Good morning, my name is Dennis and I will be your conference operator today. At this time I would like to welcome everyone to the United Health Group Second Quarter 2008 Earnings Conference Call. (Operator Instructions) This call and its contents are the property of UnitedHealth Group. Any use, copying, or distribution without written permission from UnitedHealth Group is strictly prohibited.
Here is some important introductory information. This call will reference non-GAAP amounts. Reconciliation of non-GAAP to GAAP amounts is available on the financial reports and SEC filing section of the company’s investors’ pages at www.unitedhealthgroup.com.
This call contains forward-looking statements under US federal securities laws. Such statements are subject to risks and uncertainties that could cause actual results to differ materially from historical experience and present expectation. A description of some of the risks and uncertainties can be found in the reports that we file with the Securities and Exchange Commission from time to time including the cautionary statements included in our current and periodic filings.
Information presented on this call was contained in the earnings release we issued this morning and in our Form 8-K dated July22, 2008, which may be accessed from the investors’ page of the company’s website at www.unitedhealthgroup.com
I would now like to turn the conference over to the president and chief executive officer of UnitedHealth Group, Steven Hemsley.
Good morning and thank you for joining us today. We previewed second quarter earnings three weeks ago and the themes this morning are unchanged. We are taking aggressive actions to improve our company’s growth and earnings performance across all businesses. Those actions are intended, in the short and the long-term, to improve our customer focus and financial performance as well as respond to broader industry and economic pressures present in the overall economy and in our sector specifically. We expect these actions to strengthen our enterprise and its performance in 2009 and position us for greater advances in 2010 and beyond.
Second quarter results are basically in line with the estimates we provided you on July 2. Earnings per share of $0.67 excludes special items totaling $0.40 per share. To briefly touch on these items, first we agreed to propose settlement of legal claims for historical stock option matters and related costs. Second, we recognize severance charges related to actions to reduce operating costs and finally, we divested a portion of our Medicare Advantage business in Nevada, which brought proceeds that we are required to record as an offset to operating costs in the quarter. Including these special items, we reported earnings of $0.27 per share in the second quarter. I will use only adjusted numbers for the balance of my remarks this morning.
For first quarter, our first half-financial results reflect a number of business developments. Our overall commercial medical costs trends continue to perform within expectations, while the commercial risk based benefit businesses are short of expected premium yield and enrollment. In the senior’s business there are gross margin pressures on special needs plans and in Medicare Part D. Medicare Advantage growth is meaningfully improved from last year, but short of plan on membership and on revenue.
Medicaid and our Enterprise Services businesses are performing very well with the exception of the behavioral cost pressures at OptumHealth and some Pharma research project cancellations at Ingenix. We had an unusually intensive [inaudible] spike in the first quarter and have a lower interest rate environment for the year. We expect the second half of 2008 will proceed like this.
Earnings in line with our revised annual expectations: Beginning with the third quarter in the low to mid $0.70 per share range with improved operating margins. Further profitability gains in the fourth quarter, driven by the seasonal performance of the Medicare Part D program and by strong high margin sales at Ingenix. Full year consolidated and commercial Medicare ratios to remain in line. Continued reductions in run rate operating costs quarter-by-quarter and improved alignment and translation of UnitedHealthcare’s strategy to local market resources and operation across all UnitedHealth Group health benefit businesses. A common regional structure with strong regional leaders across all of our health benefit businesses to drive more in market coordination and leverage performance across the spectrum of common local market needs and opportunities; pricing and commercial risk underwriting disciplines across the board to deliver premium yields at or above our projected medical cost trend; more effective local engagement in marketing and distribution for commercial health plan businesses. First phase consolidation and focus of clinical care services across all of our health benefit businesses. A similar consolidation of technology operations across our entire health benefits enterprise that goes hand in hand with a tighter and simplified technology and capital spending agenda; an enterprise wide commitment to substantially completing all remaining integration efforts by the end of 2010. An invigorated Medicare Advantage marketing approach for the 2009 open enrollment period, more grass roots in nature with more dedicated to controlled sales and enrollment resources. Successful preparation and start up for our recent Medicaid market wins; continued growth in generic and mail order drug utilization with a Prescriptions Solutions PBM business; operating cash flows in the range of $4 billion in the second half prior to the consideration of the timing of legal settlement payments.
Advancing these items of the next six months and into 2009 will produce a stronger business, one that is beginning to again perform in the face of challenging market conditions.
We will now turn to a discussion of second quarter financial results.
Second quarter revenues of $20.3 billion increased 7% all in year-over-year including 3% organic growth. Revenues in the quarter included $50 million in realized capital gains on fixed income investments as expected. The consolidated medical care ratio was 83.4% and the UnitedHealthcare medical ratio, excluding national accounts, was 82.9%. If you include national accounts, the UnitedHealthcare ratio was 83.8%. There was no net change in our estimates of prior period medical costs in the second quarter, where as last years second quarter results had a $110 million benefit from prior period development. This represented a 60 basis point variation in the consolidated medical care ratio year-over-year.
Our operating cost ratio at 14.6% is excessive and reflects an infrastructure size for growth that did not develop in 2008. We have taken aggressive action to adjust this and expect to remove $500 million in run rate operating costs by the second quarter of 2009 and continued beyond that.
Second quarter cash flows from operations were $600 million. This included the unscheduled return of $170 million in deposits to a continuing customer to accommodate its request. Second quarter 2008 cash flows were also negatively impacted when compared with the second quarter of 2007 by the timing of more than $700 million in income tax payments, which historically would have been made later in the year.
We continue to forecast full year adjusted operating cash flows in the area of $5 billion; this is in the area of 1.3x net income with strong second half cash flow results as government payments are received and working capital is reduced. We have already collected nearly $500 million in government receivables this month and received notice of another $250 million for August 1, which will bring down our government receivables balance by ¾ of a billion dollars in the third quarter. We have direct line of site to cash flows from operations in the area of $1.8 to $21 billion in the third quarter and a comparable amount in the fourth quarter.
Turning to growth trends, on the services side our enterprise services businesses continue to be on track for strong 2008 revenue growth. Ingenix is positioned for full year revenue growth exceeding 25% and closed the quarter with backlog of $1.8 billion. Despite some abrupt and unexpected contract cancellations, Ingenix CRO sales activity remained solid and it closed ratio for the first half of 2008 is strong at more than 35% on a dollar basis.
Emerging Ingenix both areas include consulting services under a long-term contract serving payers, providers and the government sector. We are also starting to see more international sales such as the large North Hampton share primary care trust contract which was secured this month.
OptumHealth has seen continued strong growth in public sector services which partially compensates for the membership shortfalls in its ancillary business within UnitedHealthcare and other commercial benefit carriers. We are targeting full year revenue growth in the mid to upper single digit percentages. OptumHealth financial services also continues its strong growth momentum with now more than $600 million in assets under management, a 50% year-over-year increase.
As expected Prescription Solutions revenues decreased due to the previously announced reduction in auto assigned Part D business as well as increasing generic drug utilization, which is good for consumers while it strengthens our margin.
The Enterprise Services businesses continue to perform well in the aggregate on growth and earnings metrics. They are each well situated for growth for long-term performance.
Let me turn to the benefits businesses. Starting with UnitedHealthcare commercial markets our business remained soft in the second quarter with stable fee based enrollment and a decrease of 95,000 people in risk based products. The commercial market continues to be characterized by low employment levels, intense economic pressure, and strong competition.
On a full year outlook for an 800,000 or more person decrease in risk based business includes an estimated loss of 350,000 people from PacifiCare and 100,000 in conversions to our fee based offerings. Participation in fee-based arrangements continues to run more strongly than originally expected with current expectations for stable enrollment this year.
Including the Fiserv Health and Sierra acquisitions we anticipate 2008 gains of about 900,000 consumers for our commercial business in total, which would be a 3% year-over-year increase. We continue to see our national commercial health plan medical cost trend at 7.5% plus or minus 50 basis points, essentially toward the upper end of this range, with the upward pressure coming from inpatient unit costs in California and the northeast. Our gross margin pressures relate principally to pricing where we have not seen the yield advances previously expected and forecast.
Relative to pricing we have not seen changes in the market place for risk based offerings for 2009. While one can create a case for firming and pricing in the market we are not relying on any improvement in competitive conditions at this time. I will reiterate that our discipline and long standing underwriting philosophy and approach is to fully price our expected cost trends. There is no change to that approach and there never has been, but we must become more effective in achieving the premium yields we target and meet.
To that end we will compete differently going forward. We are going to be more engaged at the local market level and do a better job in support of local market tactics and execution. Key differences in regional market structures, cost positions, and competitors mean different markets require different approaches. The goal is to bring customers the largest and most diverse set of resources in the most local way. This approach combined with sharper more disciplined underwriting and continuing gains in service and innovations will once more advance our value to customers.
On the national customer side we bring a comprehensive, integrated set of service offerings combined with excellent medical cost trends driven by distinctive, clinical information and intelligence, effectively aligned medical care management, leading quality designation programs and the broadest network on a single system. As the 2009 selling season is about half done we don’t yet have a final bead on January 1 results. At this point we have lost a couple of high profile accounts where we believe the business went to the market at lower price points than we were willing to accept. Accordingly, we expect some membership decline for January 2009 in this market segment.
In the Medicaid market place AmeriChoice added 375,000 people this quarter including 55,000 through organic growth putting them slightly ahead of the growth plan at this stage of the year. We closed the Unison acquisition on May 30, sooner than expected. Unison’s strength [ph] is our public-sector business in Tennessee and Pennsylvania and adds market presence in northeast Ohio, Delaware, South Carolina, and Washington D.C.
Two years ago AmeriChoice was struggling. We reorganized it under new leadership to take better advantage of the UnitedHealth Groups resources and to get closer to its markets. Today margins have stabilized and we have the number one market share in the state Medicaid market segment. In just the past 90 days we have seen new market wins or contract extensions in Arizona, Connecticut, Florida, Washington D.C., and a double win in Tennessee. I credit Rick Gelnic and Tony Walters and their team for work well done. Well there is always more to do, in some ways this work represents a template for the directions we are moving in commercial and senior markets.
In the senior markets growth results are mixed. Medicare supplement is on track to add $125,000 seniors. Evercare is continuing to win new contracts and expand its state based programs in markets such as Texas, Hawaii, and New Mexico. Hospice while small is growing nicely.
Most of our growth in Medicare Advantage this year has come from special needs plans rather than SecureHorizons traditional HMO products and accordingly revenues will grow only modestly, roughly 7% organically. SecureHorizons has the potential to perform better and that is being addressed with new leadership, stronger control of distribution resources, more grass roots focused approaches to sales, marketing and enrollment and adjustments to benefits design at the county level for 2009.
We have previously discussed the probability issues with special needs plans this year, including for the 80,000 seniors enrolled in our chronic care plan. We established a $49 million premium deficiency reserve this quarter for those special needs plans, which contributed 30 basis points to our second quarter consolidated medical care ratio. This reserve is intended to address the loss exposure on these plans of the balance of 2008.
We are confident that our 2009 benefit bids with CMS have fully addressed benefit underwriting issues and we will have more specific comments on product positioning later this year, after their approval in October.
I will move from growth to touch further on operations. As I noted, we are taking aggressive action to address operating costs. The goals are to achieve the full benefits of the scale of our enterprise, to better support our local businesses in their regions and to tighten the control processes that led to excessive operating costs relative to our achieved levels of business. Let me tell you how each of these goals are within reach.
We are aligning clinical and network organizations and technology operations across our health benefits business unit in an effort to improve their focus, simplify their agenda, and eliminate redundancy. We will get better basic outcomes at lower costs. We are accelerating multi-year integrations in businesses like OptumHealth and UnitedHealthcare where there is ample opportunity for performance improvements for customers, as well as cost efficiency’s as we consolidate redundant operations and processes.
Our clinical operations will be more local market centered and continue to operate within the boundaries of national clinical policies. Our relationships with medical societies and professional association and their inputs regarding issues of science and administrative simplicity will continue to be core. We will continue to have a prominent position and brand supporting clinical excellence which has long been one of the strengths of this organization.
Collectively these activities improve visibility, accountability and speed while freeing up dollars to support investments in local market resources that improve market relationships and responsiveness. To that end we are also changing our strategy for advertising, promotion and distribution; in the Medicare market in particular to become more grass roots in local markets and much lower in cost.
Our final topic this morning is capital. During an unusual market condition our team has managed our investment portfolio well. We have avoided material impacts from sup prime investments, auction rate securities and other troubled asset classes and we have prudently generated $103 million in capital gains in the first two quarters.
As of June 30 we have a gross unrealized capital gains position of $100 million and a net unrealized loss position of $52 million. Our strategy of investing in a diversified mix of high quality securities and generating appropriate risk adjusted returns has been appropriate for this market environment.
We will lower our capital expenditures in 2009 and the supporting expenses will therefore also be lower. Again, we are focusing our investment agenda on those items which have the greatest favorable impact for customers and our future growth and cutting or deferring items which are lower priorities with lower returns.
For more than ten years we have maintained a strong share buy back agenda. We have viewed this as the most effective way to use excess capital given our view of the potential for our businesses. Until the last two to three years that approach has been exceptional. It was clearly not effective over the last two years or more; however today, even looking at our businesses conservatively, with long-term growth rates, margins, and cash flow levels less than expected for our sector, our shares appear under valued and compelling. Accordingly, for the near-term we believe continued share repurchase to be more accretive than it has ever been, exceptionally so.
As our businesses perform at more predictable levels and as our equity returns to a more typical valuation, we will continue to assess rebalancing our capital allocations and evaluate dividend levels in light of our size and the strong cash flows we’re capable of consistently producing.
While market conditions are perhaps less predictable than they have been in a decade, we believe the actions we are taking across our businesses will produce a measured performance recovery in 2009 and set the pace for an accelerating performance level going into 2010 and beyond. We recognize execution is key. Only through better execution will the financial markets restore fully the valuation we believe the enterprise is worth as a diversified organization.
In the interim as we grow some businesses and turn around others, the sensible path is to pursue the returns we believe we are capable of generating through share repurchase given our level of projected operating cash flows and the low relative stock valuation that I mentioned earlier.
I will close with a brief summary and some forward-looking comments. Our focus at this point is on 2009. I have described the steps we are taking to improve performance. We are refocusing regionally and locally, strengthening underwriting discipline, reducing operating costs and capital spending levels, correcting senior product benefit membership mix and distribution, opening new Medicaid markets and continuing to execute in our Enterprise services businesses.
As we move toward 2009 the results of these steps will be accelerated, but the economic approves. For 2008 we continue to project revenues to be in the range of $81 billion with earnings of $2.95 to $3.05 per share supported by operating cash flows approaching $5 billion as adjusted.
We appreciate your interest today and we can now move to questions. I am joined in this room by many of our senior business colleagues, John Penshorn, Brett Manderfeld, Mike Mikan and others will continue to be available after this call to respond to questions you may have through the course of the day.
(Operator Instructions) Your first question comes from Justin Lake with UBS.
Justin Lake - UBS
I have a couple of questions, one specifically on the commercial MOR in the quarter it was a little bit better than I had expected and I’m just curious the 83, 3 number that you have out there for the full year, I know it’s plus or minus 50 basis points, but as I look, to get to that number the back half of the year would need to see a significant deterioration in MOR of about, I ‘m measuring about 250 basis points. As I look back to last year the MOR was closer to 100 basis points up seasonally. I’m just curious if there’s anything that you can tell us as far as what you think might change there year-over-year. Where do you think you might be towards the lower end of that plus or minus?
Well Mike can kind of respond to this and then I might comment after his comment.
Justin, we are going to stick with the guidance that we gave three weeks ago of 83.3 plus or minus 50 basis points, but what we’re seeing on a year-over-year basis, or what we expect to see is a heavier utilization in July than we saw last year given that July 4 fell on a Friday this year. Last year it fell on a Wednesday as I recall and that was a long weekend, so we expect higher outpatient procedures this year for that time period compared to last year. So it really is driven by that for the third quarter.
Typically I think we’ve said in the past that we expect third quarter to be flat to slightly down from the second quarter. This year we’ll see it slightly up from the second quarter and then the fourth quarter we continue to expect and I think prudently so, the deductible wear off that will impact the fourth quarter, so I think our estimates are in line with our expectations.
So yes, year-over-year it will be higher this second half than last year.
Justin Lake - UBS
Okay, and —
Justin we are going to try to keep these to single questions. We have been allowing too many questions per and have gotten some feedback, so we could keep these to one each. So, I might move to the next question please.
Your next question comes from Charles Boorady with Citigroup.
Charles Boorady – Citigroup
What is the biggest challenge to cutting $500 million from your admin cost structure while at the same time trying to improve customer service and does that $500 million include the CapEx reductions that you refer to or would that be in addition to the $500 million?
Well it includes the capital expenditures. There are internal costs that go along with them so it includes that portion of the internal costs, but we really have quite a start on this and I’ll let Dave Whitman kind of respond to give you some of the facts.
One of the metrics we’re trying to achieve is the reduction of somewhere around 4,000 FTEs in our business and we’ve accomplished about 2,000 of that through June 30 and we have had another 1,200 reductions since that time frame up until today. So we have about a remainder of 800 to come out, but that will come out net of seasonal adjustments that we need to make for our staffing, which tends to rise seasonally towards the last half of the year, to prepare for the fourth quarter utilization period.
So that’s obviously we are managing it very effectively the getting these headcount reductions in place. The reason why this isn’t nearly as complicated as you might otherwise think is that we did grow quite substantially on a same store basis our FTE counts leading up to about this time last year, so we’re actually still in excess of last years counts as of June 30. So against that we have also not grown to our expectations so, what we’re really doing is right sizing our labor to respond to the growth budget and materialize and those changes are under our operations area sales local service etc…
We are also centering our IT agenda on a more narrow set of very important and strategic initiatives and as a result of that we’ll have some labor reductions there as well. That $500 million does include some portion of non-capitalize able expenses that generally trail our capital expenditures so those will be eliminated as well.
Both technology, administration, some areas of what I might call internal operations, I think the orientation towards, as we say, rebalancing towards regions are favoring regions and addressing redundancies on the national side of our metric, those are areas that we have found to be most effective. We have not really had to look at the service disciplines, etc… all of those which have improved significantly over the course of the last year, so I appreciate the question.
Your next question comes from Matthew Borsch of Goldman Sachs.
Matthew Borsch - Goldman Sachs
I was just wondering if you could comment on you capital levels at your subsidiaries, where they are now. If you could give us an RBC ratio perhaps and what your target is.
I think Mike Mikan can best address that.
Our RBC levels are over 300%. I think we’ve said before that we are very well capitalized across all our legal entities. We continue to work with states on getting appropriate from those levels, but we feel we continue to be very well capitalized and consistent with prior years.
Matthew Borsch - Goldman Sachs
And your outlook just on that, if I could just ask a follow up. So, what are you assuming, if you can share with us, in terms of dividends from your subsidiaries for the back half of the year?
We have anticipated that we would have somewhere between $3 and $3 ½ billion worth of dividends in 2008 and we expect to have about $2 billion for the remainder of the year.
Your next question comes from Josh Raskin with Lehman Brothers.
Josh Raskin - Lehman Brothers
I have a question on 2009. You know Steve I think you did a good job of highlighting some of the pluses and minuses, but could you just sort of outline what are the biggest pluses and minuses, maybe just in the top and could you sort of expand what exactly did the measured performance recovery in 2009 mean? Does that mean earnings you’re expecting higher earnings in 2009 than 2008?
Well obviously I am not attempting to provide specific guidance on 2009. I would say, I’ll go back to the comment I made as I closed the formal commentary. I think that the orientation to the local markets for the commercial businesses, I’ll use that first, is quite potent. We have a great deal to offer and I think we can be more effective on a market by market basis, making sure we align the right products to the marketplace, optimize our cost structures in those markets and engage, I think, more effectively and I think we have the right leadership in place with respect to that. So, I think you will see a much more competitive dynamic from United in that basis.
The same might be said of the SecureHorizons business on a market-by-market basis, particularly in the front end of the business in terms of the sales distribution, enrollment disciplines etc…expect a much stronger business along those lines.
Pricing disciplines, we are committed to commercial pricing disciplines in our risk-based business and we have made the appropriate corrections with respect to our Medicare benefits for 2009. So, I expect better performance out of all of those and I think those are all basic fundamental margin contributing actions.
We can do a better job on operative costs. I think as Dave’ comments suggested we are really dealing with what we consider to be excess cost levels and I think we are going to see the effects of those in the latter part of 2008 and into 2009.
There are other businesses we have that are quite strong and have a great deal of momentum, so I could be optimistic about 2009 without being specific, recognizing it’s a challenging economic marketplace and we are coming from a place, particularly with our commercial risk business, where we have not had momentum and have to recapture that momentum and are going to do it by engaging the local market. .
That is I think the best I can do in terms of giving you kind of a body language sense of ’09 and I think 2010 is when I expect to be fully back in stride.
Your next question comes from Gregory Nersessian with Credit Suisse.
Gregory Nersessian - Credit Suisse
I was just wondering if you could comment on the Medicare bill that passed last week and how you anticipate that might impact your operations going forward and then along those lines, just specifically to the group private fee-for-service products, nothing you have been necessarily seeing a lot of growth in, but where do you see that business going, going forward? Is there still an opportunity there?
We thought that question might come up. Simon I think is prepared for that.
Well Greg, as you know we have had a strategy of deliberately positioning ourselves in favor of network based Medicare Advantage rather than private fee-for-service over the years, because we think we can unleash more value from Medicare that way and because of what we perceive to be a slow blue [ph] risk, if not a risk that is now crystallized in the new law.
So the direct impact on us is minimal, because only around 7% of our Medicare Advantage membership is in private fee-for-service and all those 100,000 or so members 3/4 live in areas either unaffected by the law or where we already have network based alternatives. The direct specs are minimal but we do think that indirectly the more essentially great the growth opportunities for us, because obviously the end of deeming will mean that perhaps 80% of the private fee-for-service market will now over the next two years have to migrate to a network -based product and that’s not something that we’ve been critically positioning ourselves for.
Potentially 1.7 million private fee-for-service members are going to be triggered into shopping and as the largest operator of network based Medicare Advantage with, what 100 still involved perception panel [ph] behind us, we hope to be able to capitalize on that opportunity.
As to the group market the congressional policy changes obviously mean that by 2011 group Medicare Advantage members will have to again move to network based products and that again we see as presenting a meaningful opportunity for us. In the meantime we are seeing a pleasing upswing in and interest in our group Medicare Advantage for 109 [ph].
Your next question comes from Cheryl Skolnick with CRT Capital Group.
Cheryl Skolnick - CRT Capital Group
I would like to delve into your local market strategy a little more to understand this because my questions are related to that. One isn’t local markets a strategy less efficient, less standardized way of doing business versus a national standardized PPO approach? How long does it take to roll that out given how broad a distribution of across the country UnitedHealth currently still enjoys and how long will it take to get traction do you estimate and how much will it cost?
I might start with a couple of themes and then ask Gail to pick it up, but as I think you know we have operated in what I’ll call a matrix for several years, so we basically maintain a regional structure down to the local markets level and we maintain national, what I’ll call product line and functional structures and we have, in essence, some redundancies in of those and we have been saying for the last year, I think, that there needs to be a rebalancing back towards local market dynamics. This really is a meaningful step and commitment in that direction; so we have really operated on those two dimensions for some time.
We believe in kind of an 80-20 rule and have for some time, but while there are common elements across markets and you can fully scale and get the leverage of the enterprise and consistency that you reference, but there are meaningful elements that are local in nature, how the products are positioned, the cross structures, the relationships etc…that we have not been taking advantage of those to the extent we could and it has made a difference in terms of our competitiveness on a market by market basis. This effort is really headed in that direction. From a cost point of view I actually expect that we will be more effective from a cost structure point of view, because we will adjust our cost structure between the national and local levels.
Just sort of building on Steve’s comments, first let me start with we still plan to use our leverage on a national scale but deploy that more effectively. I do think it is about changing and rebalancing from a national and product view that we currently have to a regional and local view. We had some examples of that already, so isn’t a brand new model to us, we’ve actually been very successful in managing our network contracting under this model for some time. We have a very strong national oversight in that for example, we have regional leads and local market individuals already deployed and you can see those results in our excellent unit cost results that we’ve driven over a number of years.
What we are really doing is we are taking that model that was used in network very successfully and aligning our clinical products and our analytical resources. The other thing that you need to remember, and I think Steve touched on this as well, is we already have our financials organized by region and product so we can take a view of that as well.
As I sort of sum that up, our focus is on strong regional and market leadership and disciplined local market execution and remember this has to be supported by a simplified operating model and we’ve already taken those steps to go forward to support those tactics, so we’ve reduced our regional structure from six to four; we have new regional leaders in place who know how to execute on this business design; and also have a very strong and deep financial and operational health plan experience. They know how to do this. They have been through this before. As we think about summarizing that, it is going to drive much more specificity on how we take our national resources and deploy them locally. As we think about that, that is how, I guess, I would summarize. We are pretty well prepared to execute on it now and that’s where we’re moving forward.
Your next question comes from Lee Cooperman with Omega Advisors.
Lee Cooperman – Omega Advisors
I’m not quite sure what the question is, it’s more of an observation and you did a very good job of addressing some of my questions and issues, but I kind of say to myself from the one side if you announced this morning that you were going to take that $3.00 in earnings and it would leave you a $1.50 dividend and $0.75 to run the business and grow the business and $0.75 to use for capital management purposes, my own personal opinion is stock would yield 4%, so at 37.5.
So it seems on the surface to be significantly under valued and I am wondering to what extent this under valuation is the result of the extreme approach that you, Aetna or WellPoint take in terms of capital management, meaning virtually no dividends at all.
On the other hand I say if it’s worth 37.5 it’s really exciting, about the prospect of buying it back so far below fair value. But then I look and I see in the first half of the year we’ve spent $2 billion buying 48 million shares back with an average price of $41.67 and we talk about spending $3 billion for the year which means we’ll spend a billion at a hell of a lot lower price than we’re willing to spend at higher prices.
I guess the question is are we really facing coven issues or balance sheet constraints as to why we’re not buying back at least as much in the second half as you bought in the first half. Then second assuming your policy regarding capital deployment remains the same, that we use our cash flow to buy back equity because we think it’s under valued and I’m not discouraging you by the way from doing that.
Could we assume that next year that the $3 billion that we’re spending this year could be replicated, as a rough idea, assuming no dramatic change in the price of stock, that $3 billion ongoing repurchase program in ’09 would be a distinct possibility assuming no dramatic change in business or stock price?
Lee Cooperman – Omega Advisors
I don’t know where the question was, but I’ll leave that for you to figure out.
It’s hard to know where to begin, but since you and I have had conversations along these lines, I believe that what our thinking was in relative alignment. There is a compelling opportunity today, we are dedicating our available excess capital to repurchasing our shares and we’ll continue to do so, so long as that valuation looks compelling and looks to be under what a market norm would be.
Lee Cooperman – Omega Advisors
[Interposing] of $3 billion represents 10% of the market cap, so you know, if mister market continues to give you the chance, not only can you grow the business, but standing still we had 10% earnings by virtue of the free cash flow being employed. But thank you for your comprehensive remarks.
[Interposing] the terms is almost new term and that is this could be perhaps more accretive than it has ever been before and the only thing that I would then add to that is that at a point in time when I would say that the restoration of the business and its market value reaches what we consider to be what we consider a more normal level we will undertake the consideration of dividends that are probably more expected from an enterprise of our size, scale and with our cash generation capacities and do that in a measured way and communicate with the market place our thinking along those lines as well as any other items that we think should be seriously considered to drive shareholder value without compromising the long-term interest of the operating company.
Your next question comes from Carl Mcdonald with Oppenheimer.
Carl Mcdonald - Oppenheimer & Co
I wanted to come back to the pricing strategy for 2009. On the early July call you got the question a number of times and it didn’t, at least the perception was, there wasn’t a real straight answer there, there was a lot of focus on case by case underwriting, focused more on local markets, where as today it just seems like you’re making a much more definitive statement that you are going to price at our above trends in 2009. Maybe you could just give some color around was that the intention around the pricing strategy for next year?
I would tell you that the message got through. There was never an intention in our previous call to signal anything other than a real commitment to disciplined pricing to our cost trends and while I recognize we got into a discussion about how does that play on a case by case basis, the core theme is we are going to price to our price, we are going to price to our cost trends and maintain that discipline and strengthen that discipline down at the local market level which is what Gail has alluded to and we are just confirming that message today.
There is no change here other than we could have done a better job of discussing it in our last call.
Your next question comes from Scott Fidel with Deutsche Bank Securities.
Scott Fidel - Deutsche Bank Securities
A couple weeks ago you had mentioned an expectation for medical cost trends in ’09 in the 7.5%, 8.5% range and maybe if you could just talk about within the individual components which areas you see the most risks for, potential acceleration and then which areas do you see the most potential for improvement in. Then also if you could maybe just spike out some of the actual issues that you’re seeing around your behavioral costs and the actual plans that you’re taking to address that.
That is a well packaged, three questions, question; maybe Mike do you want to talk about the 2009 [indiscernible].
Sure Steve said on the July 2 call we expected and are expecting a cost trend of around 85 plus or minus 50 basis points. That is slightly up from what we’re seeing this year. We think it’s prudent to take that view given we have seen some inpatient unit cost trends, as we’ve mentioned over the last several calls, in the northeast as well as the west coast. We’re really not seeing any dramatic changes other than that. We have seen some slight up ticks in orthopedic devices and things like that, but nothing dramatic, so we think it’s prudent at this time to forecast 8% plus or minus 50 basis points and that’s where we’re expecting right now.
Sure, there is two primary drivers impacting behavioral benefit costs. The first one we underestimated the impact of the mental health parity legislation that was enacted in New York and as a result under priced that business. We will fix that and factor it into 2009 pricing decisions. The second one is across the boat we’re seeing some overall increase in utilization as a result of more of our consumers accessing their behavioral health benefits, so we’re seeing a slight increase in penetration. Again that will be an underwriting matter and we will incorporate that as we see appropriate into 2009 pricing.
Scott Fidel - Deutsche Bank Securities
Do you think that’s economics related or more benefits related in terms of the increasing utilization?
I am speculating, but I think it is a result of what’s happening in our country today. The economy we have seen similar blips historically.
Your next question comes from Doug Simpson with Merrill Lynch.
Doug Simpson - Merrill Lynch
A lot of my questions have been asked, but if I could just ask, given the amount of volatility we’ve seen this year and the tough economic backdrop, how would you define a successful year for the commercial risk margin next year? If all goes well how does that wind up looking relative to the weight of, if all the actions you’re taking are successful, maybe give us sort of the best case, worse case scenario directionally relative to where you expect that to be for ’08. Any color you could give, sort of direction, would be helpful.
The only thing I can respond to is thematically there, because again we’re not trying to give specific guidance on 2009 and I’ll have Gail comment, but if we are committed to pricing to our costs, that to me speaks to margin preservation and strengthening. I think we can be more effective in medical cost management and I think we can be more effective in operating cost management; so I think that those things can improve our performance. You do have to recognize that as we go into 2009 we have 800,000 would be our projection of commercial member loss, which we will lose those member month and —
Doug Simpson - Merrill Lynch
Approximately how much a year Steve?
800,000 for 2008, but it runs into 2009 and then you have the, we have not given guidance with respect to 2009 membership, but we are going to hold the pricing discipline.
I think Steve hit on the key points, the only component that I would add, you talked a lot about pricing and I just want to reiterate we have ticket increases in our remote pricing, we’ve also focused on reducing our new business discounted pricing, so we’ve fundamentally strengthened the underwriting and pricing discipline. We’ve also brought some new leadership into our underwriting area, an individual who was leading that three years ago in another part of our business, so fundamentally we are taking a very disciplined approach to our pricing.
Your next question comes from John Rex with J.P. Morgan.
John Rex - J.P. Morgan
Yes just back on the commercial premium yield outlook, with that having fallen below your expectations, again as you look back at the controls you had in place, what about those did you think were ineffective? Was it the leadership that was there, was there an actual control mechanism that was ineffective in terms of it coming in below plan? Then as you moved to a more localized structure, I wanted to be kind of clear on this, is it the impact of a more localized structure you think will help you achieve those targeted yields more effectively?
Gail I think you can give an observation on that.
Let me first touch on this couple of questions embedded in that. One as we look at our yield issues, we talked a little bit about this a few weeks ago. First we didn’t see the acceleration that we expected in first quarter. Second we had a mix shift because of the 800,000 fully insured lives that we’re going to see a decline in and that’s a big driver of what happens and finally this mix of new business is greater than in prior years and again the case-by-case negotiations.
A lot of why we expect, when you get back to the leadership issue, again strengthening our resolve around case-by-case negotiations, which I just talked about, also greater visibility and insight as we talk about the financial leadership in the regions which we’ve dramatically strengthened with the changes that we’ve made and also strengthening our leadership in our underwriting area.
Part of this is much better visibility into the types of products we’re positioning in the market and selling and we do have, I believe, through more engagement in the local market, an opportunity to manage that better. We’re not doing this passively, we’re going to be aggressively managing that as we’ve all discussed in the marketplace.
John Rex - J.P. Morgan
Your assessment, you didn’t see it as a systematic control issue then as you’ve kind of looked at what, this sound more like about products that were sold and some leadership issues than a systematic control issue. Is that your fair characterization of your assessment?
We don’t have a systematic control issue, we have good strong national control, so it really is a mix of business, again, that we can focus back on what happened as we look at the yields.
Your next question comes from Michael Baker with Raymond James.
Michael Baker - Raymond James
You did a good job in terms of giving a sense of the competitive dynamics in pricing on the commercial health plan business. I was wondering if you could provide an update on the pharmacy benefit management side of your business, how it’s comparing to last year?
I think we can. In terms of the performance of that business it has had some nice steady growth, but its real performance has been driven by the concentration and improvement and penetration of mail order itself and in generic. I think that has been the story. We are also in sourcing all our specialty pharma through RX Solutions and while that is evolving that is very good for both our benefit businesses and for RX Solutions itself. Bill you might have any other comments?
No I think you said it well. 2008 has been a year where Prescription Solutions has been focusing on improving generic penetration and the results have been nice in that area and also improving mail service penetration and those results have been productive and as Steve said then, we’re pleased with the progress so far from the standpoint that it not only lowers costs but improves our margin in that business.
Michael Baker - Raymond James
How about if you look externally, are you seeing anybody particularly aggressive on price and changing the dynamics in that business or is it pretty much steady stayed compared to last year?
My experience would e that it is a competitive market. It always has been a competitive market, but I haven’t seen any significant change in dynamics. Does that answer your question?
Michael Baker - Raymond James
Which means the severe cost pressures there continue.
Yes through strong competitors.
Your next question comes from Brian Gicker [ph] with Merrill Lynch
Brian Gicker [ph] - Merrill Lynch
I was wondering if you could comment a little bit on capital structure. I was wondering if you have a target leverage ratio of debt to EBITDA and can you offer any specifics on share buy back plans, an example would be do you plan to use any debt to finance the buy backs.
I missed the second part of the question; can you repeat the second part?
Brian Gicker [ph] - Merrill Lynch
Yes the second part was if you could comment at all on specifics of the share buy back plan for example if you plan to use any debt to finance the buy backs.
As we’ve stated before we are estimating due [ph] to maintain our debt to total capital ratio of around 40%. It has closed out above that in the second quarter as a result of the litigation charge that we took or the proposed settlement charge that we took. We expect to remain around that for the foreseeable future, so I don’t see any change with that. Then we fund our repurchase program using our operating cash flow.
Your next question comes from Al Copersino with Madoff Investments.
Al Copersino - Madoff Investments
Clearly you are not in a situation [indiscernible] within the 80s and 90s where we tested the, hey Steve can you hear me?
You could benefit from starting over, I don’t know what you have in the background there, but—
Al Copersino - Madoff Investments
Yes, there is nothing here. Can you hear me now?
Yes let’s try again.
Al Copersino - Madoff Investments
I was just saying that we obviously, even with the greater challenges this year for several companies, we’re not in that vicious cycle the industry was in in the 80s and 90s of a few good years, a few bad years. The industry has remained relatively disciplined on pricing the last few years. That combined with a slowing economy, I’m just wondering first of all if you agree with this hypothesis that we’re at a point now where it’s just getting more and more difficult for employers to afford some of the managed care risk products. Would you agree with that hypothesis and if so what does United do about that?
In terms of pressure on benefit affordability, I think that has been in the environment for some time and it’s always a relative thing, but we continue to see employers supporting benefits, carrying benefits and being very much committed to them and actually integrating them more and more with their total employee relationship and approach to their workforce.
What we’ve seen employers do is then pursue the products that have lower content, have a consumer engagement element, and begin to engage the consumer, as we’ve said for years, into participating in this health relationship with them. We are actually seeing more commitment than ever on the employer’s side to engaging on that kind of level, which actually gets them more involved in the benefits and they’re seeing positive things.
Our trends for many or our large clients have been quite exceptional this year, as they have engaged in these kinds of programs.
Gail, I don’t know if you’d like to add color to that.
I think affordability is absolutely an issue that employers are very focused on. We have a broad portfolio leading consumers and platforms and we’re seeing and continuing to end spring new products to market. Those are tailored based on the specific market needs, but in a small group we see a continuing purchasing of linear benefit products and continuing buying of those, so I think we’re going to continue to see that trend. The upper end, consumer engagement continues to be an important position and that’s an area where innovation I think, serves us extremely well. So we are very focused on good product design and then secondarily, actually it’s very important is helping to manage the medical costs and renew focus on that; so both of those tie very much into the affordability discussion.
So while your premise that there is tension and what I might characterize as health care crisis, that’s almost a prevailing environment and more and more I think are relevant to, as an industry, to the marketplace to be able to provide these benefits and manage costs effectively and help employers and their employees. I think our market value actually continues to increase and our execution abilities as an industry are getting better.
Your last question comes from Peter Costa with Ftn Midwest Securities.
Peter Costa - Ftn Midwest Securities Corp.
I’m still a little bit confused as to how your premium yield problem is going to get resolved by moving decision making closer to local management, which you would think would be even more concerned about losing a group and perhaps be willing to cut price to keep that group. Maybe you can answer that question by explaining a little more specifically what the 300,000 lives that are the specific lives that are not the conversions but the other 350,000 lives. What were those lives? Were they small group, mid group, were they geographically specific, were they product specific?
Let me clarify this is, again, a balanced strategy. We have strong national underwriting controls and we manage this again, pricing is managed on a market product segment specific basis, so it’s the combination of the national controls with local insights, because pricing again is both mathematical as well as assessment of the market conditions. So again, we’re pricing to beat our cost trends.
Getting back to sort of that distribution question you asked. As we look at the overall numbers it breaks down between as you said 350,000 from PacifiCare, 100,000 from conversions, roughly 100,000 in just attrition in the books and then it’s a balance between our small book of business and our middle market. We do see a concentration, again, in certain states and California being one of those.
I might also broadly suggest to you that we talk about pricing, but it’s really a broad underwriting dynamic and it’s really putting the right product and basically crafting a solution for a customer that will perform for the customer and drive the margins that we’re looking for from an underwriting point of view and that takes a degree of intimacy that has to be achieved at the local market level.
Before we go I might just touch again on a couple of the themes for the quarter. That basically our results were in line with what we had reported three weeks ago. There are strong elements of our business that are growing quite well, including AmeriChoice, Ingenix, our enterprise services businesses and in the businesses that are more challenged, we are taking actions to improve our growth and financial performance and to strengthen our operations across the board.
As we make progress on this thorough the balance of this year and into 2009 I think you will see our performance come in more in line to what you have historically expected from us and this will only get better if the economic environment strengthens.
We appreciate your interest today. Thank you.
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