Magellan Health Services Q3 2007 Earnings Call Transcript

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Magellan Health Services (NASDAQ:MGLN) Q3 2007 Earnings Call November 2, 2007 9:30 AM ET


Melissa Rose - Senior Vice President of Financial Planningand Investor Relations

Steve Shulman - Chairman and Chief Executive Officer

Rene Lerer - President and Chief Operating Officer

Mark Demilio - Chief Financial Officer


Josh Raskin - Lehman Brothers

Michael Glynn - Credit Suisse

Melissa Jaffe - Merrill Lynch

Michael Yuan - Banc of America Securities

Brian - Raymond James


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

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

Melissa Rose

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

Certain of the statements made during this conference callare forward-looking statements contemplated under the Private SecuritiesLitigation Reform Act of 1995. These forward-looking statements are subject toknown and unknown uncertainties and risks, which could cause actual results todiffer materially from those discussed.

These forward-looking statements are qualified in theirentirety by the complete discussion of the risks set forth in the caption riskfactors in Magellan's annual report on Form 10-K for the year ended December31, 2006, which was filed with the Securities Exchange Commission on February28, 2007 and also discussed in the 10-Q that we filed with the SEC later today.

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

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

Steven Schulman

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

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

In addition, the quarter's financial results were morefavorable than we had originally estimated due to higher than projectedmembership and lower than projected start up costs related to our new MaricopaCounty Medicaid contract.

However, we are focused on ICOR, given its continued lagversus expectations and I will discuss this more in a moment. First let mespend a few minutes updating you on the successful implementation of theMaricopa contract, which went live on September 1st. With analyzed revenue ofapproximately $580 million, this contract is larger than we had originallyprojected and it is the largest behavioral care contract carve-out in theUnited States for Medicaid.

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

I am very pleased to report that the implementation has gonequite well. Thanks to the diligent work of hundreds of Magellan employees. Weimplemented this contract quickly and efficiently, while at the same timekeeping up our service metrics for the rest of our Magellan customers aroundthe country.

Our success is a testament to our national scale, our verystrong operational infrastructure and expertise in implementing and managinglarge and complex specialty managed care contracts. The local response forMagellan has been very positive and was exemplified in a guest editorial bySusan Gerard, the Director of the Arizona Health Services that appeared in theArizona Republican on September 28.

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

In addition to a smooth operational implementation, we arealso very pleased that start up expense related to Maricopa came in lower thanoriginally projected. In addition, operating results were better than expecteddue to higher than projected membership and earlier than anticipated impactfrom management of the contract.

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

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

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

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

We have entered into an agreement to partner with the healthplan to bid on the regions. Our partner has asked we keep its identityconfidential. It is important to note that we have had partnershipconversations with several firms and that we have chosen our current partnerbased on their strong managed care and Medicaid capabilities in our confidenceon their commitment to bidding on both regions in the RFP

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

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

However, based on what has occurred in the middle regionwith this population, we think it's likely we retain this business on acarved-out basis. Let me also give you an update on our radiology business. Whythe implementation of the Maricopa Behavioral Contract has been a major eventfor us this summer it certainly has not been the only major implementationunder way.

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

In addition, our Empire Radiology contract successfullyconverted to our risk contract on July 1st. Service for both the Empire andCIGNA contracts have gone very well since the implementations. Financially thisquarter's care, as we had projected, was negatively impacted by the building ofIB&R reserves.

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

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

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

Moving to specialty pharmacy, ICORE's performance thisquarter has continued to lag our expectations. Our investment was predicated onICORE's differentiated ability to bring formulary rebates to the pharmaceuticalindustry. As we discussed last quarter our rebate business is performing ontarget. However, our distribution and consulting revenues are lagging ourprojections.

We believe that we could successfully integrate rebates anddistribution capabilities into a competitively advantaged product. Distributioncontinues to be impacted by slower than anticipated ramp in our newdistribution contracts.

In addition, both the distribution and consulting businesseshave not achieved their respective new business targets in 2007. The consultingcontract has been adversely affected in part due to increased concerns formanufacturers about having consulting relationships with the same vendor, whichit contracts to rebates. This is adversely impacted ICORE's consultingbusiness.

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

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

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

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

As we move forward, we are also increasing our salesresources in the areas of distribution and consulting. This includes significantlyreducing the operational responsibilities of key executives in these areas sothat they can focus on business development.

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

Given the strong third quarter, we are increasing it, as I saidearlier to $215 million to $225 million of segment profit, including Maricopastart up in operating results. Driven by solid performance in both ourbehavioral and radiology businesses, we are performing in total well ahead ofprevious projections and we are projecting much of the strong performance tocontinue into the fourth quarter.

Our health plan segment has been running favorably this yeardue to lower than projected costs and we have projected this to continue in thefourth quarter.

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

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

Mark Demilio

Thank you, Steve.

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

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

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

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

Net income for the third quarter of 2007 was $25.1million or$0.63 per share on a diluted basis. For the third quarter of 2006, thecompany's net income was $21.2 million or $0.54 cents per share on a dilutedbasis. As stated, segment profit was $57.4 million for the third quarter of2007, compared to $54.6 million for the third quarter of 2006. Segment profitfor the nine months ended September 30, 2007 was $157 million.

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

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

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

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

In particular, the improved care trend in the health plansegment, which was demonstrated by the favorable prior period development, aswell as the lower care trend in the quarter and which we are now projecting tocontinue into the fourth quarter.

The other major factor contributing to the increase thereguidance is the favorable change in our expectations for the Maricopa Countycontract, due to improved operating results, based primarily on highermembership and an earlier than projected impact on managing the contract, bothof which impacts will continue into the fourth quarter.

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

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

Specialty Pharmaceutical Management segment profit was $4.6million compared to $4.2 million in the prior year quarter. As you know, we didnot acquire ICORE until July 31 of 2006 and therefore there were only twomonths of results for this segment in last year's segment profit.

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

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

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

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

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

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

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

The effective income tax rate for the nine months endingSeptember 30, 2007 was 40%. As, the effective income tax rate varies fromfederal, state statutory income tax rate primarily due to state income taxesand to permanent difference between book and tax income. Our effective ratewill vary from period to period depending upon the amount of permanent to bookto tax differences realized during the period.

Our effective rate for the nine months reflects ouranticipated effective rate for the full year of 2007. So our estimated rate of40% has decreased from our previous estimate of 42% due to clarification ofcertain tax positions on 2006 state tax returns that were filed during thethird quarter. Our effective rate for the third quarter was 37%, which reflectsthe impact of changing our estimates for the year from 42% to 40%.

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

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

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

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

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

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

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

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

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

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

Terminated contracts, including the Anthem and TennCareMiddle Region contracts, which terminated as of March 31, 2007 and the EmpireBehavioral and Blue Cross Blue Shield of Massachusetts contracts that willterminate as of January 1, 2008 as we previously announced, and the rateadjustments for 2008 with respect to behavioral business.

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

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

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

Steven Schulman

Thanks, Mark. Before we close today, I want to spend a fewminutes discussing our strategy and updating you on our current position on ourcapital deployment initiatives. Our strategy for the past several years, aswell as today, is to leverage Magellan's strong and efficient platform byaccelerating growth organically and through acquisitions to supplement our moremature business lines.

Our flat platform is comprised of our operationalinfrastructure, customer base, management team and balance sheet. Our focus ison growth by expanding our existing markets as well as entering into new, highgrowth areas of healthcare with the goal of accelerating our overall growthrate.

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

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

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

When identifying new markets in healthcare, we continue tolook for areas that meet the following investment criteria that we have statedover the last three or four years, markets that represent a meaningful portionof the healthcare dollar, markets where costs are growing at a faster rate thanother healthcare expenses, areas where costs are separable from other medicalcosts and are measurable, areas where we can demonstrate value through improvedoutcomes and reduced cost.

Over the long-term, we believe this strategy of expandinginto new markets will create significant shareholder value. Since our lastearnings call, certain shareholders have expressed to our Board of Directorstheir desire for us to implement a share repurchase or dividend. We take thisfeedback very seriously.

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

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

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

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

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

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

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

In closing, let me take a moment to comment on Mark'searlier discussion of 2008 guidance. As Mark stated, we are currentlyprojecting the 2008 segment profit will be down slightly from the new increased2007 guidance. We are still in the midst of our budget process.

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

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

Questions-and-Answer Session


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

Josh Raskin - Lehman Brothers

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

Steven Schulman

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

Josh Raskin - Lehman Brothers

Okay. And on the margin side, I know you guys are capped at4% to 5%. That's post, that's after taxes. Would you expect to be sort of thisthat run rate for the full fiscal year of '08 at this point? It sounds like youknow you feel like you are getting better margins at this point already.

Steven Schulman

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

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

Josh Raskin - Lehman Brothers

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

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

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

Steven Schulman

Well, it's a fair question. Certainly let me just back upand say what we are seeing in the marketplace, not only the value of our cashis higher, the costs of the debt is higher. But we are seeing a return tonormal patterns, because the cost of capital to financial buyers has increasein their ability to leverage the company as much as they could with nocovenants has decreased.

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

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

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

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

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

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

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

Josh Raskin - Lehman Brothers

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

Mark Demilio

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

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

Josh Raskin - Lehman Brothers

Got you.

Mark Demilio

It pretty much netted out.

Josh Raskin - Lehman Brothers

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

Mark Demilio

Yes, that's right.

Josh Raskin - Lehman Brothers

Okay. Perfect. Thanks.


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

Michael Glynn - Credit Suisse

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

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

Mark Demilio

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

Michael Glynn - Credit Suisse


Mark Demilio

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

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

Michael Glynn - Credit Suisse

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

Mark Demilio

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

Michael Glynn - Credit Suisse

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

Steven Schulman

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

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

Michael Glynn - Credit Suisse

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

Rene Lerer

Hi this is Rene. The sales cycle for specialty dealsprimarily with health plan, so it is not a January date implementation timesfor ICORE, particularly on the rebate side is reasonably short. So we believethere is still significant opportunity for us to hit the sales prospects for a2008 implementation. Obviously January is a bit early, but we think throughoutthe course of 2008 we have opportunities for increased sales with all the lineswithin ICORE.

Michael Glynn - Credit Suisse

Great. Thank you.


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

Melissa Jaffe - Merrill Lynch

Hi, guys.

Steven Schulman

Good morning.

Melissa Jaffe - Merrill Lynch

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

Steven Schulman

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

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

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

The point we look at, I'll give you specific numbers offline but in the commercial world behavioral world behavioral health is 2% to3%, in Medicaid it is closer to 10%, given the nature of the people, a lot ofit is, people with behavioral illness cannot work and therefore it is causesthem to enter into Medicaid with a much bigger percentage.

And you guys know the total dollars in Medicaid, I would say10% of that is our market and discount it for penetration assumptions.

Melissa Jaffe - Merrill Lynch

Okay. Thanks.


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

Michael Yuan - Banc of America Securities

Hi good morning guys I just had a question on TennCare. Iknow the Middle Region where you partnered with Blue Cross, Blue Shield, youbasically won on every metric except costs and that is because they weren'twilling to bid on a risk basis.

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

Mark Demilio

We’ve obviously as Steve talked about during his remarks, wehave talked to lots of different partners and obviously, we are intimatelyknowledgeable and familiar with what happened in the Middle. So honestly, it isnot fair for us to except comment on how a partner would bid or would thoughtbid.

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

Michael Yuan - Banc of America Securities

Great. Thank you.


Michael Baker of Raymond James you may ask your question.

Brian - Raymond James

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

Mark Demilio

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

Steven Schulman

In the form that we have today.

Mark Demilio

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

Brian - Raymond James

Okay thank you.


At this time there are no further questions.

Steven Schulman

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

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


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