Centene Corp (CNC) 2016 Q3 法說會逐字稿

Good morning and welcome to the Centene Corporation third-quarter 2016 financial earnings conference call.

(Operator Instructions)

Please note, this event is being recorded. I would now like to turn the conference over to Ed Kroll, Senior Vice President Finance and Investor Relations. Please go ahead, sir.

Thank you, Denise, and good morning, everyone. Thank you for joining us on our 2016 third quarter earnings results conference call. Michael Neidorff, Chairman and Chief Executive Officer, and Jeff Schwaneke, Executive Vice President and Chief Financial Officer of Centene Corporation will host this morning's call.

The call may also be accessed through our website at centene.com. A replay will be available shortly after the call's completion, also at centene.com or by dialing 877-344-7529 in the US and Canada or in other countries by dialing 412-317-0088. The playback code for both of those playbacks is 10093224.

Any remarks that Centene may make about future expectations, plans and prospects constitute forward-looking statements for purposes of the Safe Harbor Provision under the Private Securities Litigation Reform Act of 1995. Actual results may differ materially from those indicated by these forward-looking statements as a result of various important factors, including those discussed in Centene's most recently filed Form 10-Q which is dated today October 25, 2016, or the most recent Form 10-K dated February 22, 2016 and other public SEC filings.

Centene anticipates that subsequent events and developments will cause its estimates to change. While the Company may elect to update these forward-looking statements at some point in the future, we specifically disclaim any obligation to do so.

With that, I'd like to turn the call over to our Chairman and CEO, Michael Neidorff. Michael?

Thank you, Ed. Good morning, everyone, and thank you for joining Centene's third-quarter 2016 earnings call.

During the course of this morning's call, we will discuss our third-quarter results and provide update on Centene's markets and products. Additionally, we will bring you up to date on the Health Net integration.

Let me begin with a few comments on Health Net. As part of our ongoing fair-value analysis during the second quarter, we recorded a premium deficiency reserve of approximately $300 million due to unfavorable performance in some of Health Net's business operations. The PDR covers the period March 24 through December 31, 2016.

We have taken significant actions over the past few months to improve the business operations for 2017 and beyond. These include price increases, plan design changes, and certain market exits. We fully believe we have now dealt with all the factors that contributed to the PDR.

During the third quarter, we reduced the $300 million PDR to $285 million, as the outlook of substance abuse claims liability in California has improved. Please note, this had no effect on third-quarter earnings.

The largest component of the PDR is $110 million related to the California commercial business. We negotiated with the California Department of Insurance the necessary benefit changes.

On October 3, we submitted our filings to the CDI for the 2017 plan designs and rate adjustments. These substantial benefit design changes allowed us to reduce our original 23% rate increase to 9.9%.

Some of the key benefit changes included, the first-time inclusion of an out-of-network deductible for platinum and gold plans of $5,000 for an individual, and $10,000 for a family. A significant increase in the out-of-network maximum out-of-pocket level to $25,000 for an individual and $50,000 for a family.

The elimination of non-emerging out-of-state coverage and travel network access. The elimination of the default rate of 75% of billed charges for out-of-network services that do not have a Medicare rate.

The reduction of reimbursement for out-of-network positions and other services and supplies to 100% of the Medicare rate from the 85th percentile of fair health and 190% of the Medicare rate respectively. And restrictions on third-party premium payments which were not included in the original 2016 offering.

We believe these substantive changes will significantly strengthen our control of out-of-network utilization which was the main driver of the PPO cost issues. In addition, we expect to further improve the operating performance of these products with the implementation of Centene's medical management tools as well as network enhancements.

We appreciate the collaboration efforts of the CDI through the process. We expect the rate and benefit design changes to create a more competitive product in 2017, and allow for a balanced book of business.

Let me now go through the remaining components of the PDR, and the corrective actions we have taken outside of California. First, $70 million related to Arizona individual commercial.

We will exit the Arizona individual PPO business effective January 1, 2017. This exit represents $32 million of the $70 million loss. The remaining $38 million of the loss is associated with the individual HMO exchange product in Arizona.

We have reconfigured our geographic presence, increased rates, and redesigned benefits. We will remain in Pima County and in Maricopa County as the only carrier. We expect the Arizona exchange to generate $500 million in incremental revenue, and operate within our normal marketplace margins in 2017.

Second, $15 million related to Arizona Medicaid. As of July 1, this business has been fully transitioned to Centene's operating platform. We expect Arizona Medicaid to be profitable next year.

Third, $20 million related to other smaller items, including the Arizona small group and Oregon individual business. We have applied for rate increases and benefit design changes to address these issues.

And lastly, $70 million related to Medicare Advantage. We submitted bids in June, and are taking actions on unit costs and medical management initiatives to achieve profitability next year.

Next let's talk about Health Net integration. The integration process continues to go well, and we remain on track or ahead of schedule in many areas. We have now completed the actions needed to capture all of the $75 million first year synergy target.

During the third quarter, we began the conversion of Health Net's California plan on to Centene's medical management systems. We expect this conversion to help drive better operating performance through the application of Centene's award winning case management tools and programs.

Turning to third-quarter financials. Membership at quarter end was 11.4 million members, representing an increase of 6.6 million beneficiaries over the third quarter of 2015.

Total revenue increased 86% year over year to $10.8 billion. On a sequential basis, total revenues declined by $50 million due to exchange membership attrition and the eligibility redetermine process in California Medicaid. This is partially offset by a commencement of Medicaid expansion in Louisiana, and all of these were expected.

Note, the redetermined results in a sequential loss of approximately 61,000 Medicaid beneficiaries in the state. It has now been completed, and roughly 16,000 members were added in October.

The HBR improved 200 basis points year over year to 87%. This was primarily attributable to the commercial product mix shift from Health Net. Importantly, we continue to see stable medical cost trends consistent with our expectations in the low single digits.

Lastly, on a GAAP basis, we reported diluted earnings per share of $0.84. We reported adjusted diluted earnings per share of $1.11, or $1.16 when excluding a $0.05 expense related to the 2015 risk adjustment and reinsurance reconciliation under the Affordable Care Act.

Recall that in the second quarter, we recorded a $0.19 diluted EPS benefit related to this reconciliation. Thus, the net benefit we have recorded in the past two months is actually $0.14. Jeff will provide further financial details, including updated 2016 guidance.

Now onto market and product updates. First we will discuss recent Medicaid activities.

In August, Centene was one of three plans selected to serve long term care recipients in (inaudible) Pennsylvania's HealthChoice programs statewide. This program covers more than 420,000 individuals who are dually eligible, and those with physical disabilities. This contract will be rolled out in three tranches.

The Southwest zone will be the first to go live with an expected launch date of July 1, 2017. The Southeast zone is expected to commence January of 2018, and the remainder of the state is expected to begin on January 1, 2019.

Pennsylvania marks Centene's 10th state managing long-term care for long-term care beneficiaries. We are the largest provider of long-term care support services, one of the fastest growing segments of the managed care market. While the contract has not been finalized, we expect that it will ramp up and be profitable within a normal timeframe.

Alabama, in September, the Alabama legislature approved the funding needed to create its regional care organization structure. Centene's specialty solution division, Envolve, has contracted with five nonprofit RCOs in the state to provide management services. Operations are expected to commence July 1, 2017. This award highlights Centene's depth and breadth of management services under our Envolve grant.

Missouri, last week, we were pleased to be selected to provide managed care services to Medicaid recipients in all 114 counties in Missouri. This award is a successful re-procurement and expansion of Centene's presence in the state.

This expanded program covers over 240,000 additional Medicaid beneficiaries in Missouri, bringing the total number of individuals covered to over 740,000 lives. The program is expected to commence May 1, 2017.

Next, Medicare and Duals. Our quarter end, we served over 300,000 Medicare and dual beneficiaries. We continue to move forward with our growth plan to expand our Medicare Advantage footprint into Centene's Medicaid states next year.

We're launching new MA plans in Texas, Florida and Mississippi. These new plans will be launched under our four-star parent rating and are eligible for a 5% premium bonus.

In Georgia, we're using our existing special needs plan to launch Medicare Advantage. This plan will also be eligible for quality bonus.

Consistent with Centene's overall strategy, we will focus on low-income Medicare beneficiaries. We fully expect to have a profitable MA business in 2017.

Let me make a brief comment on the recently announced 2018 Medicare Advantage star ratings. We are pleased to have maintained our four-star PERA grade. Seven of our plans saw an improvement in star ratings, and seven plan's star ratings stayed the same.

Our Oregon plan's star rating declined from 4 to 3.5 stars, primarily due to a reduction in PERA D scores. This was the result of the addition of a deductible to our prescription drug benefit which was done to improve profitability.

This issue was limited to the Oregon market. Maintaining a high-quality star rating is a top priority for Centene.

Now health insurance marketplaces. Centene's exchange experience continues to be favorable, and we are achieving margins at the high end of our targeted range. Our marketplace strategy is different from most of our peers.

We designed our exchange solutions to be able to leverage our Medicaid platform, including provider networks as we are focused on low-income subsidized individuals. In the third quarter over 90% of our exchange members were subsidy eligible. This is consistent with our prior experience.

We ended the quarter with over 580,000 exchange members in 15 states. We continue to anticipate serving approximately 550,000 exchange members at year end due to normal attrition. Overall, we continue to expect our market place offerings to be profitable next year.

Shifting gears to our rate (inaudible). For Medicaid, we continue to expect a 2016 composite rate adjustment of between 0% and 1%, consistent with the past three years.

In summary, we are optimistic about the future of our ability to extend Centene's leadership position in government-sponsored healthcare. We are on track with the integration of Health Net. We have taken the necessary actions to substantially improve the underperforming markets and products covered by the 2016 PDR.

Our growth pipeline is bigger than ever, and we continue to expand our Medicare Advantage market. We remain committed to long-term margin expansion, and continue to make the necessary investments in systems and infrastructure to successfully execute our strategy.

As a reminder, our next Investor Day is on December 16 in New York City. As is our custom, we will provide full, first-time 2017 financial guidance.

I'd like to make a couple comments on our expectations for 2017. At this time, we believe total revenues will be approximately $46 billion, at a minimum. This represents a $1 billion increase over the estimates we provided at the June Investor Day, and a 15% increase over 2016.

Importantly, the outlook continues to be favorable despite the fact that the denominator is significantly larger. Equally, while we are still finalizing our AOP, or annual operating plan, for 2017, we have no reason to believe that the consensus estimate for 2017 will be outside our target range.

Thank you for your interest in Centene. Jeff will now provide further details on our third-quarter financial results.

Thank you, Michael, and good morning. This morning, I will begin with highlighting the results for the third quarter of 2016 and provide an update on our 2016 full-year guidance.

For the third quarter of 2016, Centene's membership was 11.4 million members, an increase of 137% between years driven by the Health Net acquisition. Total revenues were $10.8 billion, an increase of 86% over Q3 of 2015.

Diluted earnings per share for the third quarter of 2016 was $0.84 compared to $0.75 last year, and adjusted diluted earnings per share for the third quarter of 2016 was $1.11 compared to $0.87 last year. Adjusted diluted earnings per share includes a charge of $0.05 per diluted share associate with the Arizona Risk Adjustment program.

During their third quarter, we received information from CMS that some of the participants in the Arizona Risk Adjustment program were unable to pay the amounts owed to the federal government associated with the 2015 risk adjustment reconciliation. As a result, the uncollected risk adjustment amount was prorated to all insurers in the market. Accordingly, we recorded a charge of $0.05 per diluted share recognizing our portion of the risk adjustment that will not be collected, which reduces the $0.19 per diluted share benefit we recorded in the second quarter of 2016.

Now for some more specifics. Total revenues grew year over year by $5 billion in the third quarter, primarily as a result of the Health Net acquisition. Expansions or new programs in many of our states in 2015 and 2016 and growth in the health insurance marketplace business in 2016.

Sequentially, our revenues were slightly lower than the second quarter due to lower commercial membership. Primarily as a result of expected attrition in the health insurance marketplace business, and lower membership in the California Medicaid program as a result of annual eligibility redeterminations completed by the state. This was partially offset by growth in other markets, specifically in Louisiana Medicaid expansion.

Our health benefits ratio was 87% in the third quarter this year, compared to 89% in last year's third quarter and 86.6% in the second quarter of 2016. The 200 basis point decrease year over year results from the addition of Health Net, as well as the growth in the health insurance marketplace business, both of which operate at a lower HBR. Sequentially, the 40 basis point increase in the second quarter reflects normal seasonality in the business.

We continued to deliver strong membership in margins in the health insurance marketplace business during the third quarter. The product continues to achieve margins at the high end of our targeted range, and we now have over $329 million accrued as a risk adjustment payable for services provided in 2016. For 2016, we continue to record reinsurance at the 50% coinsurance rate, record no risk corridor receivable, and record the risk adjustment utilizing the information we received from the data aggregators consistent with 2015.

Our general and administrative expense ratio was 9.2% in the third quarter of this year, or 9.1% excluding the costs associated with the Health Net acquisition. Compared to 8.4% in the third quarter of last year, and 9% in the second quarter of this year, also excluding Health Net acquisition costs.

The increase year over year reflects the addition of the Health Net business which operates at a higher G&A ratio due to a greater mix of commercial business. Sequentially, the 10 basis point increase is due to lower revenue in the third quarter.

During the third quarter, we incurred $0.07 per diluted share of business expansion costs primarily associated with the Texas STAR Kids award and the 2017 Medicare expansion compared to $0.05 per diluted share in the prior year. Investment and other income was $33 million in the third quarter of 2016, compared $8 million for the third quarter last year and $32 million in the second quarter of this year. The increase year over year is the result of the larger investment balances associated with the Health Net acquisition.

Interest expense was $57 million for the third quarter of 2016, compared to $11 million for the third quarter last year and $52 million in the second quarter of this year. The increase year over year is primarily due to the financing associated with the Health Net transaction. The sequential increase is due to the full-quarter effect of the $500 million of additional senior notes we issued in June of 2016.

Our tax rate for the quarter was 53.8%, compared to 48.3% in the prior year. The higher tax rate is driven by the acquisition of Health Net. During the third quarter we received approval of our refund in connection with our tax position with respect to 162(m)(6), or the limitation on the deductibility of certain executive compensation. As a reminder, we expect to be subject to 162(m)(6) limitation in 2017 as a result of the Health Net acquisition.

GAAP diluted earnings per share from continuing operations for the third quarter was $0.84, and adjusted diluted earnings per share for the third quarter was $1.11. Both amounts include a $0.05 diluted earnings per share charge associated with the Arizona Risk Adjustment program previously discussed. As a reminder, adjusted diluted earnings per share excludes $0.12 associated with the Health Net acquisition costs, and $0.15 associated with intangible amortization.

Cash and investments totaled $8.1 billion at quarter end, including $268 million held by unregulated subsidiaries. We estimate our risk-based capital percentage for NAIC filers to be in excess of 350% of the authorized control level.

Debt on September 30 was $4.6 billion, including $300 million of borrowings on our revolver. Our debt-to-capital ratio was 44.1%, excluding our non-recourse mortgage note, compared to 44.4% at the second quarter of 2016.

Our medical claim liability totaled $3.8 billion at September 30, representing 41 days in claims payable. The days-in-claims payable decreased during the third quarter due to annual provider risk share settlements of approximately $115 million in our California market, as well as the timing of claims payments at the end of the quarter.

We had strong operating cash flow for the third quarter of $480 million or 3.3 times net earnings. This was primarily driven by net earnings, collection of outstanding capitation payments, and prepayment of amounts from CMS associated with the Medicare product. This was partially offset by a payment of the health insurer fee of $513 million at quarter end.

A quick update on the substance abuse claims. During the third quarter, we revised our estimate of the level of substance abuse costs we anticipated to occur between the acquisition date and the end of the year. As you recall, we established a reserve of $50 million in our acquisition accounting in the second quarter as an estimate of the liability associated with these claims for the period from March 24 through December 31, 2016.

Based on the level of incurred and projected claims through the third quarter, we have lowered our estimate from $50 million to $35 million. This adjustment had no effect on earnings. We continue to evaluate the fair valuation associated with the substance abuse claims, and expect to complete that analysis in the fourth quarter.

As Michael mentioned in this comments, we have taken actions associated with products that were included in the PDR, including product design, premium rates, product exits, and numerous medical management and network initiatives. Based on the action we have taken, we believe we have resolved the issues associated with the 2016 premium deficiency reserve for 2017. We look forward to providing more details and full 2017 guidance at our normal December Investor Day.

Lastly, an update on our 2016 full-year guidance. As described in our press release this morning, we are adjusting our guidance for the risk adjustment charge related to the Arizona recognized in the third quarter. As we previously disclosed, during the second-quarter 2016, we recorded a benefit of $0.19 per diluted share and increased our full-year guidance for the 2015 reconciliation of the risk adjustment and reinsurance provisions of the marketplace business at that time.

As a result of the information received from CMS in the third quarter, the benefit recorded in the second quarter was reduced by $0.05 per diluted share to $0.14 when combining both quarters. We've updated our 2016 guidance accordingly.

Our updated annual guidance is as follows. Total revenues of $39.4 billion to $40 billion, GAAP diluted earnings per share of $2.73, to $2.83, adjusted diluted earnings per share of $4.28 to $4.38. G&A ratio of 9.4% to 9.9%, the G&A ratio excluding the transaction costs of 9% to 9.5%, an effective income tax rate of 54.5% to 56.5%, and diluted shares outstanding of 162.5 million to 163.5 million shares.

The guidance above implies a fourth-quarter GAAP diluted earnings per share of $0.83 to $0.93, and an adjusted diluted earnings per share of $1.05 to $1.15. This range now includes business expansion costs which we expect to be at the high end of our guidance range of $0.25 to $0.30 in the fourth quarter, driven by increased costs associated with our expected health insurance marketplace growth in 2017.

We continue to estimate our operating cash flow on a long-term basis to be between 1.5 and 2 times net earnings. As previously highlighted in the second quarter, we do anticipate that there will be variability in our cash flow from quarter to quarter depending on the timing of payments to certain states associated with minimum MLR programs, primarily in California.

Subsequent to quarter end, we received amendments to our California contracts with the Department of Healthcare Services to amend the Medicaid expansion medical loss ratio definition. All reconciliation periods remain open, however, we expect the amendment to reduce our minimum MLR liability and are currently working with the state to evaluate the impact of the amendment.

That concludes my remarks, and, operator, you may now open the line for questions.

(Operator Instructions)

Josh Raskin, Barclays.

Wanted to start on the 2017 commentary, I think that was really helpful and just give us some direction before December. If I think about the consensus and compare that to the updated guidance, excluding the $0.14 of good guides this year, it implies just around 15% growth which is exactly in line with what the top line expectation is.

And so I'm curious, your margins are still running below your long-term goals. Is there some sort of conservatism in there? I would've expected with some of the synergies and it sounds like you're assuming the full $300 million of Health Net comes back, are there some headwinds from a margin perspective or is this just a conservative place to start?

I think at this stage in our AOP annual operating plan process it's a safe place to be. So we're going through the final process, we're looking at startup costs for the various new products we have et cetera.

And so we really are outside our pattern of not saying much of anything about earnings until the December call. But we felt that with all the things out there, we would give some indication and then we'll give you a lot of granularity and a lot more color in December, Josh.

Okay, that's fair. Maybe just on Arizona, you've got two the bigger counties where you are going to be the sole remaining exchange carrier. It sounds like you're expecting that to remain profitable.

And I'm curious just based on the market exits from others, what gives you the comfort? Is there that dramatic a difference in your plan design and rates relative to what others in the market were providing?

I think this is a pure HMO. We have the right rates, the right positioning. It's one that has been very successful for us in other markets, and we really we exited the PPO and those and then the HMO that Health Net had that was not as well structured, and so we're confident that it will be profitable. Do want to add anything, Jesse?

Josh, this is Jesse Hunter. So just a couple things. One, we will be the sole carrier for Maricopa County on the exchange, but not in Pima County. We'll be one of two in Pima County. So I think it is important to provide a little bit of context for Arizona marketplace just in general.

I think the starting point for the whole market was off, so that's what drove a lot of the carrier exits. You had grandmothering or policies, you had a number of other things. So Health Net had that experience, that experience has been fully reflected in our plan for 2017.

In addition, we have added new products. Particularly in Maricopa County, we've added a new silver and a new bronze and better product, which is consistent with what we have in the other Centene and better markets. Those are the kinds of things that give us a lot more confidence around leveraging the Centene marketplace experience versus the historical Arizona marketplace experience.

[Bill], is there anything you want to add? No, okay.

I guess just to follow up real quick, Jesse, do you know what the experience of the exited carriers was? Just thinking about what was the overall loss ratio in that market for those plans that are no longer around. So what were those members incurring in terms of expense?

I don't know with specificity on that, Josh, but I think that all of the folks that had the more traditional commercial orientation in the Arizona marketplace had equally bad experience. And we have reflected that in terms of how we are thinking about it, and changing the plan design et cetera to move more to the focus on subsidized populations and the like that we see elsewhere.

And we did this using our network. It's as usually said, it's highly subsidized, 90% plus. So it's our normal model, Josh.

Okay, perfect.

Scott Fidel, Credit Suisse.

The first question, just interested if you can give us an update on that Pennsylvania contract that you had won earlier on the year for more of the classic Medicaid RFP, and then some of the losing bidders had appealed that. So just interested where we are in that status, and whether you've assumed that contract in the 2016 initial views on revs or whether that on 2017 or whether that would prove to be upside if you are upheld on that contract win.

Several things. One, I think the state handled it wisely. There was a court case and rather than appeal and appeal and drag it out, they said let's do a new RFP. It will be faster.

So we expect to hear in the next month or two I guess where that stands. There's no reason to believe we won't continue to prevail, because we were the number one in all regions, the scores showed by a wide margin last time. Relative to the second part of your question, the timing, and the second part I lost -- .

The second part, it's not in the number that we gave you for 2017.

It's not in the number. No, we will not add something until it's been awarded to us and clearly ours.

Got it. Okay. Just second question just on the risk adjustment accruals, and thinking about that $0.05 hit that you had on the 2015 reconciliation. Just interested in terms of as you've now updated your risk adjustment assumptions, whether you've built in some additional conservatism just for the variety of co-op failures that we've seen over the course of this year and that could create a bad guy in terms of potential imbalances between payables and receivables in the risk adjustment program?

Yes. This is Jeff. Obviously, that's something we are looking at and we have looked and ultimately that's -- it was part of the risk adjustment process is ultimately determining the collectibility. So as we continue to look at that, we'll have to evaluate that as we get closer to the end of the year, specifically for 2016 and where everybody stands.

I think importantly, last time when we had the $0.19, we just added it right in. Didn't try and take any credit for it as part of the normal earnings and we added the full $0.19 in. So this really amounts to a adjustment of the $0.19 by $0.05 that we didn't get, so it's once again I think a very balanced approach. I almost wish we'd have a separate line, but accounting rules don't allow that.

Okay, thank you.

Chris Rigg, Susquehanna Financial Group.

Just wanted to ask about the Medicare Advantage expansions for next year. Are you guys just estimating you will have a toe in the water in the three new states, a relatively small amount of membership, or do you think you'll actually gain a foothold within the first year?

Jesse?

Yes, Chris, this is Jesse. So I think as we said at our June investment day when we talked about our launch of its actually four new MA products in our existing markets.

But we talked about this as a proof of concept. So we definitely are taking a softer launch approach for 2017 so we can be in a position to then grow from that base within those four markets in 2018 and forward, but then also entering other markets in MA in 2018. So we'll see a continued progression, but we're looking at our growth in MA is a multi-year strategy.

I think when we commented at the investor day is it's no different than how we entered the marketplace. You go in it carefully, you prove the concept, and then you once you get comfortable with it you turn up the heat on it and that's worked well for us. We've always said it's not how fast but how well, and so we're applying that same principle to this product.

Okay. And then just on the synergies, I get a little turned around sometimes in terms of where things exactly stand for this year versus what we should expect for next year. So is the right amount that's actually going to be realized in earnings this year $50 million to $55 million and then next year you get the residual, and have you seen any upside to the original target at this point? Thanks.

Well I'll start, then Jeff and others can pick up. We always talked about the $75 million would be the first 12 months of operation. So you have the -- this year, you have roughly 9 months of it. I think, Jeff, it was about $50 million in that range? But why don't you -- ?

Yes, that's right. I think if you just take the -- we said the first 12 months $75 million, second 12 months $150 million. And I think if you just take that and assume a March transaction date and shift that out, there is obviously just based on the fiscal year.

So that's what we indicated is that we've executed on all the actions to get the $75 million within the first 12 months, and only 9 of those months fall into 2016. So you're correct is that benefit would continue obviously into 2017, and then there's additional synergy capture there as well that we're confident that we can achieve.

Okay, I'll leave it there. Thank you.

Kevin Fischbeck, Bank of America Merrill Lynch.

Just wanted to reaffirm, so when you guys narrowed the guidance range, you lowered the top end by more than you raised the bottom end and that's just related to the $0.05 Arizona charge and then hire expectation for business start-up costs. Is that the way to think about that?

I think the way I'd think about it is if you just take the old midpoint, lower it by $0.05 and then it's plus or minus $0.05 from there. So you come up with a $0.10 range.

So I'm just trying to think why the high end goes lower by 2017. Was there anything else driving that besides the charge and the higher business expense costs?

No, it's just the charge.

Okay. And then you made a comment that you're at the high end of your margin target for the exchanges this year, but I think the comment for next year was profitable. Is there -- is the expectation that next year you'll be just at the midpoint of a target range for exchange profitability, any comment there?

No, I think we haven't given our full 2017 guidance. So I think we would leave a little bit of the detail for that as we go through, but I would not read into profitability as being deterioration from 2016.

We see normal -- we were talking I think probably as much to the Arizona issues where we've turned that around and taken all the corrective steps as well as California on a PPO part.

Okay. And I guess you said a number of dynamics around Health Net for next year. But so you address the PDR, it sounds like the synergy targets are all coming in line. So it sounds like to me, Health Net, your expectation for healthcare for 2017, is pretty much where -- on track to be what you thought it was going to be when you closed the deal. Is that an accurate statement?

Well I think we were making all the progress we expected at this point in time, and I'm fully confident we will achieve next year and on the out years what we've expected when we did the deal, yes.

All right, great. Thanks.

Michael Newshell, Evercore ISI.

Going back to the Health Net PPO and EPO product in California, could you just clarify or frame the level of losses that you expect to continue into 2017 here? I know the rate hike and the benefit design changes are obviously going to significantly reduce the loss, but even in the rate filing itself you have a projected pretax loss of around $40 million.

Could you talk about one -- like what are the upsides to that $40 million loss from benefit design changes or medical management? And also does the rate filing itself reflect the $15 million reduction in the PDR related to substance abuse that you announced today?

Jeff, do you want to start, then I'll -- ?

I think as we look out into 2017, first of all, the rate filing would account for some decreased substance abuse utilization. As far as the $42 million, you're correct, that was in the rate filing and we are taking and continue to take medical management and network initiatives. Then at this point time, we believe we've covered more than half of that and we're not done and we think we has continued actions that we can take between now and next year to get us closer to the breakeven point.

And would you expect to reach profitability on this product in 2018?

Yes, I'm sure we would. I think what's important here is that rate filing was based on the actual assumptions on the experience, the historic experience, as well which is part of the requirement. And so you file that and then we have all the benefit and other changes, some of which is figured in there, because it went from $50 million some to $40 million.

But then there's all the other things that we'll do that we believe, as Jeff just said, will get it to breakeven. Based on the population we attract being able to have lower premiums, we may do better than that. But that's for discussion later in the year as it unfolds.

Great. Thank you.

Peter Costa, Wells Fargo Securities.

Health Net had an agreement with the state of California or a settlement targeting a 3.25% margin with 50% buffer around that. In 2017, that goes to no adjustment between 1.25% to 3.25% I believe. Can you tell me where is that contract operating today, is it above 3.25% margin and then what's your expectation for next year?

Yes, so if you look at this -- this was disclosed I think in Health Net's 2015 10-K. But I think the settlement account effectively had a surplus of over $300 million or something in that range.

And again, as a reminder, the Medicaid expansion business is a component of that settlement agreement. And so I guess what I would say is that number has continued to build over time, and I don't think this settlement agreement is going to have an impact

So no change for next year in terms of how it's going to -- ?

Yes, no change.

Okay. And then can you tell us, your insurer fee revenues have been less than the expenses for the insurer fee recently. Can you tell us why that's going on, why isn't it higher reflecting the gross up?

So just a quick thing. The accounting rules require that if the insurance fee is billed as one premium, it's in premium revenue. So for example, in Medicare, the insurer fee is actually embedded in the revenue line in premium revenue line.

Whereas from Medicaid, is a separate component of the rate, and it's actually billed separately so it's shown separately. And so that's just an accounting technicality there.

I see.

Same thing for marketplace, by the way.

All right. And then the last question, if you don't mind. What's left to do on the California PPO business?

You talk about continuing to focus on from your commentary it doesn't seem like that's quite yet up to profitability for next year. So what are the things that you can do over the next year to try to improve the profitability of that?

Well I think that you're going to see us putting emphasis on growing it on a very balanced book of business. The previous design I'd almost characterize as a inexpensive indemnity type product. It was the loss for Health Net in 2015 as well we knew that.

But I think when we look at, we have the right rate structure, the rate benefit structure to attract a balanced book of business, to drive the utilization in network which is intended. The out-of-network should be the exception, not the primary use of it. So we've done all those things, and I think now it's just starting to grow it in the right way and market it and we will return it to the place that they chose to be.

Thanks.

Dave Windley, Jefferies.

I wanted to go back to the California PDR exposure. So I just wanted to understand the two pieces. On the substance abuse side, am I understanding correctly that your exposure there, obviously it declined in the update this quarter, but your exposure into 2017 is mitigated or eliminated by your change in certificate of coverage?

I.e., you don't have to pay those types of claims going into next year, and then rate and benefit design are what you are using to attack the other $75 million? Is that the right way to think about it, or is there a blurrier line?

I think when you look at all the products associated with it, the out-of-network coverage, the benefit design they had before without the Medicare maximum and the other issues where it was a percent of billed charges. They could be out-of-network, the providers could bill what they wanted and we were liable at the time for 75% of billed charges till they changed the certificate of coverage. So virtually putting in the changes that I discussed during my formal remarks eliminates the incentives to put people into that product at the same level, and we already see a material drop off of that taking place.

It was a bad design before. The state and everybody recognized it and it's been fully fixed, and there's other steps taking place that I'll let the legal authorities deal with as it relates to it. So that affects that.

It also affects the normal PPO outside (inaudible), the same principle applies. We now have a product that will have great appeal to people who want to use our in network, and who on some rare occasion want to go out of network. They now have an exposure of $25,000 maximum out-of-pocket, which is significantly greater than what it was but very competitive.

So it's really -- we now have the right PPO design. And PPOs have always been intended for in-network use with out-of-network being the exception. Before, virtually all the utilization was out of network.

So we believe that together with the lower rate increase to be more attractive to the balanced book of business. These are things we've done successfully for many years, and we'll really -- we'll turn this around and (inaudible) and will put us where we want to be.

Great. And so, Michael, the change in the certificate of coverage, the impact of that it's already reflected in your reduction of the exposure from $50 million to $35 million. Is that what you're referencing?

Yes, I think what you are going to see is, you're going to see obviously the new certificate is not in effect until January 1. There were some changes they made effective earlier than that where they could. But so we're starting to see where there's less people being transferred in because they know they can no longer bill 75% of billed charges, and there were instances were lab tests were thousands of dollars that we paid $8 for.

Right, okay. Shifting to Medicare if I could briefly. Curious if your reaction to the slight to modest decline in star scores for the Medicare book of business, what are your plans to boost those back up? And then maybe more broadly, your plans to begin to build track record in your new markets to have them be able to maintain a bonus level star score?

I'll turn it over to Jesse in a minute. I want to remind you there were seven STAR scores that remain constant, there were seven that improved.

There was one that's lost half a star because of the benefit change in the Part D drug, and that was in Oregon one of the smaller markets. So there was not a dramatic shift as some notes may have indicated. And, Jesse, do want to pick it up and talk about the program?

Yes. I want to highlight a couple things. One, in terms of the implications, I think some of the math that was referenced in a few of the notes that we saw included the dual members, DSNP members, in terms of the percentage of members that applied in various star levels. So I think there's a little bit of mixing and matching with respect to that.

But as Michael referenced, we did improve our star scores in a number of our plans. Including our DSNPs plans which are widely recognized to be more challenging to increase the STAR scores. So we've demonstrated that we can do that.

So we have a number of programs, not the least of which is provider engagement and how we're working with our providers in all of these markets. And remember when we were launching these new programs in, as we referenced in Georgia, Texas, Florida, Mississippi, those are markets where we have long-standing provider relationships. So that will be a center point in terms of not only our growth strategy, but also our stars and quality improvement strategies going forward.

I want to just respond to the second part of your question in terms of the new markets. The team that achieved these four and greater stars are the same team out of Health Net that's working with us on the new markets, and we have every reason to believe they will use the same process, same approach to it that will achieve the high star levels.

Great. Thank you.

A.J. Rice, UBS.

I appreciate the comments about 2017, and the fact that the disputed contract in Pennsylvania is not in there for revenues. I know at one point you were looking at absorbing some costs associated with that this year, and that was part of the $0.30 I think or so of expansion costs.

Can you comment on whether you've absorbed that this year? Is that going to be in next year's numbers, or has that been delayed largely till next year and I know you have the LTS contract rolling out? Do you think the overall expansion number for next year will be more or less than the $0.30 you've incurred this year?

Well I would say at this point in time, Michael mentioned, we're in the process of finalizing our AOPs. And specifically with the timing of some of these awards, and obviously that's one of the moving parts. So I'm not going to comment specifically on what we expect for 2017 on that front, but I will tell you that what we said today is that the costs for this year are actually higher in the fourth quarter.

So yes, you are right, the change in that award status has reduced the level of costs associated with that. But then on the other side, we do expect significant growth in our marketplace business in 2017. We have seen an increase in startup costs of that in the fourth quarter.

Okay. All right. Then maybe a quick point on the PDR, so it now stands at $285 million. Tell us how that evolved -- can you just give me some help on thinking about how that evolves over time?

Do you expect since this relates to 2016 to run that down to zero by the end of the year? Will some of that carryover in case there's negative development from 2016 next year that you'll be able to offset against it? How should we offset think about how that plays out over the next period of time?

That will run down by the end of the year. Now specifically just on the substance abuse, ultimately some of those end up in IBNR and they get paid -- from a cash perspective they get paid next year. But the $285 million will run down to zero by the end of this year.

Okay. And do you think -- will there be any that gets carried over in case there's negative development on any of these items for next year?

Well the piece that would get carried over would be in IBNR. It would be in our medical claims payable.

Okay. And then just the last quick question, you mentioned on the synergies on track and pleased with that. I know one aspect of the longer-term synergies you were evaluating was your pharmacy benefit status, both Health Net having one way they were approaching as you doing it with your own internal PBM. Is there any update on where that all stands this point and your thinking on that?

I will start. There's a blend really where we still have our PBM very active, and we're using some of the things that Health Net was doing. And Jesse can give a little more color and granularity on it.

Yes. I think the starting point here, A.J., is that one of our core philosophies is serving the whole person, obviously pharmacy is part of that so Centene is committed to the pharmacy business. So I think that's an important starting point.

As we look at our PBM, there's a number of things that we have developed and we think our core competencies which includes benefit design, formulary management, clinical programs, analytics, mail-order, specialty, et cetera. There's all of those things that are very much embedded in how the Centene pharmacy management model.

We've also -- will be launching what we're rebranding as our external approach with involved pharmacy solutions. Some of you may have seen a release that went out recently where we're going to be working with Mercer on some opportunities from an external perspective. But all of that said, Michael referenced the hybrid approach, so we have entered into an arrangement with CVS Caremark to really leverage some of the scale, particularly from a network perspective and certain back-office functions for pharmacy.

And does that increase your thinking on synergies, or is that in line with what you originally thought on the synergies?

It's in line with what we originally thought on the synergies.

All right. Thanks a lot.

Ralph Giacobbe, Citi.

I just want to go back to the exchanges in your position for next year just given market exits from peers Any concerns around network adequacy? And then do you have any enrollment caps in place at this point?

And then just want to clarify, I think in you're prepared you'd talked about Arizona your expectation of $500 million of incremental revenue. I think just from the exchange, which I think is about 140,000 lives back of the envelope, for some reason we're talking about a 25% increase in the exchange enrollment just from Arizona. So I guess help collaborate against those numbers, and then just in terms of how we think about capital in terms of all the new lives coming on next year? Thanks.

Jeff, do you want to start on the capital?

Yes, so I can handle the last question first, which is on capital. Obviously, Centene has been a very high-growth company over the last five years. We've put over billions of dollars into capital at our subsidiaries, and we would expect obviously with this growth that we would have to contribute capital to fund the growth as well.

However I will tell you that on a percentage basis, we've had years where we've had 50% growth. On a percentage basis, that growth is smaller in compared to the organization in total. So the capital requirements, a lot of those can be funded with free cash flow.

I'm just going to add to it. But as it relates to the growth, we're expecting significant growth, and we'll more -- a lot of granularity on that in December in our investor day. But importantly, some people I know are worried about well are you going to pick up some of the individuals of a high cost out of other plans? We think, one, we have our network, and if our network is [eventually still] and that's fine because it's a well-managed network.

Secondly, we are a net payer of a lot of money, $300 million or so. So there's a safety net there within that amount which approaches what some others said they'd lost.

So if we look at the exchanges going forward, we see ourselves in a very strong position to effectively grow it and still maintain the margins that we've become used to having on it. Anything want to add anybody else?

Just specifically under the question, Ralph, around the network just to further Michael's point. We are very focused on network adequacy for the expected growth, but our orientation there is really we think we're fine in terms of facility-based network. So our focus really is on physician services, particularly primary care.

Okay. And then no enrollment caps I guess?

No.

Okay. And then just on the Medicaid expansion states, federal funding goes down a little bit in 2017, I think 95%. So just wondering, your communication with states how they may or may not be approaching that? You said composite rate increase overall was flat to up slightly as has been consistent over the last few years, but any other pushback there in terms of states wanting to fill that gap and any pressure for you all there? Thanks.

We continue -- we constantly talk to states about it, rates have to be actuarily sound, and they're very much aware of that. And you always have that one or two states that it's a little more discussions required to get there.

But we're comfortable that we're saving them levels of medical expense that we remind them, you don't want to kill the golden goose. And I think that's still a prize in 99% of our states.

Okay. Thank you.

Christine Arnold, Cowen.

I think you referenced about $70 million in Medicare losses that you expected to incur this year. What's your outlook for that going into 2017? Do you expect to eliminate those losses with your recent filings and changes in plan designs, how do I think about those Medicare Advantage losses?

Yes, that's exactly right. The $70 million was in reference to the premium deficiency reserve, and so those are losses on the premium deficiency reserved for Medicare is looked at in aggregate across all Medicare products. And so that $70 million was the PDR that we booked, and yes, we do expect it to be profitable based on those items you mentioned.

And what exactly (technical difficulty) possible?

Say that again, you cut out.

I'm sorry. What exactly are you doing to make that profitable?

I think that some of the things I discussed how we did plan design, rates adjustments, a whole series of things.

I would just add, Christine, this is Jesse. That when we went through the bid process in 2016, we took into account a number of different factors, including network, including plan design, benefits, and the like which resulted in a profitable bid for 2017. In addition to that, we have obviously ongoing medical management and network initiatives to continue to enhance our financial performance going forward.

Great. Thank you.

Justin Lake, Wolfe Research.

Couple questions. The first on the DC compliant business, the individual business. Can you give us some color in terms of where you sit right now in terms of where you think you're 2016 premium is going to shake out?

And it sounds like you're rightly expecting a fairly significant increase in membership and premiums here for next year. Any kind of ballpark directionality you can help us with in terms of how much premium increase you think you're going to get for next year?

I think that's a better question for -- you're talking about the 2017 what it's going to like in 2017?

Just first, a baseline of how much premium you have in this business this year. And then just directionally, do you think it's going to be up 30%, 50%, 10%?

Are we talking about the marketplace?

Yes. The marketplace exactly.

So you're just talking about the look forward into 2017? We're not going to get the specifics on 2017. Obviously, we're beginning the open enrollment process at this current point in time, so we're not going to give any specific colors I guess on 2017.

But what I did say was that we do have additional costs in the fourth quarter because we do expect significant growth obviously from this year, and then obviously we've commented specifically about Arizona and what we expect there. That was the $500 million that Michael mentioned.

Okay. Can you tells what your premium is this year in the exchanges?

The total premium on exchanges -- .

A little over $1 billion this year.

Okay great. And then just any other color on this California Medicaid expansion MLR floor would be helpful. For instance, is there any expectation -- was there any impact to the third quarter or expected in the full-year guidance, and just some background on this like how significant can it be?

Yes, so a quick thing. There was nothing in the third quarter associated with this, so this is where the state is effectively changing the MLR definition to be consistent with the federal regulations and the biggest change is really excluding federal and state taxes. We are working through the calculations with the state at this time, so we haven't sized the total amount.

Obviously the MLR began back in January of 2014 at the inception of the Medicaid expansion program. This has been in process for some time, so a piece of this was included and has been included in our guidance. And it's within our guidance range for this year, and that will come in the fourth quarter.

I think the part associated with 2016's in the guidance, any prior period as is our practice we will treat as a one time -- (multiple speakers).

That's right. Only the piece associated with 2016 was included in our guidance, so there will be a piece that will be retroactive. And again, I think all those reconciliation periods are open, and we haven't seen the draft calculations from the state at this point in time so we're waiting for that.

Any way to size the impact for 2016 or in the fourth quarter from this that you've already accrued or that you will accrue in the fourth quarter?

I can give you this -- we have included a piece in our guidance. I could tell you that was roughly about $0.09, so that we have in the fourth quarter associated with this. That's our best estimate at this point in time.

But I would hesitate to size the total magnitude. It's a positive, obviously, for the Company, but I would hesitate to size the magnitude of that, and this will be -- it's cash, it's a cash positive as well. Because if you recall, we have a liability back to the state of over $0.5 billion associated with this minimum MLR program.

It's been accrued.

It's been accrued, yes. So what would happen is it would reduce that amount that we owe, and of course we already have that cash on our balance sheet today.

Got it. So the full-year 2016 benefit is $0.09.

That's right. That's estimated, again, like I said, we haven't seen the draft calculations so we still have to work through that with the state.

Thanks a lot.

Matt Borsch, Goldman Sachs.

Thanks for squeezing me in. Just on the -- can you talk about the group commercial business that you have from Health Net? How has the renewal process been, and what are your expectations just directionally? I'm not looking for guidance, but directionally in terms of account wins or account losses on the group commercial cycling into next year.

Frankly, I would not spend a lot of time on it as far as the AOP process which we're going through now. And, Rone, anything you can comment on that?

We are going through the December 1, January 1 is the large period for renewals in the group business. The large group business has been a good performer, relatively stable, and we're continuing to see that this year.

The small group business has been a business that we've been looking to improve the margins, and we have been increasing the rates for that. We're going to see that reflected to some extent in terms of membership in the fourth quarter here, but that's part of the strategy to get the business back on track to address some of the PDR issues and margin issues for 2017.

In your view on the small group business, does that suffer from some of the same issues that, not necessarily you've had but broadly the ACA business has had with adverse risk selection?

Are you talking about the small group? No, Matt, good question. The same benefit design changes we did for the individual we also implemented for the small group.

So, okay, so they'll be well in line. And once again, now that we have this right and the benefits right, it puts you in a position to effectively grow that business. And I think in the past, they were chasing a little more volume than we would. We're going to make sure it's profitable, and then we'll grow it.

Okay. All right, thank you.

Thank you.

Ana Gupta, Leerink.

The first question I have is on a -- something follow-up on a question that was asked before. So you have the top line growth I think when you exclude the issues on the PDR it's somewhere in the midteens.

In terms of the margins as your mix shifting into ABD and long-term care populations, and when you look at the overlay of the new federal Medicaid regulation. Have you had an opportunity to now study that, and do you get some [prof] subsidization as you get forward so that in essence better preserving your margin profile going forward despite the mix shifting?

At this early in the process, as I said, we're in the final stages of the annual operating plan. It would be too early to try and give too much indication. We've tried to give you the sense of that it was moving ahead with that in what consensus was. It's fair to say we'll be within our range.

But before I get too granular and I want to finish the process, because I don't want to say something today that is not confirmed again in December. So bear with us for the short period of time, but we're looking forward to 2017.

I think it's a very good year for us now that we've corrected all the issues in California. We're starting to launch the Medicare, and there's a lot of things that -- there's some RFPs still pending. So I'm looking forward to it.

Okay. (Inaudible) less for 2017 guidance, and more just some clarity from you on the reg. Which I at least tried asking other companies as well, and I'm assuming since it came out in July you had some more color on it if you are able to share at all.

I think at this point, let's talk more about it. And I know you won't forget it, and you'll asked the question -- you could ask it in December in person.

Okay, sounds good. One more question then, on the risk adjusters too, and again I'm not looking for any color on margins for next year. Just there was a really big change as it seemed like from CMS after some of the more commercially-oriented plans had issues with their risk profile and adverse selection.

And it looked like it was a little bit about prescription drugs, but there were some other changes around spreading risk better across all the plans. Did you all have any input? And how does the managed Medicaid industry that's participating in exchanges, are you advocating one way or the other and are you happy with what results I believe the comments were due on the 6 October right?

I think where our government regulatory people we had spoke with them in April in the comments, and it's still an ongoing discussion with CMS. And they're open to discussion with us because of our the successes we're having is one of the most successful fastest-growing exchange products, they are very interested in talking to us.

Okay. One last question. Sorry, one last one. On your strategies for Medicare Advantage as you're expanding into new states, will that be more tied to your desire to win long-term care contracts or opportunities there, or is it broader than that and believe you're just looking for MA business regardless of the Medicaid positioning that you have in the state? And what is it looking like for 2017?

Well I think just generally and in terms of the strategy, it would be broader, the broader version if you will, of MA. So we would be looking, as we've said, very consistently. We would be looking to support the lower income subset of the Medicare Advantage eligible population, so that will have some other implications as we think about some of the state-based products but our orientation around that is broader.

Great. Thanks for fitting me in.

And, ladies and gentlemen, that will conclude our question-and-answer session. I would like to hand the conference back over to Michael Neidorff for his closing remarks.

Well I want to thank you. We look forward to seeing you at our investor day, and we look forward to the balance of this quarter. Have a good day.

Thank you, sir. Ladies and gentlemen, the conference has now concluded. Thank you for participating in today's presentation, you may now disconnect your lines.