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Magellan Health Services, Inc. (NASDAQ:MGLN)

Q1 2008 Earnings Call Transcript

May 2, 2008 9:00 am ET

Executives

Melissa Rose – SVP, IR

Rene Lerer – President and CEO

Mark Demilio – CFO

Analysts

Josh Raskin – Lehman Brothers

Carl McDonald – Oppenheimer

Doug Simpson – Merrill Lynch

Daryn Miller – Goldman Sachs

Scott Fidel – Deutsche Bank

Greg Nersessian – Credit Suisse

Michael Baker – Raymond James

Operator

Good morning and thank you all for holding at this time. I would like to inform all participants that your lines have been placed on listen-only until the question-and-answer portion of today’s conference. (Operator instructions) Also, today's call is being recorded. If you have any objections you may disconnect at this time. I would now like to turn the conference over to Melissa Rose, Senior Vice President of Investor Relations. Thank you, ma'am, you may begin.

Melissa Rose

Thank you. Good morning and welcome to Magellan's First Quarter 2008 Earnings Conference Call. This is Melissa Rose, Senior Vice President of Investor Relations for Magellan Health Services. And here with me today are Magellan's President and CEO Rene Lerer and our Chief Financial Officer Mark Demilio. They will discuss the financial and operational results of our first quarter ended March 31, 2008.

Certain of the statements that will be 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 risks set forth under the caption ‘Risk Factors’ in Magellan's Annual Report on the Form 10-K for the year ended December 31, 2007, which was filed with the Securities and Exchange Commission on February 29, 2008, and in the 10-Q that we filed with the SEC later today.

Also, please note that in this call we refer to segment profits. For a reconciliation of segment profits to the most directly comparable GAAP financial measure, please see our form 10-Q for the quarter ended March 31, 2008, which you will be able to find later today on our website, magellanhealth.com under Investor Info.

I will now turn the call over to our president and CEO, Rene Lerer.

Rene Lerer

Good morning, everyone and thank you for joining us today. As you saw in the press release issued this morning, we produced $51.7 million in segment profit in the first quarter ended March 31, 2008. This was an excellent first quarter for us. Overall, we had better results than we had originally anticipated for the quarter and we have raised our overall segment guidance – profit guidance to $205 million to $225 million, driven primarily by strong results from our two new growth segments, radiology benefits management and specialty pharmacy. These two segments were the primary drivers of our excellent first quarter results.

The radiology segment's first quarter results were better than we had anticipated due to lower care costs and included $2.8 million of favorable one-time adjustments. We have invested a tremendous amount of effort in the last year into building out our capabilities in managing risk business and our results reflect the effectiveness of our cost management efforts in these contracts.

In addition, our refocused efforts in ICORE are beginning to deliver results and the first quarter reflected this with strong financial performance. As we previously stated, this year we have reprioritized our ICORE sales efforts back to its rebate business, which has been the primary driver of ICORE's historical success. In addition, we added resources to bolster our existing sales efforts. This refocused approach is beginning to yield improved sales and earnings and has delivered first quarter's results that were ahead of our original expectations. We believe that this focus on the rebate business, which has been the source of ICORE's historical success, will also improve our growth and bottom line of our distribution business. We have already made excellent progress in our sales goals for rebates distribution and consulting for 2008 and we are confident that we will meet our new goals for this year. Based on our excellent progress in ICORE, we are increasing our 2008 guidance for this segment.

As we look forward to 2008 in total, we are projecting that strong performance in these two segments will more than offset the first quarter’s mixed results in our behavioral segments as well as the previously announced charge related to Steve Shulman's transition agreement and, therefore, we are raising our overall guidance to $205 to $225 million of segment profit for 2008. Our EPS guidance will be $1.73 to $2.17, which reflects an $11 million reduction in interest income due to lower interest rates and higher stock compensation expense of $4 million, which is partially offset by our increase in segment profit. Mark will discuss our financial results and guidance in more detail in a few minutes.

I want to take a moment to highlight that while there has been a great deal of concern related to managed care companies care trends in recent months, we are not seeing signs of acceleration of trends in our business segments. Our trends by segment continue to be in line with our original guidance. Behavioral health risk business within our commercial segment, which is our newly combined health plan and employer segment, continues to experience trends in the 5% to 7% range. Our public sector segment is trending at 3% to 5% on a same-store basis, excluding Maricopa County. We are excluding Maricopa from this analysis because there has been significant change in the management of the program since we took it over from prior vendor, which makes it difficult to accurately separate out trends. Maricopa costs are running above our expectations, but we believe that this is not due to trend but instead is related to unique contract issues that we will discuss later in the call.

In our radiology benefits management segment our excellent quarter was partially driven by lower than anticipated cost of care. We are seeing some signs that our trends for this quarter may be running at the lower end of our projected trend range of 12% to 15%. With only one quarter of data showing this improvement of care, however, it is too early to be able to tell for certain if the trend is truly shifting and, if so, to what degree that trend has shifted. Also, given this is still the first year of these contracts, we are still evaluating seasonality and other issues including shifts in membership and product mix particularly related to January's eligibility. Given the uncertainty about the potential reduction in trend, we have not changed our forecast to reflect the full potential of improved care costs. However, we are raising NIA's guidance to reflect some modest improvement in care costs. From a sales perspective we believe that in an environment when managed care plans are struggling with costs helps us in marketing our products. Our products add value to health plans by helping them to manage their costs. When health plans are struggling with overall expense, the opportunity to download risk is even more attractive, especially in high trend areas like radiology.

Similarly, ICORE's specialty pharmacy services, which help manage costs in the fastest growing area of pharmaceuticals, look increasingly attractive when plans are actively seeking immediate solutions to managing their overall trend. While products that help bring down overall cost trends are attractive to clients regardless of the market environment, we believe that in an environment that creates a sense of urgency around cost of care initiatives further bolsters our selling efforts.

Let me give you a quick update on NIA sales efforts. The upper end of our previous 2008 NIA guidance included new risk business starting in the second half of the year. Given that we are now in May of 2008 and we have not yet closed on a risk radiology deal, a 2009 start date is becoming more likely. And, therefore, we have removed the new business for our guidance for 2008. We continue to have a good pipeline of opportunities and this delay is more of a sign of the length of the sales cycle for these contracts. I remain bullish about our sales prospects in this segment and have confidence that we will be very successful in continuing the growth of this segment.

As you recall, Tina Blasi joined us as CEO of NIA at the end of February. Tina comes to us from her previous role as Co-Founder and COO of Lumenos, a leading consumer directed health plan that was acquired by WellPoint in 2005. By leveraging Tina's strong experience and track record in product innovation and specifically in consumerism, we believe that there are excellent opportunities to further improve our cost management initiatives and to build out differentiate our full-service risk products.

Our new guidance for NIA includes investments and product enhancement, development, sales and marketing. We have already built out and are piloting a program that applies the principles of consumerism to radiology benefits management, which includes engaging and educating members before they receive services. These innovative product enhancements supplement the significant amount of sales groundwork that have already taken place. I believe that we are well positioned to close the risk deal and I look forward to keeping you updated as the year progresses.

Overall, the quarter's results were excellent. Our trends are stable and we are increasing our guidance for the year. I will now turn the call over to our CFO Mark Demilio, who will walk through additional details on the first quarter financial results and our increased 2008 guidance.

Mark Demilio

Thank you, Rene. As indicated in the press release issued this morning, our segment profit for the first quarter of 2008 was $51.7 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 cost of care and cost of goods sold, direct service costs, and other operating expenses excluding stock compensation expense. 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 profit to the line item income from continuing operations before income taxes and minority interest. We encourage you to review such reconciliations for an understanding how segment profit compares to that GAAP measure.

As you saw in the tables to our press release we have combined the behavioral health employer and health plan segments into a single segment which we were currently calling commercial. This newly combined segment was the result of an organizational change we made to integrate the historical employer and health plan strategic business units. Our Form 10-Q to be filed later today will include a restatement of last year's quarterly results to reflect this combination.

Revenues in the first quarter of 2008 were $650.3 million compared to $487 million for the quarter ended March 31, 2007. The revenue increase resulted primarily from new business added since the prior-year quarter of $219.4 million, including the conversion of a radiology benefits management ASO contract to a risk based contract and the startup of the CIGNA risk radiology contract and the Maricopa County behavioral health contract. Increased distribution activity from new and existing customers in the specialty pharmaceutical management segment of $12.7 million also contributed to this increase as well as favorable rate changes of $11.5 million, and same-store membership increases of $7.5 million. These increases were partially offset by the loss of membership due to contract terminations of $97.7 million.

Net income for the first quarter of 2008 was $17.2 million, or $0.43 per share on a diluted basis. For the first quarter of 2007, the Company's net income was $21 million, or $0.53 per share on a diluted basis. Segment profit for the commercial segment was $41 million, which was a decrease of $14.6 million from the prior-year period. This decrease is mainly due to the impact of contract terminations of $11.7 million and a net unfavorable impact of care development between the quarters of $3.9 million, which includes unfavorable care development of 5.6 million recorded in the current quarter related to prior periods. These decreases were partially offset by favorable retrospective rate and membership adjustments of $3.9 million.

It is important to note that most of the unfavorable prior-period care development in the current quarter related to the run off of terminated contracts and some relates to the higher membership in the prior period that generated the retrospective membership adjustment to revenue. With respect to the continuing contracts, the care trend continues to run as expected at approximately 5% to 7%, as Rene mentioned earlier.

The quarter was favorably impacted by membership and rate increases that exceeded our expectations and these are the primary drivers for our increasing guidance for this segment to $170 million to $175 million of segment profit from the previous range of $164 million to $169 million. Current year first quarter segment profit for the public sector segment was 18.6 million, which is $200,000 better than the prior year first quarter. This increase is mainly due to improved care in the current quarter of 5.1 million and retroactive rate adjustment to 500,000, which increases were partially offset by the net negative impact of new and terminated contracts of 1.4 million and the net unfavorable impact of out-of-period care development between the quarters of 3.3 million, which includes unfavorable care development of 1.2 million recorded in the current quarter related to prior periods.

As Rene mentioned earlier, our results in the quarter for our new Maricopa County contract were less favorable than our expectations. This is primarily due to the deferral of revenue related to contractual performance thresholds not achieved in the quarter and higher than expected care costs primarily due to higher operating costs at the Company-owned clinics. These unfavorable results were partially offset by slightly favorable aggregate care trend in our other contracts.

Looking at the remainder of 2008, initiatives are in place aimed at getting us back on track with the performance thresholds in Maricopa County and in managing the cost at the clinics. Generally the determinations associated with the performance thresholds are carried out on an annual basis. We believe these initiatives will help us bridge the gap in our results in Maricopa as we progress through the year.

In addition, as you know, our joint bid with Coventry in Tennessee was not successful and, therefore, based on the state’s schedule we will lose the bulk of our TennCare business in the west region as of November 1 this year and the bulk of our TennCare business in the east region on January 1, 2009. Based on our results in the first quarter, our revised projections for the Maricopa County contract and the loss of the TennCare west region contract in November, we are lowering our guidance for the public sector segment in 2008 to $81 million to $84 million of segment profit.

First quarter 2008 segment profit for the radiology benefits management segment increased by $13.4 million from the first quarter of 2007 mainly due to the impact of the new risk contracts of 9.6 million, favorable prior period care development of 1.1 million, and higher net favorable performance guarantee revenue of 2.1 million, of which 1.7 million related to the settlement – I am sorry, approximately 1.7 million of that performance revenue related to performance commitments for periods prior to the first quarter that were deferred until we settled with the customers in the current quarter. In addition to these out-of-period items, we also experienced favorable care in the period versus our expectations, as Rene mentioned earlier.

There were many factors that were affecting care costs during the quarter, including the effectiveness of our managed care initiatives, seasonality, and changes in membership mix related to January eligibility as well as underlying care trend. Given that these contracts are still less than a year old, it is difficult to ascertain how much of the improvement of care is attributable to each variable and, therefore, it is difficult to know with certainty the degree to which the improvement in care will continue. With only a quarter of data showing the lower care, we have increased our guidance to building modest improvement in care cost, but we have not factored in the full potential impact of the lower care cost that we have experienced in the first quarter. At this point we continue to believe the underlying care trend is running at approximately 12% to 15% annually and it is premature to adjust this range at this point. Subsequent quarters will experience intra-year care trend while risk revenue rates will remain flat until the next scheduled rate change with CIGNA as of October 1.

In addition, CIGNA continues to experience declines in risk and increases in ASO membership. As a result, the contract revenue for 2008 for CIGNA is now projected to be approximately $105 million. This includes the last region scheduled to be implemented in 2008 which went live yesterday. As Rene stated, we are removing from the higher end of our guidance any margin in 2008 associated with the new business contract.

We also are planning for increases in our direct service costs as we continue to invest in the development of new products and capabilities, as Rene discussed earlier. Despite these headwinds, intra-year care trend, lower risk membership, removing Blue Sky and new contracts, and increased investment, based on the results of the first quarter we are raising our guidance for the radiology benefit management segment for 2008 to $32 million to 38 million of segment profit.

First quarter 2008 segment profit for specialty pharmaceutical management was $6.3 million compared to $5.4 million in the prior-year quarter with the increase being mainly due to an increase in consulting and rebate revenue. The results include the recognition of $600,000 of rebate revenue related to prior periods based on information attained after the end of the prior period, demonstrating market share improvement. As Rene discussed, the results for the specialty pharmaceutical segment are tracking better than our initial estimates as our refocusing on the rebate business is reaping better sales and results in that piece of the business. The distribution and consulting businesses are also performing ahead of our plan and based on these results we are increasing guidance for this segment to $23 million to $27 million of segment profit.

Corporate and administrative costs, excluding stock compensation expense, were $1.2 million greater than the first quarter of 2007, primarily due to the $4.7 million of payments associated with the termination of employment of our former CEO under his transition agreement, which was partially offset by expenses incurred in the prior-year quarter related to bid proposals, and by lower current quarter employee benefit expense. Excluding stock compensation expense, total direct service and operating expenses were 15% of revenue in the current year quarter compared to 18.7% in the prior year quarter. This decrease is primarily due to our ability to leverage our operating and corporate infrastructure as we added additional revenues from the radiology benefits management risk contracts and the Maricopa County contract.

In the first quarter of 2008 we recognized $12 million of stock compensation expenses compared to $6.8 million in the first quarter of 2007. The increase is due to the acceleration of stock compensation expense of $5.4 million related to the termination of employment of our former CEO under his transition agreement. Primarily as a result of this charge, our new forecast of stock compensation expense for 2008 is $36 million to $40 million.

Depreciation and amortization expense was $14.4 million for the first quarter of 2008 compared to 13.7 million in the first quarter of '07. The increase is primarily due to additions since the prior-year quarter, inclusive of assets related to the Maricopa County contract, partially offset by a decrease in amortization expense due to an intangible asset, which became fully amortized in the prior year.

Interest expense was $1.2 million for the first quarter of 2008 compared to $1.9 million in the first quarter of 2007, mainly due to reductions in outstanding debt balances as a result of scheduled payments and lower interest rates in the current year quarter. Interest income was $5.5 million for the current year quarter compared to $5.2 million in the prior year quarter. This increase is mainly due to an increase in average invested balances partially offset by lower investment yields. Based on the lower interest rate environment, we are reducing our projections for interest income for the year by approximately $11 million to $16 to $19 million. As in our original guidance, this estimated projection of interest income is based on an assumption that there is no use of cash during the year for acquisitions or other capital deployment activities.

The effective income tax rate for the year ended March 31, 2008 was 41.6%, which is consistent with the prior-year quarter. The effective rate in the quarter was impacted by certain discrete items and we believe that our effective rate for the year will be 40%, as we estimated in our original guidance. As you know, our effective income tax rate varies from the federal statutory income tax rate primarily due to state income taxes and permanent differences between book and tax income.

Turning to cash flow and balance sheet highlights, our cash flow from operations for the quarter was $12.4 million and the net change in unrestricted cash and investments in the quarter was a decrease of approximately $8.3 million from $353.5 million at December 31 to $345.2 million at March 31, 2008. the decrease in cash in the quarter of $8.3 million despite the segment profit of $51.7 million was due primarily to the funding of restricted cash of $15 million during the quarter for one of the radiology risk contracts, the run out of net contract liabilities for terminated contracts of $10.2 million, the payment of 2007 management bonuses in the quarter of approximately $18 million, capital expenditures of $8 million, and other working capital changes primarily due to timing. Most of these items were expected and included in our cash flow guidance.

We are projecting that our net cash flow for the year will be approximately $20 million less than our previous guidance of $136 million to $193 million. Approximately one-half of this decrease is due to the reduction in our forecasted interest income. The other half is due to timing for items that we included in our 2008 projections of cash flow but had actually benefited 2007 cash flow and thus caused us to start the year with a higher cash balance. You will recall that when we reported 2007 results our unrestricted cash and investments were approximately $30 million higher than projected and we informed you that approximately $10 million of that higher balance was due to the timing of items that we had in our 2008 cash flow. Of course, our cash balances at the end of 2008 will be unaffected by the differences in timing. These cash flow projections include, again, no assumptions regarding acquisitions or other capital deployment during the year, so any such activity will impact these projections, of course.

Our unrestricted cash and investments of $345.2 million at March 31, 2008, consisted of $332.8 million of unrestricted cash and $12.4 million of unrestricted short-term investments. Approximately $41 million of the total unrestricted cash and investments at March 31, 2008, relates to excess capital and undistributed earnings held at regulated subsidiaries. The Company’s restricted funds increased by $21.3 million, $15 million of which is attributable to the funding of an escrow account in relation to one of the risk radiology contracts as I mentioned earlier and the remainder of which is attributable to the timing of cash flows with our regulated subsidiaries and other regulatory requirements.

As of March 31, 2008, total debt was $9.7 million, which consisted of $8.3 million of term loans and $1.4 million of capital lease obligations. Subsequent to the end of the quarter, we repaid all of the outstanding term loans and entered into a new one-year, $100-million revolver facility with Deutsche Bank and Citibank. As you know, our previous credit agreement was due to expire in August of this year and we wanted to proactively address obtaining the facility to back our letters of credit and provide additional liquidity. We were able to obtain this facility on favorable terms and it should provide a bridge until the credit market conditions improve.

Before I turn it back to Rene, I wanted to briefly explain my thinking behind telling Rene and the Board that it was time to begin a transition plan for me to leave the Company. I have not put a time limit on my departure, but I do want to begin working with the Company to find and transition my replacement. I have had a long and exciting career here at Magellan since I joined the Company in 1999 as General Counsel. Having served in the General Counsel and Chief Financial Officer roles during my tenure, including some periods of both, I have experienced some very challenging and rewarding undertakings. I am proud of the Company's and my achievements over this period and I also take pride that the Company is soundly positioned and poised for bigger and better things. And while it is tempting for me to stay and be part of that bright future, I feel that I am at a stage in my personal and professional life that it's time to move on and devote my attention to other ventures and activities, not the least of which will be spending more time with my family. Nine years is longer than I would have ever planned or imagined at the beginning of this voyage and I now feel I am overdue for a change.

It is unfortunate that my decision has come at a time when the Company is entering into a new and exciting phase with Rene as CEO. I actually postponed my decision process as a result of Rene taking over to see whether my plans could include staying and partnering with Rene on this next phase. I have an enormous amount of respect for Rene and faith in him and his ability to lead this Company forward. He and I have had a very good relationship and I think we make formidable team. All of those factors made me think hard and reconsidering my future plans. But, as I said, in the end I feel I am overdue for this change and my family and I are looking forward to the next stage of our lives.

Those who know me know that my work-life balance has always been out of kilter, so my first priority will be to inject more life and less work into that equation. I will be looking to change the course of my personal and professional life and, therefore, I do not plan to seek CFO positions because, to be honest, if I were to seek – I want to seek to be a CFO, I would continue to do so here at Magellan for Rene. I have been able to utilize my legal and financial skill sets here at Magellan, but I am looking forward to leveraging these backgrounds in new fields of endeavor moving forward. I don't know yet what that may entail, but I suspect that first it will involve serving on Boards and performing other advisory engagements.

Although I am not leaving yet, I do want to take this opportunity to thank the Board, Rene, other members of the management team, my finance team, and all of the employees at Magellan with whom I have worked over the years for helping provide a rich and rewarding experience. We have fought some mighty struggles together and achieved some remarkable achievements. I thank you and wish all of you a continued success. Please indulge me as I am sure I will continue to thank all of you as we continue to work together for the foreseeable future during this transition.

But, now let me turn this back to Rene so he can discuss more important matters, namely some thoughts on our strategic outlook. Rene?

Rene Lerer

Thanks Mark. And let me just take a moment to say that I have truly enjoyed working with you over the years. You have been a great partner and I valued your strategic insights and financial expertise and friendship throughout this time. You have played a key role in our successful transition into a diversified specialty managed care organization and while I am personally happy for you and your family and wish you happiness in your future endeavors, you will be most certainly missed here at Magellan.

Mark Demilio

Thanks, Rene.

Rene Lerer

Before we close today, I want to spend a few minutes discussing our strategy and updating you on where we stand on our capital deployment initiatives. As I stated on our last call in 2008, our priorities are to generate growth and to continue to execute well on all our existing businesses. The strong results in the first quarter are a sign that we are moving in the right direction and that we are making excellent progress on our objectives.

I also mentioned in the last call that I will be reviewing the strategy that has been set and the tactics that have been employed. Obviously, the best use of capital is part of this analysis and decisions about the use of capital must be made in conjunction with our strategic direction. We are currently in the midst of doing a full strategic review using both internal and external resource and consultants. It is my expectation that sound acquisitions will remain a fundamental component of our growth strategy; however, we continue to believe that fortifying and diversifying our platform remains the best long-term strategic use of capital.

It is also important to note that the Board has repeatedly stated that it will review its position on capital deployment on a regular basis, taking into consideration our strategic direction, our acquisition opportunities, market conditions, and our cash position. The Board's next meeting later this month and our discussion will cover our strategic review as well as our capital deployment alternatives. I want to stress that although the meeting will be occurring later this month I am not suggesting that any specific decision or announcement will be made at or as a result of that meeting. We take this matter very seriously and want to make sure we fully review and assess all alternatives.

In closing, I would like to thank everyone for joining us today. We delivered great first quarter results and have increased our guidance. Much of the upside in the quarter and the increased guidance is driven by excellent results in our two new growth segments, radiology benefits management and specialty pharmacy, which demonstrates that our investments are gaining traction and delivering results. I am very pleased with the quarter and I look forward to continuing to keep you updated as the year progresses. Thank you.

I will now turn the call over to the operator for any questions.

Question-and-Answer Session

Operator

Our first question comes from Josh Raskin with Lehman Brothers. Please go ahead.

Josh Raskin – Lehman Brothers

Hi. Thanks. Good morning. Mark, first and foremost, congrats on the pending transition, I should say. Two questions. First, on the behavioral health component, one, I was wondering if you could break out just – as a sort of a new segment change for us. The weakness, was it more employer group or health plan, and then if you could talk a little bit about what's driving the cost trends there? And then the second question, which I am sure will be echoed, in light of the lower yield environment, I am just curious if that plays into your thoughts around the ability to buy back shares. Just obviously dilutive from an EPS perspective the lower rates, but it also impacts your returns, your weighted average cost of capital as far as I calculate. So, just those two questions.

Rene Lerer

Okay, Josh, as for the first question, the quarter in commercial was not weak. We had unfavorable care development that impacted the quarter and those – most of that was related to the terminated contracts and the run out of those contracts which were, as you know, health plan contracts to the extent these are looking to identify that piece. It did relate to the old health plans. So, – but that was most of the, if you want to call weakness in the quarter, it was the unfavorable care development. And another piece of it related to retrospective membership adjustments that went – increased and we got increased revenue for that. Otherwise, the care trend in the quarter was very stable and we had membership and rate increases primarily in the old health plan segment that caused our quarter to be good and, actually therefore, caused us to increase guidance for the year.

Mark Demilio

The second question, Josh, relates obviously to capital deployment strategy. And, obviously, as we have looked at this each quarter over the past couple of years there are lots of factors that are taken into account. And, obviously, the impact of both the debt markets as well as the interest market and our ability today to generate much lower interest income is clearly an important component of that discussion. And as I said, we have spent the last couple months and continue to do a very detailed strategic review both internally and using external consultants to look at sort of the strategic direction. So, as we look at all the pieces on capital deployment, acquisitions, uses of cash, debt markets, obviously, the impact of the change in the interest rates will impact that discussion that we are going to continue to have. So, I don't have an answer, but it clearly is a material component that will be taken into account.

Josh Raskin – Lehman Brothers

Okay. And I am sorry maybe, Mark, let me be a more specific. I was talking about the unfavorable development as opposed to the weakness. Obviously, I understand the guidance coming up for the broad commercial segment, but just that unfavorable development, I guess if you see that in the health plan business, I am curious, why no change in thought around the 5% to 7% cost trend.

Rene Lerer

Okay. So, yes, the unfavorable development primarily related to the two terminated contracts, right? As we run out those contracts what we have seen is the run-out is more than we anticipated. So, it affects our current quarter even though we don’t – we no longer have those contracts. So, the other contracts, the continuing contracts, we have not seen that development, that adverse development. So, we are not seeing that additional trend. We also – to the extent that a couple of those contracts have seen unfavorable development, it's mostly those contracts that have had retroactive membership increases. So we actually had more membership last year toward the end than we knew we had when we were estimating those claims. So, that caused us to have higher – as that ran out we saw higher claims. We believe it's related to the fact that we had higher membership, but also we had retrospective revenue for it this quarter. So if you take all that in balance and you look at what we have seen in the current quarter, we don't believe that we are seeing a spike in care trend. Our continuing contracts continue to be stable and we see that continuing through the rest of the year. But we do see that the increased membership that we will have this year as well as some rate increases that were better than we anticipated caused us to increase the guidance for the year.

Josh Raskin – Lehman Brothers

Okay. That's helpful. I think I understand. And then just lastly in the Q you mentioned you were going to give the restated quarterly numbers, I assume. And then are we going to get a breakout of what segment profit for health plan versus employer was or is that just those operations are combined and we are no longer going to see them?

Rene Lerer

Those operations will be combined. We will provide you with separate MLR for behavioral risk business versus EAP business. As you know from reading our Q, most of the employer business was EAP. We will continue to provide EAP membership versus risk membership versus ASO membership for commercial, so you will – and for both membership and revenue. You will be able to track how the membership and revenue continues to track for EAP business which, again, was the bulk of that old employer segment. So, you will get most of the information that you would have – you will be able to derive most of the information you would have received for, but the actual segment profit will be reported on a combined basis.

Josh Raskin – Lehman Brothers

Okay. Thanks.

Operator

Thank you. Our next question comes from Carl McDonald with Oppenheimer. Please go ahead.

Carl McDonald – Oppenheimer

Thanks. I wanted to run through what some of the more important performance metrics are associated with the Maricopa contract and then – so what they are, how they are measured, and how big the shortfall was in the first quarter, whether or not that can be made up over the course of the year?

Rene Lerer

Well, Carl, there are a number of performance guarantees in any contract. In this contract, particularly, there are probably hundreds of them on every aspect of the business related from the clinical side to the administrative side to data and claims and so on. So there are literally dozens of pages just addressing those things. We haven't really broken them out. But for the most part, the majority of those are measured on an annual basis and not on a quarterly basis. So although in the quarter we didn't hit our goals for those achievements, as we stated in the comments, they are measured on an annual basis, so we were working very hard to try and recruit some of that and get back to it. But we haven't broken them out by what the specific items are. They really relate to every aspect of the business.

Mark Demilio

And certain of these measures like in all of our contracts there are two aspects to it. One is actually doing the performance and other is having the data to improve the performance and we think we are having difficulty in the latter as well as former. To the extent that's the case, we think it might be easier to recoup that piece of it to the extent that we need to get the data together to show that we hit the threshold versus actually having improve performance, but it's a little bit of both.

Carl McDonald – Oppenheimer

Okay. And then the Company-owned clinics in Maricopa, specific initiatives to improve cost there? And then also if you can remind us what the future of those clinics will be.

Rene Lerer

The clinics as you know are care. They are not administrative dollars. They are care dollars because everyone in the clinics are related to or directly providing services. So the administration of the clinics is looking at how we administer those clinics and are we most effectively organized and orchestrated and set up. So we continue to move that along. So it shows in care dollars even though it's the administrative expenses associated with those clinics. As you know, as part of the original RFP process there was a commitment in the RFP to transition the 23 clinics to PNOs, physician network organizations, by – within two years, which would be the third quarter of 2009. We are working pretty actively on a number of those transitions right now. We have not transitioned any of them to date, but we were working carefully with potential acquirers or parties, groups of physicians, other entities that we will transition them to. Again, the expectation is that in the next 18 months they will all be moved over. Obviously things change from time to time, but that's our goals at the moment.

Carl McDonald – Oppenheimer

Great, thank you.

Operator

Thank you. Our next question comes from Doug Simpson with Merrill Lynch. Please go ahead.

Doug Simpson – Merrill Lynch

Hi, good morning, and Mark, congratulations. Just a couple quick questions. I guess Rene, the recurring theme, obviously, on every conference call is when and what might you choose to do with the cash and what that timing might look like. I guess I will just ask it a different way. Is there something as outsiders we should be looking for in thinking about as a potential trigger that would lead up to that type of a decision? And I guess to ask you more bluntly, how do we know we are not going to be sitting here in three years with Magellan just having a bigger cash stockpile? What ultimately do you see? Can you give us some parameters around your thresholds or trigger levels?

Rene Lerer

Again, I mean we have said all along our goal at the end of the day is not to just routinely accumulate cash over time. That's never been our goal, never been our stated intent. The goal was to use that money and we have always said in a variety of fashions, i.e., either doing acquisitions or other forms of capital deployment through buybacks or dividends or whatever else. That still remains our goal. What we have done since I have taken over the reins, over the past couple of months, is really looked at the real strategic alternatives we have for that money in today's world. It's a different environment than it was both in the Company and outside the Company since six months ago or nine months ago, and it’s incumbent upon me and my responsibility to the Board to really develop a strategy for either looking at acquisitions capital deployment, one, the other, or both. So we are actively doing that. That's a change in process for us (inaudible) dedicated group of people looking at all the alternatives in actually a fairly deep manner. So, it's not our expectation that three years from now we will continue with accumulated cash and not gone down any of those roads. Likely we will go down one or potentially a combination of them. But we just need the time to really understand the current market, really understand the current M&A world and to understand the cash implications of the different opportunities that we have in front of us. So, it's not our intent to drag this out. It's our intent to be thoughtful and strategic and to come back with what we think is in the best interest of the Company and its shareholders.

Doug Simpson – Merrill Lynch

And it is interesting given the cash position and the cash flow generating ability. You just wonder if you did pay a dividend it would probably help you on the equity side, which opens up further financing options over and above just having the cash on hand. Maybe just take taking a different direction, given some of the turnover we have seen, obviously, with Mark moving on and your elevation to the CEO role, can you just give us a quick update on where the rest of your management team stands, your confidence in the depth and breadth and should we be expecting any further changes, any incremental hires with the business realignment?

Rene Lerer

Obviously, Mark's decision, as Mark stated with tears in his eyes, was a very personal decision. And it was related – Mark will be joining me and Melissa over the next several weeks and working and talking to investors and in conferences, so everyone will have an opportunity to talk to Mark and get that perspective. It really was a personal decision on his lifestyle and his relationships at home and things that he has wanted to do for a number of years. And I am disappointed, although I respect his decision, and that's what happens when you get to be his age. But, obviously, we are the same age. As far as the rest of the team, the team is quite stable. We’ve had a very strong working relationship with all of the operating units in the Company as well as all of the other corporate functions on the shared side. With the exception of a few new adds at the most senior level like with Tina, the other folks have been with the Company for many years, and have been very motivated and successful and have worked very closely with me over the five and a half years that I have been here. So, I can't tell you that there won't ever be any more surprises because surprises are, by definition, things you can't predict. But we think that the team is very stable, is very motivated, it is excited about the opportunities. And the demonstration of the growth that we have seen in radiology and specialty has been particularly pleasing to us because particularly on the ICORE side given some concerns the demonstration that that team really has been motivated to turn this and we have made great improvements is a real positive for us. So, I think the team is quite stable. I think they are quite motivated. Again, it's a tough thing for me personally to see Mark leave. But we are comfortable that we will move forward. We are actively engaged in a search to find a replacement for Mark. Mark has been great in that he will stay as long as it takes. Hopefully, it will take less than the three years that you are subscribing for the cash, but I mean Mark will be here as long as we need him to be here both until we hire someone and through a transition, and I really can't ask for any more than that. So, we are pretty comfortable with where we are, understand that changes creates some concern, but we are really in a good place from our perspective and we are moving the Company forward well.

Doug Simpson – Merrill Lynch

Okay. Thanks.

Operator

Thank you. Our next question comes from Daryn Miller with Goldman Sachs. Please go ahead.

Daryn Miller – Goldman Sachs

Hi, good morning. Mark, question in terms of what you are seeing in the debt market in the types or the amount of leverage you think you could bring on in the current environment. And then, Rene, looking at your due diligence you have done on the M&A side, what are you seeing in terms of valuations in relation to maybe some valuations that were rich last year bid up by financial sponsors, if that's maybe come back in this year?

Mark Demilio

Daryn, as for your first question, we get different input from different bankers, and most of them will admit that they are speculating because there are so few deals being done as to what the debt markets could possibly bear at this time. But generally what we are hearing is that we could lever probably comfortably at two times to three times and certainly maybe toward the upper end of that range in the face of an acquisition if we are doing an acquisition and it's a good acquisition, they see it that way then we can probably get up to three times if we need to do that acquisition. Absent that, it's probably around two times if we are levering up for other reasons.

Rene Lerer

I think it's a function of not only what the debt markets will bear but what we are comfortable with and we tend to be a bit more conservative. So, we are looking in that two to three times significantly less than we had talked about a year or two ago or Steve had talked about a year or two ago. In terms of the values that we are seeing, clearly with some of the impact in the public markets and the drops in valuations there, we are beginning to see that in the private sector as well. It obviously lags and takes a little longer but we are beginning to see expectations drop in terms of multiples on valuations or income in terms of what an acquisition would look like. So we are somewhat optimistic that those values are coming down and – but, again, it's not so much a generic comment. It really relates to specific things that we may or may not be interested in and whether the markets are seeing valuations drop or not it's much more relevant to us in the areas of interest that we are seeing those drops and that's what – our strategic review is really looking at right now.

Daryn Miller – Goldman Sachs

Great. Then one last one for you, Mark. How much was the favorable development in the radiology business?

Mark Demilio

1.1 million.

Daryn Miller – Goldman Sachs

Okay. Thank you.

Operator

Thank you. Our next question comes from Scott Fidel with Deutsche Bank. Please go ahead.

Scott Fidel – Deutsche Bank

Thanks. Good morning. And, Mark, first of all, good luck on your next endeavor. Just have a question around sort of the broader trend we have been seeing in the commercial market in terms of the ongoing shift to self-funding and movement away from risk and just interested if you guys can help us think about how that impacts your own commercial business and whether it's sort of a direct correlation, and then also if you can talk about in terms of in-group attrition expectations and commercial, what you are seeing and what you are think being there relative to the broader slowdown in the economy?

Rene Lerer

I guess on the first question is there a shift going on between risk and ASO, obviously that primarily relates to commercial business and not the public sector business. We don't see that there. On the commercial side, clearly we have seen that. And, obviously, we talked about if specifically on the radiology side that the mix in business in CIGNA where CIGNA's membership growth has been primarily on the ASO side and there has been some losses on the risk side. Obviously it impacts us. It's not a huge shift but it’s material and it’s meaningful and it impacts our risk revenue, which you saw again as we discussed the – our expectations for revenue from CIGNA for 2008. We see it in a number of places. But, again, it sort of varies with time. Right now we are seeing that. It will be very interesting for us to watch as the economy changes whether there is a concern to moving back towards risk as things change in the world around us. It does impact us, although on the ASO side we do quite well and we make very healthy margins. So obviously our businesses are mixed. And if you look at radiology, the bulk of our membership is ASO. Our risk membership is a small fraction of the total membership, although it obviously represents a much higher percentage of the revenue than membership represents. And the second question…

Scott Fidel – Deutsche Bank

Just around sort in-group attrition or how sort of particular commercial accounts are holding up relative just to the broader economy?

Rene Lerer

We don't see huge changes there. I mean, the number of uninsured is not dramatically increased. It goes up as it normally goes up. So, we have some customers on the health plan side or on the health plan side that some are losing members – some are gaining members. And in fact, the increase in our guidance in the commercial side much of it is as a result of increased membership above our expectations. So that varies from account to account, but in total, it's not a huge dramatic shift for us. Historically it's been favorable.

Scott Fidel – Deutsche Bank

Okay. And then just thinking about because you do a lot of business both with Blues and non-Blues in the commercial market. Are you seeing any difference in terms of trends relative to that mix shift with ASO and risk between the Blues and the public plans let's say or the non-Blues or are you seeing relatively similar trends around ASO to risk with the Blues and non-Blues?

Rene Lerer

I think it's more a function of national versus regional or smaller accounts. Typically, smaller regional customers generally have more risk business than national customer – than national plans. National plans have national employers and obviously the bulk of national employers are ASO. So it's a function not of Blue or commercial, it's a function of whether they are focused on small group, middle market or large market. The more they are large market and middle market focused, the more ASO penetration they have, the more small group they have the risk they have as well as changes in other kinds of customers that are focused on risk. So, we see Blues that are moving more to ASO than risk and we see Blues that are going the other way. Same on commercial. So, again, it's a function of the market they play in as opposed – and the size of their business and their typical customer more than Blue versus non-Blue in our history.

Scott Fidel – Deutsche Bank

Got it. And then just a question on radiology and the cost trends there and seems like you are seeing a bit slightly better trends there with CIGNA. And just interested in terms of what might be the drivers there. Is this utilization related and then sort of reference mix? What type of different mix impacts would bring trend down relative to prior expectations?

Rene Lerer

First, it's all of our risk business. It's not just CIGNA. It’s our risk business in general. And secondly, number one, we are putting, obviously, a fair amount of management techniques in place as we talked about. We are putting in putting in consumerism techniques. It's an issue of mix in terms of when you lose risk business and it goes to ASO what are the characteristics of the businesses that you lose versus that you keep. Do they have a different risk profile? We have actively tried to manage obviously utilization, provider unit cost, mix of provider unit cost. So it's really a combination of all of those things. And as we said in the statements the first quarter is always a little bit difficult for us. It's our first quarter for these businesses. Mix of members by product changes. Eligibility gets involved and often takes some time after the first quarter to resolve all of those issues. So, as Mark said, we are increasing our guidance, but probably less than you would have predicted based on our results in the first quarter because we are still reviewing the first quarter, still seeing incremental data to demonstrate whether that is truly a trend or just a first quarter impact that we will see go back to our expectations of 12% to 15%.

Scott Fidel – Deutsche Bank

Okay. And then just one last follow-up question just around TennCare now that we have got sort of all the information there. How would you recommend in terms of '09 us thinking about how much TennCare revenue and segment profit we should retain and how much we should take out at this point?

Rene Lerer

Well, obviously, not giving '09 guidance. But we have said that the east and west together after – in total was about 208, marketing was up 280 – 260 and we believe that there is a piece of that we will retain, which is 20 million – it was 20 million in the middle and in the combination for the kids in the east and west it's 20 million, although we have not gotten notification of that today but we have not gotten notification that we won't. If you take that out and you split it between the regions then obviously they are reasonably close in total revenue. You would split it for November for the west and January going from the east. As far as segment profit, obviously, we don't talk about segment profit by individual account.

Scott Fidel – Deutsche Bank

Okay. Thank you.

Operator

Thank you. Our next question comes from Greg Nersessian. Please go ahead – with Credit Suisse.

Greg Nersessian – Credit Suisse

Hi, thanks. Good morning. And, Mark, thanks for all the help, and good luck going forward.

Mark Demilio

Thanks, Greg.

Greg Nersessian – Credit Suisse

My question was on – is sort of a follow-up to Scott's. just in terms of the TennCare contract running off, I guess are there any more – once that contract is fully run off, are there any more large contracts that you have either in the health plan or public sector side that you would characterize as potentially being at risk or maybe going out to RFP over the next year or two?

Rene Lerer

I mean all of our commercial customers and public sector customers are being renewed. They are active. We work them daily. We don't know what they will do in 2009. Obviously, the biggest one has been Maricopa which is a three-year contract plus multiple – opportunity for multiple one-year extensions. So, we don’t – we haven’t – anything that we have talked about that is potentially at risk we have disclosed here. Obviously, things can change and things happen. But everything that we have any sense of is at risk we have talked about.

Greg Nersessian – Credit Suisse

Okay. The one that I did wanted to ask specifically about was just the WellPoint business in Ohio. Obviously, they pulled out of one CFC region there. Have you quantified how much revenue is generated from that contract and what the impact would be if they decided to pull off from other regions?

Rene Lerer

We obviously know what's happened in Ohio, that was a March 31 event, as well as any changes that they could or couldn't do we view that all the time. But all that’s baked into our forecast. So, we don't go into individual accounts. But, as we gave you our re-forecast for 2008, that business is in the health plan segment and it's included in our forecast.

Greg Nersessian – Credit Suisse

Okay. Great. And then finally just the Florida budget is due today. Is there any legislation or any provisions that you expect to come out of there that might impact your public sector business there?

Rene Lerer

I mean clearly there has been some discussion about where they come out in their deliberations in their house and senate. They talked about less of a decrease than we anticipated. But they are talking about it at a global level for all the managed care expenses. We don't know. They have not indicated to us how that gets allocated back amongst the various components of Medicaid in the state. There are MCOs in the state. There are carve outs due for service. How that gets carved out and pushed down into the regions and how that gets adjusted by region is a very complex process that we don't expect to get a sense of before August of this year. So although the budget numbers seem to be less of a decrease than potentially was anticipated, it's really very early for us to know how that would impact us directly because there are so many components to doing it. But, again, remember, in all of these contracts there is a requirement under CMS that there is actuarial soundness, so it's just way too early for us to know what that means at the detailed tactical level.

Greg Nersessian – Credit Suisse

So just to be sure, the budget that passes in July – goes into effect in July, but your rates don't get renegotiated, they get reset in September. So, even if it there is a cut there is an opportunity to negotiate your rate separately?

Rene Lerer

Yes. I mean – that's – the fiscal year for them, for us starts September 1.

Mark Demilio

We believe we will be able to negotiate each region separately based on the results of the sector because the contract requires as you said, actuarial soundness, so--

Rene Lerer

Each region is priced separately. They are all done independently of each other through whatever formulas they have across the state. There are formulas within the state, they try and do some different things in terms of figuring out the regions, but from our perspective each one is a separate contract.

Greg Nersessian – Credit Suisse

Okay. Great. Thanks.

Operator

Thank you. Our last question comes from Michael Baker with Raymond James. Please go ahead.

Michael Baker – Raymond James

Thanks. I was looking for Rene to bridge two comments that were made. The first being that with increased focus in on commercial cost trend the potential to accelerate sales. And the second one being in risk radiology benefit management some elongation of the sales cycle.

Rene Lerer

Let me do the first one. The comment really relates to some the activity what we see recently from some of the plans that may have some concerns about their MLR. A number of them talked about specific issues whether in their Medicare population or whether in their oncology business or some others. And, generally, when you begin hearing those conversations we think that creates an opportunity in a very focused way to work with those plans to identify where they have concern in their MLR and that give us an opportunity as experts in those specific areas to go in and work more aggressively with them to try to support them in their managed care programs.

Michael Baker – Raymond James

But then why would we see on the radiology benefits management kind of elongation amidst that back drop given the fact that it grows faster than what we will call average trend, so to speak?

Rene Lerer

I think there are two things associated. Clearly, we would love to see that cycle shortened. But, again, because some of these are very large, very complex plans, typically many of them multi-state, multi-product, multi-funding mechanism, the ability for them to extract data and give it to us in a meaningful way is a challenge and that's really probably one of the greatest factors to why it takes so long to do this. I think they are motivated to do it and I think what the comment is it increases our pipeline and, hopefully, will increase our ability to go after customers who are anticipating or having greater concern. Hopefully, it will speed up their ability to do the analytics with us but that's really a function driven by IT and the ability to take their data out. So the comment was more of a general comment that when people are being worried about MLR there is a greater tendency to look at solutions that are often outside of their own organizations.

Michael Baker – Raymond James

And then I was wondering as a followup, can you give us a sense as you speak with these plans kind of the top let’s call one or two components of medical costs trend that they would like to see tighter management of that you currently do not have in your purview right now.

Rene Lerer

Well, that sort of goes back to what our strategic perspective is going to be. And if we were going to do an acquisition what would be the next area and it would be defined the way you are defining it, which is an area that would be of interest to our customers because they are concerned about their cost runs. We are truly in the midst of that looking at as much as we can in the different segments, again, through internal and external support to identify what those areas would be as well as identify what opportunities we would have to get into those areas, if any. So it's two factors. And as we have said for a long time it's the ability to identify those areas and identify that they are manageable and that we can demonstrate measurable results so that we can demonstrate we are having an impact. And that really is one aspect of the gist of our strategic review. The strategic review is more than M&A. It's capital deployment, it's other things. But investment – but the one area of M&A is it's doing exactly what you are describing, which is going back and looking at what other areas that are fertile ground for us.

Michael Baker – Raymond James

Just one follow-up – final question. Would surgical benefits management fall within that or is that an area that at this point is too immature, too early for you guys?

Rene Lerer

I'm not sure exactly what surgical benefits management are. There are dozens of components associated with surgery and probably at this point I wouldn't want to comment in any particular direction.

Michael Baker – Raymond James

Thanks.

Rene Lerer

Thank you. Well, I think that's all the questions. I appreciate everyone's time and we will be looking forward to keeping you all updated on our progress. And, again, I just want to thank Mark for his support and – throughout this process. Thanks, everyone.

Operator

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

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Source: Magellan Health Services, Inc. Q1 2008 Earnings Call Transcript
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