Aetna, Inc. Q2 2008 Earnings Call

Jul.31.08 | About: Aetna, Inc. (AET)

Aetna Inc. (NYSE:AET)

Q2 FY08 Earnings Call

July 31, 2008, 8:30 AM ET

Executives

Jeffrey A. Chaffkin - VP of IR

Ronald A. Williams - Chairman and CEO

Joseph M. Zubretsky - EVP and CFO

Mark T. Bertolini - President

Analysts

Scott Fidel - Deutsche Bank

John Rex - JPMorgan

Charles Boorady - Citigroup

Peter Costa - FTN Midwest Securities

Josh Raskin - Lehman Brothers

Doug Simpson - Merrill Lynch

Justin Lake - UBS

Greg Nersessian - Credit Suisse First Boston

Matthew Borsch - Goldman Sachs

Operator

Good day and welcome to the Aetna Second Quarter 2008 Earnings Release Conference Call. Today's conference is being recorded. At this time I would like to turn the conference over to Mr. Jeff Chaffkin. Please go ahead sir.

Jeffrey A. Chaffkin - Vice President of Investor Relations

Good morning and thank you for joining Aetna's second quarter 2008 earnings call and web cast. This is Jeff Chaffkin, Head of Investor Relations for Aetna, and with me this morning are Aetna's Chairman and CEO, Ron Williams, and Joe Zubretsky, Executive Vice President and Chief Financial Officer. Following their prepared remarks, we will be pleased to respond to your questions. Joining us for the Q&A portion of this call is Mark Bertolini, President and Head of Business Operations.

During the call, we'll make forward-looking statements. Risk factors that may impact those statements and it could cause actual future results to differ materially from currently expected results are described in Aetna's 2007 10-K filed with the SEC. Pursuant to SEC Regulation G, we have provided reconciliations of metrics related to the Company's performance that are non-GAAP measures in our second quarter 2008 press release, second quarter 2008 financial supplement and our guidance summary. These reconciliations are available on the Investor Information portion of the Aetna.com web site.

Also as you know Regulation FD limits Aetna's ability to respond to certain inquiries from investors and analysts in nonpublic forums, so Aetna invites you to ask all questions of a material nature on this call. Aetna's second quarter results include the impact of our Schaller Anderson and Goodhealth Worldwide acquisitions, which closed in the third and fourth quarters of 2007 respectively.

For the second quarter of 2008, these acquisitions did not have a material impact on our operating earnings or net income. As financial results are analyzed it will be noted whether the inclusion of these acquisitions impacted the operating metrics. Now let me turn the call over to Ron Williams. Ron?

Ronald A. Williams - Chairman and Chief Executive Officer

Good morning. Thank you, Jeff. And thank you all for joining us today. Earlier this morning we reported operating earnings per share of $0.94 for the second quarter of 2008, an increase of 13% compared to the second quarter of 2007 and $0.01 higher than our prior guidance. We are very pleased with our performance in light of the challenging economic environment.

We continue to execute on the four dimensions of our strategy... segmentation, consumerism, integration, and operating excellence. Our second quarter results reflect our continued success as demonstrated by our well diversified membership and revenue growth, disciplined pricing actions, good medical cost experience as a result of our continued commitment to managing quality and total cost for our customers, operating expense efficiencies, and our disciplined investment strategy and effective deployment of capital.

Joe will provide more detail regarding our results later in the call. I now want to highlight the major events of the quarter in the context of our strategy with the focus on segmentation and operational excellence. Then I will comment on industry dynamics and their associated impact on 2008 results, and provide early observations regarding our outlook for 2009.

Our segmentation strategy continues to drive profitable growth. We achieved net medical membership growth of 32,000 members this quarter, bringing total medical membership to 17.5 million, as of June 30. Our individual, global benefits and government customer market segments all posted solid commercial membership gains as did Medicare and Medicaid. These gains were partially offset by some expected in group attrition, particularly in our national accounts customer market segment, due primarily to the slowing economy.

As a result of our strong medical membership growth of 646,000 members during the first half of the year, we are maintaining our guidance for full year net medical membership growth in the range of 850,000 to 900,000 members. Our strategy to create preference in the marketplace remains consistent, as we continue to offer differentiated products and services that meet the varying needs of our customers. We are pleased to have been awarded two significant contracts in June.

First, Aetna was selected for one of three contracts to service the state of Connecticut's Medicaid population, validating the strategic rationale of last year's Schaller Anderson acquisition. By leveraging the strength of our integrated organization, we are able to help the state provide for the health care needs of its Medicaid population, and many for its uninsured residents. We expect the current contract implementation to result in approximately 100,000 insured members by the end of this year.

The second win is an expanded relationship with Home Depot beginning on January 1, 2009. Our services will include a national PPO solution on a self-insured basis, as well as a suite of products for part-time and hourly workers, including health, life and short-term disability. This expansion will bring total Home Depot members served to at least 150,000 from its current level of approximately 15,000. This sale, combined with the Bank of America win of approximately 220,000 additional members announced last quarter are testament to the strong value proposition that differentiates Aetna in the marketplace.

Medicare is also an important part of our segmentation strategy. You have by now read the legislation that will effectively reduce the Medicare Advantage program by $12 billion over a five-year period, which includes a rate cut through the Indirect Medical Education component beginning in 2010 and require provider networks for Private Fee-for-Service members beginning in 2011.

Our business model positions us well to respond to these legislative changes. Our Medicare business profile is well diversified; including group accounts in our national account and government customer market segments, as well as individual members in Medicare advantage and PDP. Most of our Private Fee-for-Service membership is in the employer-sponsored group model, which is generally associated with membership density in specific local markets. Importantly, this will enable us to cover a large percentage of members with a relatively small number of networks.

Additionally, the group model allows us to work with plan sponsors to adjust plan designs and contribution strategies to optimize the value provided to beneficiaries.

We also continue to focus on operational excellence as a key component for our strategy. Our commercial medical benefit ratio was 80.5%, equivalent to the second quarter of 2007, reflecting our ability to forecast and manage medical cost trend and our discipline to price to it. Additionally, our underlying operating expense efficiency continued to improve, while at the same time we made important investments in our business. Our reported operating expense ratio for the second quarter of 17.8%, or 17.3% when adjusted for acquisitions, represents a 50 basis point improvement year-over-year.

Within the scope of operating excellence I would now like provide overall commentary regarding the current marketplace dynamics, what differentiates Aetna and has enabled us to deliver on our projections and some initial thoughts regarding our 2009 outlook. We are not immune to industry issues such as lower investment yields and the impact of a slowing economy. Our disciplined management processes and strong leadership team enable us to identify environmental changes early and take action. We have been focusing on these economic trends and have factored their impact into the guidance we have provided throughout the year.

There are several factors that give us confidence and the ability to maintain our momentum and achieve our operating earnings per share growth projection for 2008. Specifically, we continue to project full-year 2008 medical cost trends at 7.5%, plus or minus 50 basis points. We have not seen a material change in the overall pricing environment. It remains competitive but rational.

Our technology platforms and expert data mining capabilities enable us to have deep insights into medical cost trends and underpin our ability to forecast trend, manage it effectively and price to it with discipline. Despite the slowing economy, we believe we can continue to add net new members due to our segmentation strategy and our outstanding service model that includes our innovative and fully integrated product suite. As a result, we are very confident in reaffirming our full-year 2008 guidance of $4.00 per share.

It would be premature to provide a 2009 operating earnings per share projection. While we're encouraged by our strong business fundamentals, we recognize the economic headwinds we expect to be facing during the remainder of 2008, and into 2009. With these factors in mind we are comfortable saying we expect solid operating earnings per share growth in 2009. And we remain committed to our long-term operating earnings per share growth goal of 15%. In closing, I would like to thank our employees for their unwavering dedication to meeting the needs of our customers. It is through their efforts that we are able to continue our success in 2008 and beyond.

Now I will turn the call over to Joe Zubretsky, who will discuss our financial performance for the second quarter in more detail and provide additional insights into our outlook for the remainder of 2008 and into 2009. Joe?

Joseph M. Zubretsky - Executive Vice President and Chief Financial Officer

Thank you Ron and good morning; earlier this morning, we reported after-tax operating earnings of $466.3 million for the second quarter of 2008 or $0.94 per diluted common share. This represents year-over-year increases of 6% and 13% respectively. Our net income for the second quarter of $480.5 million included a $28.5 million after-tax benefit related to the release of reserves on the discontinued products in our Large Case Pensions business, as well as $14.3 million of after-tax realized capital losses.

I'll now discuss the drivers of our financial performance, beginning with our operating margins in the second quarter of 2008 and its key components; revenue, health care cost trend and operating expenses. Second quarter pretax operating margin was 10.2%, a 60 basis point decrease from the second quarter of 2007. This was in line with our expectations and was driven by a higher mix of Medicare and Medicaid products and lower investment income. Our after-tax operating earnings of $466.3 million were 6% higher than the year ago quarter despite lower investment income due to lower yields and reduced returns on alternative investments.

Our health care segment after-tax operating earnings of $453.9 million represents 8% increase compared to the prior year quarter, again despite the impact of lower investment income. These results continue to demonstrate management discipline across all aspects of our business. We continued to execute our strategy for profitable growth. Our strong top line growth this quarter was the result of continued membership increases, disciplined pricing actions, and contributions from acquired businesses.

Revenue increased 15% in the second quarter from $6.8 billion in 2007 to $7.9 billion in 2008. Health care segment revenue increased 18% year-over-year, or 15% excluding the impact of acquisitions, and premiums in our health care segment increased 19% year-over-year, or 17% excluding the impact of acquisitions. Our second quarter commercial premiums increased 8% over 2007. This resulted from 4% volume growth and a yield increase of 5%, partially offset by a 1% decline from the effect of product mix.

Medicare continues to be a meaningful contributor to overall premium growth as Medicare premiums increased 76% compared to the second quarter of last year. Our Medicare Advantage membership is 90% higher than the year ago quarter, due to the conversion of approximately 100,000 members from ASC to an insured arrangement in the first quarter 2008, as well as solid gains in our individual Medicare advantage and PDP offerings.

Second quarter consolidated fees and other revenue of $829.3 million increased 13% over the prior year quarter or 5% excluding the impact of acquisitions, driven primarily by volume growth.

Turning now to our health care cost experience in the second quarter, our commercial medical benefit ratio was 80.5% in the quarter, equal to the second quarter of 2007. This result demonstrates our continued pricing discipline and is further testimony that our pricing has kept pace with medical cost trend.

Our Medicare medical benefit ratio was 86.9% in the quarter compared to 88.2% in the year ago quarter, also in line with our expectations as all of our products including Medicare HMO, Group Private Fee-for-Service and PDP performed well.

Our Medicaid medical benefit ratio was 89.8% is quarter, an improvement over the 92.8% reported in the first quarter 2008 due to improved medical cost experience. Our total medical benefit ratio, which includes Commercial, Medicare and Medicaid products, was 81.9% in the second quarter 2008, compared to 81.5% in the prior year quarter. The increase is due entirely to the higher mix of Medicare and Medicaid premiums.

Additionally, in evaluating health care cost results for the second quarter of 2008, we note that prior period reserve development was not material. Our reserving practices remain consistent and appropriate, and we ended the quarter with a prudent level of reserve adequacy. Our health care cost reserves remain at $2.5 billion at June 30th, consistent with sequential premium growth trends, and our days claims payable were marginally down by 0.5 days to 43.9 days for the second quarter, consistent with our expectations.

Finally with respect to medical cost; major health care cost categories continue to be in line with our expectations and we continued to see consistent trends within cost categories. Specifically for the full-year 2008, we expect inpatient cost trending at mid-to-high single digits, outpatient at low double-digits, physician at low-to-mid single digits, and pharmacy cost at high single-digits, due to the impact of fewer new generics coming into the market.

We are very pleased with our Group Insurance operating earnings this quarter. The 500 basis point improvement in the benefit ratio was driven by favorable claim experience in our long-term disability line. This favorable underwriting result was offset by significantly lower investment income, which declined by $16.4 million year-over-year.

The third key component of operating margin results is operating expense efficiency. We continue to make investments in our future to generate new revenue streams through market and product expansions. We fund these growth investments with unit cost reductions and by leveraging our fixed costs. This quarter we achieved an operating expense ratio of 17.8% or 17.3% excluding our recent acquisitions, representing a 50 basis point year-over-year improvement on a same-store basis.

The second driver of our financial performance is investing for profitable growth. During the quarter, we grew medical membership by 32,000 members, bringing our total membership to 17.5 million at June 30. Sequentially, commercial growth was 3,000 medical members, Medicare growth was 9,000 members and Medicaid grew by 20,000 members.

The commercial growth of 3,000 comprised an increase of 44,000 insured members, offset by a decline of 41,000 ASC members. The commercial insured membership growth was driven primarily by our individual and global benefits customer market segments. Individual continued its steady growth with 26,000 members added this quarter. Global benefits insured membership grew by 21,000 this quarter, consistent with our plan to shift Goodhealth's ASC members to an insured arrangement.

Our core commercial insured membership excluding these customer segments was sequentially unchanged. The decrease of 41,000 members in our commercial ASC products was driven primarily by in group attrition in our National Account customer segment, resulting from the slower economy.

The third and final area of financial performance, I will comment on, is our management of capital and its accretive deployment. This includes our cash flow dynamics, our holding company liquidity, our deployment of that liquidity in the quarter and our capital structure.

Our second quarter 2008 GAAP operating cash flow for Health Care and Group Insurance was $237.9 million, representing 54% of GAAP net income. This lower second quarter cash flow was expected and part of our normal seasonal pattern of tax payments. Our year-to-date operating cash flow as a percent of GAAP net income was 137%, and included a deposit from a large customer in the first quarter of 2008. We continue to expect the full-year ratio to be approximately 130%.

In the second quarter, we generated $341 million of holding company cash flow. We also issued an incremental $257 million of commercial paper, resulting in approximately $600 million available at the holding company to fund acquisitions or share repurchases. Given second quarter valuation levels, we believe our shares were an excellent investment.

During the second quarter we repurchased 13.7 million shares for $600 million, bringing year-to-date share repurchases to 26.5 million for a total of $1.2 billion. Our basic share count was 472 million at June 30, down from 485 million at March 31. Our capital position continues to be strong, and we increased our debt to total capitalization ratio to approximately 28% this quarter, moving closer to our target leverage ratio of 30%, potentially including hybrid securities in the capital structure. To term out our short-term borrowings, we will consider issuing long-term debt as long as market conditions are favorable.

In light of the continued turmoil in the credit markets, I would like to provide an update on our investment risk and return profile. Our overall portfolio quality continues to be very high. Our holdings are well diversified across asset classes and durationally matched. Our asset class profile is consistent with that shared with you at our Investor Conference in March.

As noted earlier, we did have $14.3 million of after-tax realized capital losses this quarter. This reflects the accounting for certain fixed income investments which decreased in market value due to increases in interest rates during the second quarter 2008 and not due to defaults or credit issues.

Our mortgage-backed securities position is solid and of high-quality. We hold approximately $1.1 billion of Fannie Mae and Freddie Mac mortgage-backed securities. In addition, our direct debt holdings in Fannie Mae and Freddie Mac are approximately $170 million. We have been and remain very comfortable with these investment holdings and now have the additional comfort of the federal backstop.

Our overall debt and equity portfolio position remains strong. The market value of the portfolio decreased by approximately 1.5% due to the rising interest rates offset by the tightening of credit spreads during the quarter. This should be expected given that our Group Insurance and Large Case Pensions segments have longer duration liabilities, and thus their assets are more affected by interest rate movements.

Before we move to the Q&A session, I would like to provide some additional guidance for 2008 and early commentary on our 2009 outlook. Given another quarter of strong financial and operational performance, we have confidence in our ability to sustain our momentum for the remainder of 2008. We continue to monitor industry and broader economic trends and reflect the impact of these external factors in our assumptions for membership growth, fee and premium yields, utilization trends and investment income.

Based on this, for the full-year 2008, we project medical membership growth to be in the range of 850,000 to 900,000 members with approximately 50% of that growth from insured membership. We also project at least 15% health care revenue growth, medical cost trend of 7.5%, plus or minus 50 basis points, a premium yield that is in line with medical cost trend, a commercial medical benefit ratio of less than 80% with a total medical benefit ratio of less than 81.5%, and an operating expense ratio showing an approximate 30 basis point improvement year-over-year or 60 basis points excluding acquisitions.

This improvement of 30 basis points is slightly lower than our prior guidance of a 50 basis point reduction, due primarily to additional expenses to operationally prepare for the increased membership during the remainder of 2008 and into 2009. We also project a pre-tax operating margin that is lower than 2007, primarily due to higher mix of Medicare and operating earnings per share of $4.00, or growth of approximately 15%.

The operating earnings per share estimate is based on a fully diluted weighted average share count that is likely to be lower than the current 495 million. The incremental earnings per share benefit from any reduced share count could be offset by lower investment income and the previously mentioned additional spending for our anticipated membership growth.

For the third quarter of 2008, we expect the commercial medical benefit ratio to be between 79 and 79.5%, and operating earnings per share to be $1.12, a 15% increase over prior year. While it would be premature to provide 2009 operating earnings per share projection, I would like to offer some comments regarding our 2009 outlook.

We continue to have strong and balanced momentum with our January first known sales higher than at the same point in 2007. Our underwriting discipline remains strong. We do anticipate upward pressure on the medical cost trend and are factoring that into our 2009 pricing. We expect to continue our proven track record of achieving operating efficiencies while making investments in our future, and we will continue to deploy our capital accretively and move toward our optimal capital structure. While we are encouraged by these strong business fundamentals, we recognize the economic headwinds we expect to be facing during the remainder of 2008 and into 2009.

With these factors in mind, we are comfortable saying we expect solid operating earnings per share growth in 2009 and we remain committed to our long-term operating earnings per share growth goal of 15%.

In summary, I am very pleased with our second quarter results and we are well positioned to meet our full year 2008 guidance. As usual, we will provide you with a preliminary projection for 2009 operating earnings per share on our third quarter earnings call. With that I will turn the call back over to Jeff. Jeff?

Jeffrey A. Chaffkin - Vice President of Investor Relations

Thank you Joe. The Aetna management team is now ready for your questions. We ask that you limit yourself to one question and one follow-up so that as many individuals as possible have an opportunity to ask their questions. Operator, the first question please.

Question and Answer

Operator

Our first question comes from Scott Fidel with Deutsche Bank. Please go ahead.

Scott Fidel - Deutsche Bank

Thanks, first question, maybe if you could just expand a bit on your comments or thoughts on '09 medical cost trend and maybe how much of a pickup do you expect I think some payers are talking about 7.5% to 8.5%. Then within that maybe where you expect the cost components could potentially move around in '09 relative to '08.

Ronald A. Williams - Chairman and Chief Executive Officer

Yes Good morning. I'll ask Joe to provide you some perspective on our medical cost.

Joseph M. Zubretsky - Executive Vice President and Chief Financial Officer

Scott, at this early stage we're really saying that the cost trend is drifting to the upper end of our range. And right now for 2008, we are still seeing 7.5% plus or minus 50 basis points. So we are moving to the upper end of that range, mostly driven by pharmacy costs as fewer brand drugs are coming into the generic category, we're seeing upward pressure. All the other changes are rather subtle, but that's the main headline.

Scott Fidel - Deutsche Bank

Okay and I just had follow-up. Maybe if you could talk a little bit about the international business and maybe the opportunities you see there over the next few years in terms of some of the markets where you see the most potential. Then also just a more broadly how you expect the international businesses could be impacted by general economic slowdown that we're seeing globally.

Ronald A. Williams - Chairman and Chief Executive Officer

Yes Scott, as you recall, a huge part of our strategy is really focused on following our customers in the context and meeting needs that are important to them. What we have been doing is really building on the National Account franchise that we have, as our customers increasingly are global and the Goodhealth acquisition was a terrific way for us to complement our capability, which really centered around the ability to interface with the US style benefit plans that you see mostly in North and South America.

The Goodhealth acquisition gave us the ability to really interface much more with the EU-style benefit plans that you see in the rest of the world. And what we see really is that the integration is moving along quite nicely and the Goodhealth block of business was basically an ASC block of business, so some of the growth is coming from renewing and recapturing that business. And in a combined basis it's given us the ability to be the largest US based cover of expatriates. And so we're seeing that the addition of a lot of our consumer features and technology and benefits in our Internet capability is making us more attractive to international customers. Mark, anything you would like to add?

Mark T. Bertolini - President

Sure Scott, beyond the expat business, as we look to some of particularly the European countries as they wrestle with healthcare cost. I think the economy impacts to them are really around access. They have got the funding figured out from a government standpoint but they are having difficulty with the access.

So we're now very involved in a number of countries in Europe, particularly in the UK, and we have conversations going on in a couple other countries around using the ActiveHealth CareEngine to help better understand how to manage their healthcare costs to increase access within the budgets that they operate in.

Beyond that, we had a little bit of work in global in medical tourism, off one of our accounts in the Northeast and we are also looking at the opportunity for supplemental and insured products, but that's a fourth quarter issue for us as we look at expanding in the international markets

.

Scott Fidel - Deutsche Bank

Thank you.

Operator

And our next question comes from John Rex with JPMorgan. Please go ahead.

John Rex - JPMorgan

Thanks. Just a quick follow-up on your commentary on cost trend. And there have been some comments about rising acuity in the marketplace. Just wondering what you're seeing in terms of that, and if that has any influence in your higher view for '09.

Ronald A. Williams - Chairman and Chief Executive Officer

Yes, I'll ask Mark to speak to that.

Mark T. Bertolini - President

Yes John, we have seen a continued decrease in bed days. They have been running down about 2% year-over-year, 2007 to 2008. We see a little uptake in the outpatient area as more services go outpatient, particularly in orthopedics and some increase in diagnostic imaging. But all in we're not seeing any real increase in acuity or intensity of services, other than where they're being provided. And that tends to move around from time to time any way.

John Rex - JPMorgan

And then in the '08 guidance, I guess it's just a slight tick down in the operating earnings, maybe 2% if I just compute what you're saying with the share count. Is that mostly about investment income and the higher G&A expense you are referring to in your prepared comments?

Joseph M. Zubretsky - Executive Vice President and Chief Financial Officer

Yes, that would be the driving item.

John Rex - JPMorgan

Okay, Great. Thank you.

Operator

And our next question comes from Charles Boorady with Citigroup. Please go ahead.

Charles Boorady - Citigroup

Thanks Good morning. First question is just on the backlog and progress in the group MA business and what the reaction was to your group MA customers and prospective customers to the recent legislation that would eliminate deeming in 2011.

Ronald A. Williams - Chairman and Chief Executive Officer

Yes Charles, Good morning. I think that the focus that we have on the National Account in government employers sponsored business is one of the unique strengths that we have, given the relationships we have with those clients. As we have talked to them very specifically I think they still see the Medicare Advantage as a very attractive opportunity. Obviously it has to fit in with their other priorities in the context of their benefit strategy, but I think we haven't seen any change in the tone, tenor or appetite and we continue in conversations with many clients.

As you recall, we have a very unique relationship with the Human Resource Policy Association. Mark has been very active in the marketplace and his team in meeting with employers and really explaining the benefits of that and the employers who participated in that have been quite pleased with it.

Charles Boorady - Citigroup

And then my follow-up is just on generally what the biggest concern you have about achieving your long-term EPS growth target in 2009. I recognized the impact of the economy and what that might mean for enrollment. But you mentioned you're ahead of where you were last year this time in terms of enrollments for next year.

So is it more your view on where interest rates may go or margins may go or what the main concern is about '09 from where you sit today?

Ronald A. Williams - Chairman and Chief Executive Officer

Well Charles, I would, one, remind you that the National Account component of our business is really the component that we have the best visibility in. We are beginning the process of moving the closure on the Middle Market and then the Small Group and other businesses will follow that. So I think it's fairly early.

I think in our case, we start with what we call eternal vigilance on everything and I think as you know this is a business where execution is extremely critical. We believe we have the right strategy, we believe we have been executing it very consistently over a sustained period of time and eternal vigilance around execution is critical. And I'll ask Joe if there's anything he would like to add.

Joseph M. Zubretsky - Executive Vice President and Chief Financial Officer

No I think that's right Charles. We have been very clear many times of what the drivers and the profitability, the profitable growth of this business are in terms of membership, leveraging premium yields in high single digits and the ability to maintain MBRs in their current 80% range, which we consider to be equilibrium in the marketplace so nothing more than just driving across the fundamentals of the business.

Charles Boorady - Citigroup

That's great, thanks.

Operator

And our next question comes from Peter Costa with FTN Midwest Securities. Please go ahead.

Peter Costa - FTN Midwest Securities

Actually... a question regarding acquisitions. Do you have any targets for what you're looking for at this point in time in terms of... your acquisitions have grown in size over the last few years. Are you looking to do anything more substantial this year, given valuations where they are in the group and what not?

Ronald A. Williams - Chairman and Chief Executive Officer

Yes Good morning Peter. The strategy that we have around acquisitions it remains the same in the sense that we are focused very much on acquisitions that give us an ability to manage medical quality and costs; they have a positive impact on quality and costs in healthcare.

We also continue to look at acquisitions that give us innovations and capabilities to serve either existing customer segments or penetrate new customer segments. And then as we described before, we're looking at opportunities that increase our local market strength.

I think for us it is really about having a belief that the acquisition can help us strategically in the marketplace serve the needs of our customers. So I would tell you that our strategy has not changed. It's very consistent. Obviously we look at a lot of properties of various sizes and scales.

We have a very rigorous process we put these through in terms of financial hurdles, return on investment and I would also say cultural affinity in the context of a culture that we believe is consistent with the culture we have as an organization. So I would say that we will continue to be active and to the extent we find things that meet that criteria, we would not hesitate to proceed.

Peter Costa - FTN Midwest Securities

Okay and a follow up. Looking at your Medicare MLR, was sequentially up... that's a little different and what you normally see in the industry where medical MLRs tend to improve through the year. Can you talk about why your MLR goes up in the second quarter? And I know it did this last year as well.

Joseph M. Zubretsky - Executive Vice President and Chief Financial Officer

Peter, I think you're seeing various effects of product mix. You're seeing PDP products which start very high at the beginning of the year and migrate down to lower MBRs later in the year due to the donut hole effect. You're seeing the impact of premium flows. As you know, collecting risk-adjusted premium from CMS is a factor in this business. So there's lots of factors affecting the MBR, but the MBR for this quarter was a fairly clean shot and a good view of the current profitability of the business.

Peter Costa - FTN Midwest Securities

Okay.

Operator

[Operator Instructions]. And our next question comes from Josh Raskin with Lehman Brothers. Please go ahead.

Josh Raskin - Lehman Brothers

Ho thanks, Good morning. Just a quick question on the cash flow. Joe you had mentioned the timing of federal tax payments I think is what you said. What was the size of the additional payment?

Joseph M. Zubretsky - Executive Vice President and Chief Financial Officer

The comment was that the second quarter is always seasonally affected by the timing of cash tax payments, about $400 million. Really you have to look at the six-month numbers. The six-month numbers are more comparable. That brings you to a 137%, and even if you would adjust for that onetime payment we received in the first quarter we're in the low 120's. So on a six-month basis we're really on target to hit our 130% target for the year.

Josh Raskin - Lehman Brothers

Got you and then just the second question on the cost trends, I am curious... you suggested you're sort of towards the higher end of that 7.5 plus or minus 50 basis points range. Now, I believe you said pharmacy was the bigger... the biggest driver for that. My understanding is that's maybe 15% of the overall cost trend. So, has there been a real big move in order to get that 50 basis point impact? Or and also I guess just in light of industry trends that IMS data, not sure that's most consistent with industry, so I'm just curious what you guys are seeing specifically on the pharmacy side.

Ronald A. Williams - Chairman and Chief Executive Officer

I would just first remind you that the comment regarding upward pressure was focused on '09 not '08. And so for '08 we're really saying that we're at 7.5 plus or minus 50 basis points with things stable. And Joe, do you want to comment on the second?

Joseph M. Zubretsky - Executive Vice President and Chief Financial Officer

Sure, and the math would be if your pharmacy trend does increase by 200 to 300 basis points and it's at 15%, you can do the math to 50 basis points which is why it's putting upward pressure on the range.

Josh Raskin - Lehman Brothers

So that was expectation for '09?

Joseph M. Zubretsky - Executive Vice President and Chief Financial Officer

For '09, correct.

Josh Raskin - Lehman Brothers

Okay, Perfect, thank you.

Operator

And our next question comes from Doug Simpson with Merrill Lynch. Please go ahead.

Doug Simpson - Merrill Lynch

Good morning. Joe, I was wondering if you could just flash out the 15% for us. It looks like over the last couple years the EPS growth rate, you go back to sort of '06 period the last three years the average has been around that 15%. And it sounds like you're remaining committed to that longer-term. We've seen debt to cap rise from sort of the 13% to 14% level up to 28% now. As you make that 15% comment, can you just give us a sense for how you're thinking about the balance sheet?

Joseph M. Zubretsky - Executive Vice President and Chief Financial Officer

Sure. We have said repeatedly that we thought the Company was under-leveraged. When I got here it was in the high teens. We moved it to 20% and then 25% last year and might, depending on market conditions, move it to 30% by year end, again depending on market conditions.

We think that is a very good profile for this company. It's all about the earnings power of the business and coverage ratios. And even at that 30% debt to total cap, the coverage ratios are still AAA ratios. So, we're very comfortable that, that leverage profile withstands all the stress tests that they need to withstand.

Doug Simpson - Merrill Lynch

So should we be expecting the operating income growth to sort of accelerate, if we're holding the leverage relatively constant for the next couple of years, because going from 20 to 30, not too big a change? Would you expect sort of an uptick in the core operating growth to get you up to the 15?

Joseph M. Zubretsky - Executive Vice President and Chief Financial Officer

Keep in mind that as you're leveraging up, your interest expense comparison year-over-year will be higher which will put pressure on operating earnings as you're leveraging up. Then once you reach your target leverage ratio that fact should moderate. So while you're leveraging up there will be pressure on operating income due to higher interest expense and year-over-year comparisons.

Doug Simpson - Merrill Lynch

Okay and then maybe just directionally with the MLR in the 15%, are you sort of seeing the level you have now is sustainable? Are you baking in - just how do you think about that directionally, against that 15% comment?

Joseph M. Zubretsky - Executive Vice President and Chief Financial Officer

Well as we said, at this early stage we see slight upward pressure on medical trends for next year and we believe we have the foresight and the ability to be able to price to that trend. So yes, we think the MBRs on a commercial basis are at equilibrium in the marketplace, the pricing environment seems stable and rational.

Doug Simpson - Merrill Lynch

Okay, thanks.

Operator

And our next question comes from Justin Lake with UBS. Please go ahead.

Justin Lake - UBS

Thanks, Good morning. Just first I guess a quick question on the pricing environment, and with now three of the largest companies in this space talking about higher medical cost trends, is there any evidence that you're seeing out there that you can point us to as far as plans starting to embed that in their pricing for '09? As far as maybe the filed pricing that you see with... at the state level or even just anecdotal evidence, when talking to brokers?

Ronald A. Williams - Chairman and Chief Executive Officer

Good morning Justin. I'll ask Mark to respond.

Mark T. Bertolini - President

Hi, Justin. We have not seen, other than the focal renewal for Blue Cross/Blue Shield in California any significant change in the pricing environment. Now in other markets that we talked about in the past, we've seen small moves as the Blues' strengthen pricing in Florida. But given how far away they were from a competitive standpoint, those moves are not discernibly changing the price environment in those markets for us.

Justin Lake - UBS

Okay when would you expect to have evidence one way or another that plans are embedding higher pricing for '08 on higher medical cost?

Mark T. Bertolini - President

One of the things that Ron talks about is eternal vigilance. So we're constantly looking at it monthly. We would have expected to see some of it by now. We've not yet seen it.

Justin Lake - UBS

Okay and does that give you any concern for how the '09 pricing environment is going to set up, given some folks out there are looking for firming on pricing for '09?

Mark T. Bertolini - President

Relative to our performance and our marketplace we believe the market is rational, that we're in a competitive position in the marketplace and any moves up in pricing by competitors would be helpful to us. I can't comment on their own situation.

Ronald A. Williams - Chairman and Chief Executive Officer

Justin, I would remind you that these are very localized situations. In the long-term context of the industry, they come and they go. The strength of Aetna as a company is our geographical flexibility and our multi-segment strategy where we have a significant diversity geographically and by customer segment. So my view is that over time we will see changes in some of these markets. Our belief is that when those occur they will be very good opportunities for us because we've kept our pricing discipline and continued to exhibit very strong underwriting and pricing discipline. Our product set will be, we believe, well received at the point that a couple of these markets turn.

Justin Lake - UBS

Got it. And then just a follow-up on the achieved yields that you're reporting for the P&L. They're trending... for most of the industry somewhere between 3% and 5%. I guess in this quarter you would probably pull towards the lower end of that range.

Ronald A. Williams - Chairman and Chief Executive Officer

I would say that the yield that you had observe from the financial statement, if you have the exact number, it would be closer to 4%. And that's obviously is affected by the full range of product and geographic and customer segment mixes and different benefit designs, but if you had the exact number of months, the yield would be 4%.

Operator

Our next question comes from Greg Nersessian from Credit Suisse First Boston. Please go ahead.

Greg Nersessian - Credit Suisse First Boston

Thanks, just a quick follow-up there on Justin's last question. I guess as you think about the economic conditions, broader economic conditions deteriorating and your view that medical cost trends are going to be increasing next year, you're going to be pricing those higher trends, how do you expect the behavior of your commercial risk-based accounting, small group and mid-market, to change next year?

Do you anticipate even more buydowns, maybe those mid-market accounts that are kind of on the edge converting to self-funded? How do you think they're going to react to higher trends, another year high single digit price increases, and then as their core unit costs are going up as well?

Mark T. Bertolini - President

Greg, this is Mark Bertolini. We are seeing and we will continue to see employers look at ways of ameliorating their premium increases year-over-year. On benefit buydowns they have been in the 7.5% to 10% in the small group market, on the lower end of the smaller group market and under 50 or under 10 lives. We see that starting to creep up into the select market space. At the large end of the market and the key accounts, which are 300 to 3000, we've seen employers move more to self-funding.

We believe that's cyclical and that's largely driven by the premium competitiveness of the stop loss market. And so as more stop loss cases come to the market and those premiums harden, then we see employers move back into the insured space. So I think we'll see more of the same that we've seen already. Again our view of trend uptick for next year is not significant. And it will look to employers to be more of the same year-over-year.

Greg Nersessian - Credit Suisse First Boston

Okay, so do you expect that if you could just maybe provide a little more color on that stop loss comment, do you expect that environment to change next year or are you just saying cyclically over time it will harden? And then my last question was just on your MA expansion plans into next year, if you could comment on where you file or how many new markets you filed.

Mark T. Bertolini - President

Typically the stop loss market is cyclical. We are now in a market where the loss ratios and stop loss are fairly stable. So we don't anticipate any uptick in stop loss premiums. In the Medicare area we're still filing and waiting for approval of our filings from the Feds on expansions for next year.

Greg Nersessian - Credit Suisse First Boston

Okay, thanks.

Operator

And our next question comes from Matthew Borsch with Goldman Sachs. Please go ahead.

Matthew Borsch - Goldman Sachs

I just had a question on the employer buying habits you're seeing going into next year. Specifically, with the economic pressure, are you seeing any change in employer preference for some of sort of extra programs, disease management, maybe some of the additional specialty programs that they might choose, again just in light of the economic environment?

Ronald A. Williams - Chairman and Chief Executive Officer

Yes Good morning Matt. The general environment, when I talk to particularly CEOs who are focused on this and CFOs, is a strong recognition that their success is linked to total medical costs. And so generally I would say that there is an appreciation for the impact that proven programs, such as our CareEngine and disease management and other approaches have on medical cost, it will always vary a little bit by client obviously, but I think generally these are not viewed as frills. These are viewed as fundamental and extremely important components to improving quality and managing costs. And I'll ask Mark to comment further.

Mark T. Bertolini - President

Yes Matt. I think at the very high-end of the market, in National Accounts and in our key accounts segment, our large middle market employers, there's a great deal of interest in wellness. And so we're spending a lot of time with employers talking about exactly what wellness means. And that program is very much in the eye of the beholder, so they're very much customized to the employee population, the type of demographics, the level of morbidity they have in the population. We fine-tune those programs for their employees.

And that's what you will see with the Bank of America account and the Home Depot account and a few others that we will have sold by January 1, 2009. I think in the middle market we're seeing more employers interested in the integration of services as a way of addressing cost integrated health and disability for example, managing disability cases and the medical cost through one case management nurse. And so as you get down market it's more about the price of premium and employers are looking for programs that we're willing to put in place that can be reflected in premium savings over time.

Matthew Borsch - Goldman Sachs

That makes sense. If I could ask one follow-up, your enrollment guidance for the remainder of the year, you maintained the outlook. It looks like you're guiding to a higher mix of insured, if I've got that right. Can you just tell us... help us understand what is influencing that?

Joseph M. Zubretsky - Executive Vice President and Chief Financial Officer

That's correct. If you just take the upper end of our range at 900, we would expect half of that to be risk membership, which is 10 points higher than the last time we guided.

Matthew Borsch - Goldman Sachs

And what is it that has made that change, if you could comment on that?

Joseph M. Zubretsky - Executive Vice President and Chief Financial Officer

Just better insight as to how the membership is going to flow for the remainder of the year and the large Medicaid account that we at the state of Connecticut installation.

Matthew Borsch - Goldman Sachs

Okay, got it, thank you.

Operator

There appears to be no further questions at this time. I would like to turn the conference back to Mr. Chaffin for additional or closing remarks.

Jeffrey A. Chaffkin - Vice President of Investor Relations

Thank you Nicky. A transcript of the prepared portion of this call will be posted shortly on the Investor Information section of the Aetna website at Aetna.com. If you have any questions about matters discussed this morning, please feel free to call me or one of my colleagues in the Investor Relations office. Thank you again for joining us this morning.

Operator

Ladies and gentlemen, that does conclude today's conference. Thank you for your participation, you may now disconnect

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