the economy grows just day in and day out faster in small group than it does in the large end of the market with new business startups and growth and so on and so forth. So you've got competing factors going on there. But the most important thing I want to point out to you is that, in the last economic downturn, I forget the year, but call it five years ago, whatever it was, when many of our competitors in the large end of market were talking a lot about in-group enrollment losses. I think we are on record as sort of saying it was a nonevent for us and is outweighed by a factor of 10 based on how successful we are in writing new business versus cancellations in any given quarter. So I think we've demonstrated in the past that even in weaker economic times and considering all of those factors, you really want to know how we are doing in selling business more than what's happening in the economy.

In terms of what we do to keep affordable, without trying to be trite, it's all about cost management. And so some of the questions that we've already addressed today, some of the points we made in our discussion, we are committed to being a low-cost provider of goods and services. And the bells and whistles that are most appealing in the large end of the market may be less appealing in the small end of the market. The competitive advantage there is your relationship with your broker, your ability to service business effectively, and your low cost position. And we are committed to all of those. And so, whether it's benefit design, whether it is actually our cost structure in admin, whether it's our medical management or contracting, they all end up to a low cost position that has been demonstrated by our success in that end of the market.

Matt Perry - Wachovia

If I could just squeeze in one more, Dale, you've usually, I think, in the last several quarters, given us an update on the kind of expansions and how you're tracking in some of your newer markets.

Dale B. Wolf - Chief Executive Officer

Yes. We actually did some of that. In the press release, you'll actually see some of those numbers in there. I have felt like the voice in the wilderness on this subject sometimes, but I've got to tell you that feels better today than ever. Oklahoma is now a full-fledged market for us. It's up to 17,000 lives and is just adding hundreds of members a month, as is South Carolina now, and as is Memphis, Tennessee. So those feel really, really good.

We are working on Tampa; we've told you that before. And we have two or three others in the works and are thinking about ways to increase our resource commitment to this area, because it feels really good. And we think about it in terms of the commercial group market, but it's also an important outlet for us in the individual business. We go into one of these markets with our two lead products being individual and small group. And by the way, it provides a platform for Medicare over time as well.

Matt Perry - Wachovia

Thank you.

Operator. [Operator Instructions]. We'll go next to Michael Baker with Raymond James.

Michael Baker - Raymond James

Yes. I just wanted to follow up on the question that was just asked, in light of the woes of some of the larger players in the industry and the lead times kind of needed to affect impact on new market development. It sounds like you're starting to think about potential exhilaration of resources. Is there any more color you can give us on that side of it?

Dale B. Wolf - Chief Executive Officer

I don't think so. I think that, if you look at our history on this, we started with a market or two in a year. We talked about, going into '08, that we would try to do somewhere between two and four. And I think all you're seeing here is a feeling like the upper end of that range is a better answer, going forward, than the lower end of that range and sort of don't over-think it beyond that.

Michael Baker - Raymond James

So it sounds like kind of the overall constraint is making sure you do it right.

Dale B. Wolf - Chief Executive Officer

As with everything we do.

Michael Baker - Raymond James

Thanks.

Operator

Thank you. And at this time, I have no additional questions. I'd like to turn the conference back over to Dale Wolf.

Dale B. Wolf - Chief Executive Officer

Thanks a lot, folks. Have a great day.

Operator

Thank you. This will conclude our conference call today. We appreciate your participation. You may disconnect at this time.

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