Humana Inc (HUM) 2003 Q2 法說會逐字稿

Good morning, my name is Gail and I will be your conference facilitator today. At this time I would like to welcome everyone to the Humana second quarter earnings release conference call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks there will be a question and answer period. If you would like to ask a question during this time, then please press star then the number one on your telephone keypad. If you would like to withdraw your question press the pound key.

I would now like to turn the call over to Regina Nethery, Vice President of Investor Relations. Ms Nethery, you may begin your conference.

Thank you, and good morning everyone. We appreciate you joining us this morning for a review of Humana's second quarter 2003 performance, and an update on our earnings guidance. Participating in today's call are Mike McCallister, Humana's Chief Executive Officer, Jim Bloem, our Chief Financial Officer, and Art Hipwell our General Counsel.

This morning's call and virtual slide presentation are being recorded for replay purposes. That replay will be available approximately two hours after the conclusion of this call on Humana's web site, www.humana.com.

As we begin this morning's call I need to remind each of you of our cautionary statement. Certain of the matters discussed in this conference call are forward-looking and involve a number of risk and uncertainties. Actual results could differ materially. All participants in this conference call are advised to read Humana's press release issued this morning, July 28, 2003, as well as the following documents as filed by Humana with the Securities and Exchange Commission. Our form 10-K for the year ended December 31, 2002. And our form 10-Q for the quarter ended March 31, 2003. these SEC filings contain detailed discussions of important risk factors.

As described in this morning's earnings press release, we have adjusted our second quarter and year-to-date 2003 results to exclude unusual items. In our fourth quarter 2002 earnings released dated February 30, 2003, we had also adjusted those adjust those results to exclude unusual items. Consequently any 2003 or 2002 amounts referred to in our conference call this morning are on an adjusted basis. A detailed reconciliation from GAAP to adjusted results, and any other non-GAAP financial measures for the second quarter and year-to-date 2003 may be found in the statistics pages included with this morning's press release. And for 2002 in our February 3, 2003 earnings press release. Each of those releases is available via the investor relations page of Humana's web site.

Additionally all references to earnings per share made during the course of this call represent diluted earnings per common share. Today's call includes a question and answer session for industry analysts. But we encourage the investing public and media to listen in.

And now I will turn the call over to Humana's CEO, Mike McCallister.

Good morning and thank you for joining us. As Regina said in her opening remarks, all of the results discussed in this call are adjusted to exclude unusual items recorded in the first half of 2003, and the fourth quarter of 2002.

Today Humana announced earnings per share of 37 cents. The two prime drivers of this 37% improvement in earnings over last year's quarter are first, commercial segment margin improvement, and second, TRICARE revenue adjustments which were both earlier and greater than had previously been expected.

Let me start with the improvement in our commercial segment. The second quarter again showed a significant improvement in our commercial results over the prior year, more than doubling on a pre-tax basis. Humana's commercial segment pre-tax margin improved 90 bps over the prior year. We are raising our projected 2003 earnings from our commercial segment to more than $130m on a pre-tax basis. This also more than doubles the $54m our commercial segment earned in 2002.

More importantly, it represents a significant movement in the mix of our earnings. We now expect the commercial segment will represent over 35% of our 2003 earnings. This compares to only 18% in 2002, and 13% in 2001.

We are particularly pleased with this quarter's results as they provide further evidence of the soundness of our commercial strategy. Humana's reputation in the commercial segment as an innovator in solutions for employers is not only growing, it is leading to increase in sales activity in all commercial segments. That activity, combined with consistent pricing discipline, has helped drive the improved commercial results for our second quarter. We anticipate our innovative products will continue to accelerate interest in all of our products, and in turn lead to improved results for Humana.

So what is different about our commercial strategy today, that is helping us make these leaps forward in profitability? The prime difference is that a few years ago we had a market level focus. While geography is important, today our commercial strategy focuses on four specific lines of business. National accounts, mid market, small group and individual. Having a dedicated operational unit to support each of our commercial lines facilitates more comprehensive analysis of the competitive environment, as well as provides more depth of expertise across the actuarial, underwriting and sales organizations. This level of focus, complimented by implementation of electronic capabilities across all product lines, helps us really maximize the value proposition we bring to employers.

The commercial sales pipeline for 2004 is very active. In our national account space our innovative product solutions for large group employers is creating quite buzz among the employee benefit consultants, serving the accounts with over 3,000 lives. We are seeing more than a 25% increase in new requests for proposal for national accounts here today. Our approach to this space is to specifically target national companies that have a regional operation in our major markets. These national employers are facing the same struggle with rising health insurance premiums as every other employer in today's economy. We are finding that these employers are more than ready to carve out specific geographic locations when presented with cost effective solutions.

For mid-market accounts, those with 50 lives to 3,000 lives, the sales pipeline is up over 20% compared to the same time last year. This market segment tends to follow the lead of the national accounts. Consequently, we are able to take advantage of the indirect impact of trends in plan choices in the national accounts space. The mid-market account sales, combine the relationship driven aspects of the national accounts, and the transactional aspect that also requires a focus on transactional thinking. By this I mean ensuring that we get our fair share of opportunities in the space by focusing on total opportunity, pull volumes and close or win ratios.

Our discipline focus has helped us to identify new opportunities to increase our level of quote activity and ultimately our market share in this space. We are targeting increased full replacement sales in national and specifically mid-market accounts through our Smart product strategy, based on full replacement. Which also fits well with our work to rationalize our slice accounts.

The Small group and individual business lines, while both more transactional in the nature of the sale, also benefited from having dedicated operational focus. With small group employer is increasingly eliminating the health insurance benefit for the employees, and small group employees looking for less expensive alternatives, our entrée into the individual market nicely complements the needs of individuals as well as those that are self-employed. Our sales of the Humana One product have been steadily increasing, and we're now adding approximately 2,000 to 3,000 individual members each month, and growing. By leveraging our proprietary network strength, we have the opportunity to displace some of the traditional players in this line of business, that rely on rental networks.

Our experience with the individual product also has a secondary benefit, in that it provides a terrific opportunity for us to obtain direct consumer feedback. Since these customers tend to buy high deductible plans in a retail environment. We can then, in turn, leverage support tools as we have a direct relationship with our customer, without the involvement of a third party, the employer. What we learn from these direct interactions will be valuable in all other lines of our commercial group business.

Turning to our Smart products. The interest there is growing at a good pace. Employers are increasingly recognizing that Humana is differentiating itself in the marketplace by presenting a turnkey total solution product that actively engages consumers. Rather than a simplistic cost shifting strategy seen frequently presented as consumer approaches.

SmartSuite quote activity during the second quarter of 2003 was the highest since we began the major marketing of this product in the fall of 2002. This quote activity has thus far translated into over 150,000 members enrolled in one of our Smart products. Over 50% of these members are already effective and involve a mix of geographies and industries. Both existing and new accounts have been selecting these products, with about 60% of the membership coming from existing accounts. Employers can also choose between providing these plans to their employees either on a fully insured or self-funded basis.

Approximately 40% of the membership sold thus far is [ASO] business. We believe the trend can be managed, and we are showing employers how to do it. Humana's medical cost trend for its own associates is running in the 1% to 3% range for the plan year ended June 30, 2003. And a 7% trend for our Louisville associates is forecast to be nearly offset by a negative 1% trend for our associates outside of Louisville.

Further, our external clients with claims experience mature enough to evaluate are generally averaging a projected annual increase in medical costs of only 6%. We are not only getting in the door with the Smart products, we are well ahead of the competition in the compilation and development of actuarial data. And, most importantly, the innovative study and use of this data lets us continue to attack trend.

Understanding the consumer is an integral part of our strategy. From product design to the moment of actionable information to claims adjudication. Our offerings include such innovative concepts as the Humana Access Master Card, an integrated membership and debit card that provides convenient member financial services, as members use their flexible spending account. Specialized customer service units, where members are directed to service reps trained to guide members through the use of their specific products. And an enhanced clinical model, including more interaction with our highest cost members in the support of data analysis and technology.

More specifically, personal nurses with specialized skills are matched with high cost members to help guide them through the healthcare system, and triage those members who may also benefit from our disease management programs. Predictive modeling of data then takes these clinical discussions to a new level, as nurses can use this data to alert our members of potential health issues.

We believe members who are informed about their financial and clinical options spend healthcare dollars more wisely, and thereby lower trend.

Turning now to our government segment. As many of you are aware, last month the House and Senate passed separate Bills that would add a prescription drug benefit to the Medicare program. These bills also envision adding wider private sector offerings to the traditional Fee for Service Medicare program in the form of regional PPOs. Substantial differences in the two bills have yet to be ironed out in the conference committee before a final Bill can be presented for approval by Congress and subsequently the President.

With the government remaining the largest purchaser of healthcare services in the United States, and the possibility of combining private solutions with the traditional Medicare program, we believe we are positioned well to respond to opportunities presented by a Medicare Reform Bill. We've been working consultatively with CMS on the development of alternative offerings for a number of years. For example we are participating in a private Fee for Service pilot program in DuPage County, Illinois. And we're offering a private Fee for Service product in the Upper Mid West. We are also involved in a pilot Medicare PPO product in Pinellas County, Florida.

We believe our Medicare team leads the industry in its actuarial and operational expertise. This strength has helped us to keep Medicare a strong contributor to our earnings, while others have run from the program. Through our participation in each of [CMSs] beta tests, we are also ready to apply that valuable experience should private plan Medicare products expand further.

As in the past, our financial forecasts assume current law only. Predicting the impact of risk adjusters and budget neutrality adds another layer of complexity for 2004, and will not be fully known until the fall of this year, when the risk adjuster data submission to CMS is completed. However, we will be ready to file [ACRs] in September, having completed our evaluation on how best to balance benefit headroom with individual premiums, to ensure our Medicare revenues remain at or above the projected medical cross-trend.

Further, our team can turn on a dime to react to any changes either in Washington or in competitor offerings, so that we will continue to be well positioned, regardless of the environment. We continue to foresee our Medicare membership ending 2003 at around 310,000 to 320,000 members.

Turning to our TRICARE operations. We experienced some very positive activity this quarter for our current contracts. The ongoing discussions we have been having with the Department of Defense came to fruition in June, when our TRICARE revenues were adjusted. And we received payment for certain expenses we've been incurring related to the conflicts in the Middle East. The related revenue adjustments were both earlier and greater than we had previously anticipated.

As for [T-NEX], the Department of Defense recently asked us if we would extend our bid on the south region an additional 30 days to August 27, and we agreed to do so. This would indicate the timing of an award announcement to be around the latter part of August, though the DoD could request another extension. A bit for the north region has been similarly extended.

With respect to the TRICARE retail pharmacy contract, or T-REX as it's called, we submitted our bid for that business on June 11, and also expect to hear back from the Department of Defense by the end of August. We continue to feel confident about the various opportunities we have with respect to our TRICARE business going forward.

In summary, our commercial segment margins are clearly gaining traction. We are again raising our guidance for expected commercial pre-tax earnings. We are forecasting 2003 to be at least $130m. Our government business continues to be a strong contributor. With the combined strength of these two segments we now expect to ear between $1.44 and $1.47 per share on a consolidated basis for all of 2003.

Looking ahead to next year. Given that our government business has more variables than it usually does at this time of the year, we are projecting earnings for 2004 to be somewhere around $1.60 per share. Our range of projected earnings is forecast to be between $1.55 and $1.65 per share.

I am very excited about and confident in our ability to grow out commercial earnings and membership from both our traditional offerings and our innovative Smart products and services. As well as the continuation of significant contributions from our government segment.

Now I will turn the call over to Jim Bloem for a more detailed overview of our financials.

Thanks, Mike, and good morning everyone. Our second quarter results continue the trend of improved commercial performance. And our increased commercial earnings guidance indicates that we expect this trend to continue.

Let's begin with a discussion of the components of our earnings. Again all the numbers in this morning's call are on an adjusted basis. Consolidated revenues for the second quarter were $3b, up $183m or 6%, compared to the second quarter of last year. This was our first $3b quarter. Commercial premium yields combined with higher medical membership drove the increase.

Government segment revenues were down slightly as the impact of lower Medicare membership was partially offset by an increase in TRICARE revenues. We continue to expect 2003 consolidated revenues to be in excess of $12b, compared with $11.3b in 2002.

As a result of the significant improvement in the commercial segment medical expense ratio, our consolidated medical expense ratio improved by 50 bps over last year's second quarter. As Mike mentioned, the second quarter commercial segment medical expense ratio declined by 90 bps year-over-year, to 83%. Our adherence to strict pricing discipline continues to bear fruit. We achieved this improvement despite a continuing slight shift to large group fully insured membership. Approximately 65% of fully insured membership is now in large accounts, versus 64% at this time last year. Bear in mind that there generally is about a 600 bps to 700 bps differential on the MER between the larger and smaller groups.

The key to any improvement in our commercial medical expense ratio, including the 90 bps improvement recorded the past quarter, is our ability to correctly predict our medical cost trends, so we can price at a level that both exceeds those trends and meets or beats the competitions pricing. With this principle as a guide, we continue to forecast our commercial medical cost trends will be in the range of 12% to 14% for 2003.

Here's a run down on the three main components of our commercial medical costs. First, both the inpatient and outpatient hospital costs continued to be higher than our aggregate trend for the second quarter of 2003. Hospital rates rather than utilization continue to account for the great portion of the rise in our inpatient costs. Second, physician cost trends continued to be in the mid to upper single digits, and were lower than our aggregate trend. Finally, pharmacy cost trends continued to be higher than our aggregate trend, but still well below secular trend.

We're careful not to react too quickly to quarterly or even semi-annual fluctuations in cost trends in either direction. Rather, we look for and monitor sustained changes in our medical cost growth rates. While we believe cost trends have plateau'd, we remain conservative in our trend forecasts.

Just as important as cost trend is our actual cost position relative to competitors. Based on research, we believe we are competitive with respect to our commercial network cost structure. We have a cost structure on which our commercial strategy can continue to profitably grow.

Turning next to administrative costs. Our commercial segment SG&A expense ratio increased 40 bps compared to last year's second quarter. However, sequentially our commercial SG&A ratio has either been flat or improved in each of the last three quarters. The year-over-year increase in the SG&A ratio was the result of short-term duplication in staffing in preparation for service center consolidations. As well as investments in marketing and advertising costs, including the development of a branding campaign to support our new innovative positioning. Neither of these expenses were incurred in the second quarter of 2002.

Accordingly, we continue to anticipate that the commercial segment SG&A ratio will range between 16.3% and 16.5% for all of 2003. This represents a 60-day 80 bps improvement over 2002.

Moving now to the government segment. Our second quarter medical expense ratio was relatively flat with the second quarter of last year. Our Medicare Plus Choice Premium yield and medical cost trend expectations remain unchanged from our previous guidance of 4% to 6% this year. Our government segment SG&A ratio improved by 30 bps over last year's second quarter. This was the result of additional TRICARE ASO revenue received in connection with change orders and bid price adjustments. We anticipate that the government SG&A ratio will remain relatively unchanged for the rest of 2003, from its June year-to-date ratio of 13.2%.

Looking next at EBITDA, the cash content of our operating earnings. We earned $121m in consolidated EBITDA in the second quarter, a 20% improvement over the $101m of EBITDA in the second quarter of last year. Improvement in the commercial segment accounted for the vast majority of this increase, with commercial EBITDA going from $36m in the second quarter of last year to $52m in this year's second quarter. And increase of 47%.

For the first half consolidated EBITDA was $234m versus $204m a year ago. Commercial EBITDA improved 58% for the first half of 2003, totaling $130m compared with $82m in the first half of last year.

Moving to the balance sheet. As Mike commented, our discussions with the Department of Defense resulted in an acceleration of collections for a substantial portion of our bid price adjustment and change order receivables. We are projecting that our TRICARE receivables will remain fairly constant for the remainder of 2003, ranging between $300m and $325m. A substantial portion of this amount will be represented by the monthly base receivable.

Looking at medical claims reserves. We again have included three pages of disclosure on our reserves in the statistics pages of today's press release. We continue to experience favorable developments in our estimates of prior year's medical claims liabilities. Since we have consistently applied the same level of conservatism in our reserving methodology, the prior year favorable developments had no favorable impact on year-to-date results. Further, our earnings forecast for 2003 and 2004 do not assume any benefit from favorable development of prior year's reserves.

A separate measure of the quality of our results are cash flows from operations. In the second quarter of 2003 we marked the fourth consecutive quarter that our cash flows from operations have exceeded our net income. The $161m in cash flows from operations generated in the second quarter is a $205m improvement over the $44m of cash flows used in operations during the second quarter of last year.

The combination of this year's improved earnings and lower receivables accounted for the significant improvement during this year. For the first half, cash flows from operations were $259m versus $33m a year ago. Based on these results we are increasing our cash flow forecast for the year, and now project between $375m and $400m in cash flows from operations for 2003. This projection compares to $332m in cash flows during 2002, and $166m in 2001.

Meanwhile, our debt to total capitalization ratio is again at a multi-year low of 26%. We remain focused on maintaining the strength of the balance sheet, and further improving our overall hope of liquidity. Here in the current interest rate environment, we actively are pursuing options to further improve both our capital structure and overall liquidity using our shelf registration.

In July of 2002 our Board of Directors authorized share repurchases of up to $100m. Today we have repurchased 8.6m shares under that program at a total cost of nearly $95m, at an average cost of $10.98 per share. Today we announced that our Board has authorized share repurchases of up to an additional $100m of our common stock.

In conclusion, we are pleased with the improved financial performance, both for the quarter and for the first half. We especially appreciate the effectiveness of all the associates who have made these improvements possible. Our updated guidance in this morning's press release indicates our continued confidence regarding the future.

With that we will open the phone lines for questions. Operator, will you please introduce the first caller?

(Caller Instructions) Your first question comes from Matthew Borsch from Goldman Sachs.

Hi, good morning. Thank you. A question about the enrolment and the enrolment forecast. You lowered the forecast slightly on the upper end of the range. Can you just talk about what you are seeing and whether that's being driven by some of your larger accounts?

Matt, it's sort of mixed. If you recall the last time we talked about projections for the year we indicated we had a fair amount of business up in the air. We just have more clarity around it today than we did at that time, so we've brought it down a slight bit.

Great thanks. And second question, and forgive me if missed this, but can you give an update on where the renewal negotiations stand with your Puerto Rica Medicaid contract?

We're in the middle of a multi-year contract; we are not in the process of renewing that right now.

Okay, I guess I thought that you’d had a negotiation for the new rates that would be effective July 1 of this year.

No, that was a multi-year arrangement that started I think last year.

Okay. Got it. How about an update on the Chicago market?

No news, things are going well. The network is very stable. Markets performing well; nothing new there.

Great and the last question is, as you look to 2004 are you seeing any change in the customer appetite for benefit buy-downs? And maybe also whether there's continued shift towards self-funding?

You know, let me answer the self-funding question first. That waves back and forth depending on the company. If they've been self-funded and have a bad experience, guess what, they think about going back to insurance. If they have insurance they go the other way and they think about self-funding. So I've said all along, we remain indifferent to that. Everything we are doing with them and for them relative to product design, the new Smart products, all of that stuff can go either way. And it's kind of up to the individual companies which way they're going to swing.

Clearly there's a continued benefit buy-downs going on, and the degree to which that's occurring varies dramatically by company. And it's very aggressive in the small group space, a little less so in the large group space. But people are uncomfortable that just pure benefit buy-downs are going to solve their problems. So that's why we get pretty excited about showing them a different way out of the problem.

Great, thank you and congrats on the quarter.

Thanks.

Your next question comes from Joe France from Banc of America Security.

Sorry about the noise. Mike, a lot of the companies had the sequential improvement, or are reporting a sequential improvement at Medical [indiscernible] Show. And then looking back over the last couple of years like this quarter, you generally have a degeneration sequentially. Could you just remind me why does [indiscernible] doesn't -- it seems to deteriorate in the second quarter?

Yes, Joe. It's really straightforward. It's dangerous comparing these companies. I'd say that almost every metric we look at. We have a very high percentage of our large group business as fully insured. So what happens in January is really straightforward. Premiums jump up based on cost projections going well out in the future. And all the deductible applications apply new to that business. Now that deductibles tend to have an effect for about 90 days in general. So what you have in the second quarter is you have the deductibles wearing off. And since we have a lot of fully insured business the impact on Humana is different than others. If I was a really bit ASO play this would be a non-issue for me. It doesn't happen in the small group space. So it tends to be driven by the type of business we have, and just the way the map works.

That's helpful. Thank you very much.

Your next question comes from John Szabo from CIBC World Markets.

Good Morning, Mike. I was wondering if you could just expand on your comments about the rationalization of the slice business? What exactly are you trying to do there? And I guess relative to your expectations for '04, what do you think may end up in the SmartSuite products there?

Well the slice business, you know, we get consolidated in or we get consolidated out of that. There's no question there is a movement away in the large group space from offering a lot of different companies inside of these employers for a couple of reasons. One is, administratively it gets a little complex to keep up with everyone. And so I think companies like us are re-evaluating our position relative to slice business. At the same time the employers are doing the same thing. We don't have anything fundamentally against the slice business as long as it is structured properly.

So what we have been working on is some really clear discipline rules of the road about how we will play inside of these companies when we're not the only company in there. I think there is a real opportunity for us using the Smart products to represent everything that a company would get out of slice offerings relative to choices and options and all that. And yet bring the risk pool together and solve their other problem around administrative simplicity.

So that's one of the reasons we like the Smart sort of strategy in that it not only does what it does relative to benefits and actionable information and the potential around trend. But it sort of fits nicely into the way employers are thinking about simplifying their lives by having less plans in their location. So it all fits together pretty well for us.

And where do you think the Smart products could be in terms of membership for [indiscernible]

We haven't guided to that. We are at 150 now, it will I think -- we're getting a lot more traction. I think 2004 will be a good year in that new offering space. But I'm not sure I want to go there with you just yet.

Okay, and then just one additional question. On the hospital contracting, I think Jim had mentioned that the rate was still a bigger driver of trend. Have you seen any moderation or change in that over the last couple of quarters?

A little bit. But let me take you to a different place relative to that particular metric. We all get excited about where trend appears to be us versus someone else, and this sort of thing. But actually at the end of the day, that's not the way we really look at it. It really is down to, what is your relative cost position against your competitors? Because at the end of the day that's what's going to drive the rates you put on the table to the employer. So we've spent a lot more time making sure our relative cost position is where it needs to be, as opposed to just the increase over what it used to be. Because that's just about being smart and predicting that properly and making sure you get it in your rates.

But the real question is, where are you competitively, and that's the more important thing to think about. That's something you all mightn't be able to see very well.

Okay, thanks.

Your next question comes from Charles Boorady from Smith Barney.

Hi, good morning. I had a couple of follow ups on the Smart product. You talked about the lower medical cost trends for those products. And I'm just curious about how much of that lower trend comes from cost shifting to the employee versus actual change in utilization of the employee as a result of the change in incentives to them?

Well more of it comes from actual behavior modification than it does cost shifting. There is some cost -- we refer to it as intelligent cost sharing. There is some intelligent cost sharing that goes on in this. But our own experience indicates that in the first year out we had about $2m in savings. And $1.4m of that was relative to behaviors in both choosing plans and then ultimately changes in the way they used them. The other $600,000 was cost sharing of some sort. And we have similar results in the second year. I think the --

And I know where your question is going because I get it all the time. Is this just a cost shifting strategy, and if so, how does it have legs? Well the reason I think it has legs is that it's not just a cost shifting sort of approach. That is commonly what you see in consumer directed plans, they are largely a cost shift, with some nice elegant E attachments. But the fact is, if you continue -- if you look at a total solution approach with multiple plans being offered inside of the single risk pool, and you continue to work with those benefit offerings, you can use intelligent cost sharing to ultimately drive behavior.

And now that we're in our second year with our own -- actually we've finished our second year with our own people. We are already entering second year now to some of our first adopters. And we're beginning to get enough experience and data now that says, there's actually the opportunity to get people to do things differently. And I think that's what's unusual about this. It is not just a cost shifting strategy; it's much more powerful than that.

Can you give an example, like of what are some of the things that people were utilizing more heavily that they're now foregoing? Is it mainly areas like lab or imaging or routine physicals or kinds of things people are able to change their behavior on as a result of the intelligent cost sharing?

Here's what we saw. Basically the use of a lot of high priced, hi-tech outpatient sort of things dropped a little bit. Drugs were about flat. Inpatient utilization dropped just a bit, but I'm not a big believer that there's an awful lot going to happen in the inpatient environment. And in physicians actually the use of primary care type physicians actually went up a little bit. So I mean they use doctors a little bit more, they use drugs about the same, they use outpatient services a fair amount less, and they used inpatient services a little bit less.

So on the outpatient side are there any particular procedures that you can point to that you noticed a meaningfully big difference on?

I haven't got that detail. But it's the obvious things, the radiology area, that sort of thing, pretty high priced -- Very often pretty elective type utilization of those things.

Got it. And what's the reaction of providers who may see higher bad debt expense as a result of some of your members maybe not paying the co-insurance or their portion of the expense? I know some public hospital companies have been mentioning that their ability to collect has been somewhat diminished. I'm just trying to understand how much of that may be from the reintroduction of co-insurance and other intelligent cost sharing and similar mechanisms?

Well there will be more of that for them to deal with under all scenarios, because cost shifting is occurring, whether it's in a Smart environment or not. But that would suggest their position beautifully to collect that money. So I don't frankly understand the problems. But having said that, our approach to it is we use the -- we're heading down the road of an integrated card which I talked about, which basically has that provider being paid at the time of service in a real time fashion.

So there's a great opportunity for us to redefine how that visit works financially between the patient and the doctor. As we handle all those pill pays and all those things through the use of flexible spending accounts, integrated debit environments which we have on the street. I mean we're a big believer that there's opportunity to help the providers, primarily the doctors at the time of service. I've said it before, I'm heading to real time plan adjudication. I'm not looking for four-day turnaround. We have about five-days claims in the house right now. So we're quick at it and we're pretty good at it, but that's not where I'm going to end up. I want to do it real time. I am trying to avoid the bill altogether.

So with this card you can introduce higher co-insurance, intelligent cost sharing and other ways to share more of the cost with the patient without being antagonistic to the providers in terms of leaving them with a large uncollectible. Is that -- ?

Absolutely. I mean I've started referring to it as member of financial services, that's what it is. To the extent that these numbers have more financial stake in the game, which they do, and are going to have more. There's a terrific opportunity to help them know how to fund their FSAs for example. We did that in the last round here. We basically brought historical claims information forward so that as people chose their amount of funding in FSAs they could be intelligent about that, because it doesn't rollover. So there's a great opportunity there.

And then ultimately you give them a simple easy way to actually access those funds as opposed to a paper environment. And then what happens at the provider office is that they don't have to worry about all this nonsense of trying to figure out the deductibles and co-pays and the co-insurance and how to collect it. Basically the card is presented, it's swiped through a machine and it's done.

Is that everyone with the Smart products has that capability enabled in terms of being able to automatically take the money out of the flex spending account?

Not yet. It's just been rolled out to about 25,000 people.

And you provider network, they're all able to accept this card?

Every one of them has a card swipe machine in their office.

Got it. Terrific. Thanks, Mike.

Your next question comes from Joshua Raskin from Lehman Brothers.

Hi, thanks. Good morning. I have a couple of question on the outlook for 2004. One question just in terms of the commercial contribution. I know you said there were a lot of variables on the government side. But we're just wondering what your expectations were I guess more specifically for the commercial book? Maybe if you want to give us a range of earnings or a percentage of the total contribution versus the 35% in the current quarter?

And then two nit-picky ones. Just it looks like the tax rate is expected to be up a couple hundred basis points in '04. Is that just higher earnings, or is there more there? And then the last question, just on the Capex. It looks like the expectation is down about $10m. Was that discretionary spending? And maybe what projects etc. are not going to happen, or is it just cheaper services that you're getting?

I will take the first two and then give Jim the tax question. On the commercial business we are not going to get too specific with you at this point. We will tell you more later in the year. But I will say that commercial earnings next year obviously are going to be up over where they're expected to be this year.

In terms of Capex, we had a plateau relative to all of our spending around technology. We were very hard and heavy with it for several years, and we've reached the end of that. So we can moderate it a little bit, and that's what's happening there.

So we would expect Capex to trend more similarly the new expectations going forward in terms of '04 and beyond?

It will be in the same general area, yes.

Okay.

And the tax one Jim, do you want that?

Our tax rate lowered this quarter to 33.5%. That's where it will be the rest of the year. That will give us 34% overall. Our first quarter tax rate was 36% and we anticipate that it won't return there next year. The reason for this year's -- for the last three quarters of this year was a sale of a venture capital investment from which we had capital loss carried forward to extinguish any tax liability coming out of that.

Okay. And then while you bring it up, just one last follow up. In terms of the venture capital investment, are there any other investments or similar items that you guys are currently holding on the balance sheet that could potentially provide a boost to cash flow etc. going forward?

No. And I think that with regard the Capex, I look at those things basically as timing. So we're just looking at the flow really and not necessarily a reduction in the total amount. But basically when the monies will be spent. Particularly as pertains to this year. But as Mike pointed out, there has been a reduction in capital spending over the last three years, and we think that we're right now in the 95 to 105. It's kind of like where we will be going forward. That prior limits really down to appreciation.

Okay, thanks.

So there's your cash flow for that.

Your next question comes from Christine Arnold from Morgan Stanley.

Good morning. I'd like to delve into your 2003 guidance a little bit more. I did the numbers right, and tell me if I didn't. You beat the quarter by 8 cents to 9 cents in the second quarter relative to your prior guidance. And yet you've only raised the forward guidance for the full year by 4 cents to 7 cents. First, is that math right, and second, what accounts for that difference?

Well a couple of things. The tax rate is part of it as I just mentioned in the previous question. The other part has to do with when you go forward and you look at all the uncertainties that Mike mentioned, with respect to both Medicare and with respect to TRICARE. Those uncertainties in which -- you know if you started to write all those down there is really a lot of them. That's why there a range, and that's why in terms of the 2004, that's why there needs to be a range where we give in the mid point.

Coming back to 2003, we also -- Mike mentioned that we got more than we anticipated and then also earlier. The earlier I think we all understand the earlier, but the more that was basically worth 4 cents as well. So if you take the tax rate, which will be worth 3 cents this year, and you take the more part of which is 4 cents. And we're actually looking clairvoyantly as we can toward next year, I think that gives us really a very good improvement next year given the numbers recited. As well as explaining the answer to your question about why it only goes up from $1.44 to $1.47. And we of course have narrowed the range because we're later [indiscernible].

I understand that, but you've lowered your tax rate. I mean we'd expected it to be 36% and you're now saying it will be 34% for third and fourth quarter. That would imply that's a help to third and fourth quarter and yet you've lowered your average earnings for those quarters. Because your full year guidance is lower in terms of the change versus to beat second quarter. So are you anticipating building the receivables less for TRICARE because you lowered your receivable guidance, and therefore you are being conservative on your revenue assumptions? Do you anticipate a rise in the Medicare or Medicaid in the second half of the year? Or maybe internally you're think the deductibles will cause you commercial MOO to rise? You're going to spend more on advertising? Can you help me with…?

Actually none of those. The other piece that was there is we did forward into this quarter monies that -- remember we said earlier and higher. The earlier part was because we made the settlement that Mike mentioned with the Department of Defense. We accelerated 3 cents into this quarter that won't be appearing later in the year.

Okay.

Remember Christine we originally -- some months ago we pushed TRICARE earnings back into the latter half of the year. We kept anticipating the timing to be late.

And now you're pushing it forward.

Now we've brought it forward, that particularly money just isn't going to be there in the back end. So I mean part of it is that TRICARE piece is a shift to the front.

Okay. And also the lower tax and the fact that you're changing guidance, there's not else you can point to except perhaps conservatism overall?

Well actually we think that would explain the entire thing. Because last time we guided $1.37 to $1.43 mid point of which is $1.40. If we have accelerated 3 cents of that into the second quarter that wasn't there before, we got 4 cents more - that's thinking where there was earlier and more - that was 4 cents. And then the tax rate is a 1 cent helper per quarter in the next three quarters. So that brings us I think right to where we are in terms of the $1.44 to $1.47.

Do you anticipate there being a true-up on the at-risk portion or is it just the ASL portion for TRICARE that was subject to a true-up?

With respect to the receivables?

Well you had a reconciliation with the Department of Defense expected second half of '03, on the actual number of members. And your membership didn't change really?

Okay. We get our membership numbers from the Department of Defense so they don't supply those as quickly as you get them in the commercial business. We haven't heard from them totally on the membership yet.

Okay, but that could be a second half issue, couldn't it?

We don't think that it would be very much of an issue because again we -- the reason we do all this talking about TRICARE is because we have lots of debits and credits every quarter. And those spin off to whatever positive effects they get. We don't keep them all, we just share on a risk share basis with the government, or we pay sub-contractor. So we don't look at that -- we do look at that as an issue that needs to be closed with the Department of Defense, but not one that's going to materially affect our earnings.

Okay. And the final question is, it looks like your medical payables rose, related to other factors by 2.7 days? Is that an increase in the core [IBNR]? How should we think about that?

Yes, that's how we stacked, how we think about it. We're very consistently conservative about how we book the reserves. I mentioned we've continued to have favorable developments, and that's really what that 2.7 is in the days.

Okay. But favorable developments would reduce those payables. The fact it was up 2.7 means that it was more than replaced by new reserves?

Yes.

By about 2.7. Perfect, thanks.

Your next questions comes from Eric Veiel from Wachovia Securities.

Thanks. Actually I wanted to ask a question about the IBNR as well. Just looking sequentially, Jim, it looks like it was up 10.5%, the core IBNR number versus premium growth of 2.5%. Is there anything in addition to just being conservative there? That just seems like a pretty big increase.

Well it's conservative, and then a consistent methodology that we apply, you know, booking to our actuarial best estimate. And again I did mention that we did have some favorable developments. So --

As Mike has mentioned, you know, you're certainly working towards getting claims faster, getting them paid quicker. That impacted inventory in the past. Does that calculation get translated into the IBNR? So what I'm saying is, is there some point where you guys might have to admit that your IBNR is too conservative. You've just been too conservative and we will see an adjustment come down the pipe as you have got claims faster. Maybe that's one of the bases the actuaries were using to make that?

Yes, eventually that would happen. We dipped up some more time in cycle time this quarter, and that's in the disclosure section of the press release.

Right, yes I know, I saw that. Okay. And then second question, just as it relates to enrolment and the economy in general. Did you guys - if you did I'm sorry I missed it - provide a number in terms of how many members you might have lost from accounts that you held onto but shrank due to layoffs or the lapsing of [indiscernible] benefits?

No we haven't provided specific information. But there's been some pressure on existing accounts clearly. I mean you can't have all these unemployment numbers climbing without an issue. So it's been in there, and we just look at it as one more moving part. So I don't think it's been really big for us, but it there has been an impact, yes.

Okay. Great. Thank you very much.

Your next question comes from Roberta Goodman from Merrill Lynch.

Hi, I wanted to follow-up on Christine's question about the TRICARE. Forgive me if I'm a little bit confused here. What was the order of magnitude of the incremental collections that you had during this quarters? Either the original estimates that you had given to us for the second quarter.

There are a couple of things. The second part of your question it was a little bit less than we thought we would collect, but it's a $50m difference from the end of the first quarter. We thought we might maybe collect $65m. We think that we will have that in hand this. It's very difficult to project all these things. And the Department of Defense is working on T-NEX and the other stuff as well.

But the other significant think about the TRICARE receivables, I want to make sure people capture, is that we've really increased the percentage of the total receivable, that is the base receivable. And again that went up another $27.5m this quarter. So we basically collected about a net of $50m in TRICARE receivables, but there is the $27m that were added to the base. And then there was approximately $75m or so that was collected in the BPA and change order area. And again if you look at that little graph that's are in the slides, you can see that.

Okay, so that would then put that to the 7 cents essentially that you were sharing with Christine on the faster and more than?

Yes. Again, faster was probably worth 3 cents, that's an acceleration from the past two quarters to this quarter. And again as Mike said, we'd originally thought we'd collect that in the second and third and fourth. We collected it all in the second. And then the larger was the 4 cents, and again that -- the recitation I just said about the collection of change order and BPAs accounts for that. That was 4 cents.

So what should we look at as the run rate for TRICARE premiums and TRICARE [indiscernible] in the back half of the year?

Well that's always sort of the difficult question. You know right now we're at an annual collection rate of about -- revenue rate of about 2.4, and we consider we will look for that going for ward. With more of it coming in in a ratable fashion every month as opposed to coming in on the BPA and change order processes.

Okay, and second and related. You were talking about a good amount of RSP and quote activity. Could you share with us the magnitude of the business that you've already signed for 2004 at this stage? And how that will compare to where you were last year at this time?

We will get more specific about that on the next call, Roberta. I do expect the first quarter of 2004 to be better than 2003. But the degree at which it's going to be better, I think we need to let it mature a little bit more.

Okay, thank you.

Your next question comes from Bob Yeded (ph) from Percival Capital.

Congratulations on such a good quarter. My questions were just answered with the prior individual. Thank you.

Okay, Bob, thanks.

Your next question comes from Ed Kroll from S.G. Cowan.

Good morning. I just wanted to ask a couple of things about Medicare. First, could you tell us how the Medicare book did this quarter versus the first quarter? Pre-tax. [indiscernible]

We don't break that out. No, we won't do that. But again things continue to go well in Medicare.

And we've said it many, many times in the past, we can't break that out either for TRICARE or for Medicare. You see the government combined, that is those two lines of business primarily. Because were are in the middle of some very delicate discussions in Washington for example right now around whether Medicare HMOs ought to be given some more funding. So it's just not -- and we're also in the middle of a bidding process on TRICARE to these are perfect examples of why we don't get specific on that line of business.

Let me just say it continues to do well for us and is a strong contributor to the company.

And when you said you could turn on a dime, I presume that means if there was favorable Medicare reform, better reimbursements for Medicare Plus Choice. You would be able to restart the marketing engine in very short order?

Yes. At the end of the day where we are is, I have a very well organized business unit for our Medicare line of business. And that extends all the way from the corporate center to the field. It is not intermingled any longer with our commercial lines of business or our organization. So it is a focused standalone business unit with terrific actuarial talent inside of it, and strong networks. We've been -- as I indicated in my comments, we've been very aggressive about keeping our toe in the water, relative to all these new things. We are already in the Medicare PPO business as we speak. I'm already in the Medicare Fee for Service business in a couple of other places under these beta tests.

So I have information, I have a lot of experience. I was in the Medicare business in many locations in the past, and I understand how we could re-enter that business if it became viable to do so. I think we've be able to do that quicker than others. That's really what I'm saying.

Okay and then I'll try one other thing. If there is not reimbursement relief for Medicare Plus Choice, what sort of ballpark attrition should we expect for the year '04 for that book?

It's hard to say, because you don't always know what the competitors are going to do. So if nothing changed it would probably continue to slowly decline. But having said that, we've had situations where come January 1, somebody leaves the market. And all of a sudden we get a pop up in membership. So it's really -- if everything stayed the same it would be a continued slow decline and we would manage profitability using benefits and individual premiums. And we already laid out a multi-year approach to doing that. But there can always be a change based on what happens to competitors.

I mean we still have a number of competitors in parts of Florida, for example, some of which I don't think are really doing very well. And I don't know what their future is going to be. So there's always some variables that we really can't count on.

Okay. Thank you.

At this time there are no further questions. Mr. McCallister, are there any closing remarks?

Yes, thank you. Let me just finish by saying we're pretty pleased with the quarter. The earnings continue to grow. Commercial results are significantly better. Good cash flow, the SmartSuite results are good, and the interest is high and growing. We really are pleased with our positioning relative to TRICARE. And we think we have a lot of opportunity there.

And with that I'd like to close the call by thanking all the Humana associate who I know are on this call, for the work that they've done to make it all possible. Thank you very much.

this concludes today's Humana second quarter earnings release conference call. You may now disconnect.