Humana Inc (HUM) 2004 Q1 法說會逐字稿

Good morning. My name is Beth and I will be your conference facilitator today. At this time I would like to welcome everyone to the Humana first 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, simply press star, then the number one on your telephone keypad. If you would like to withdraw your question press the pound key.

I will now turn the call over to Regina Nethery, Vice President of Investor Relations. Ma'am you may begin.

Thank you and good morning everyone. As you will probably be able to tell I have laryngitis this morning so please bear with me during our opening remarks. We do appreciate you joining us this morning for a review of Humana's first quarter 2004 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, humana.com.

As we begin this morning's call I need to remind each of you on our cautionary statement. Certain of the matters discussed in this conference call are forward-looking and involve a number of risks and uncertainties. Actual results could differ materially. All participants in this conference call are advised to read Humana's press release issued this morning, April 26, 2004. Call participants are also advised to read Humana's Form 10-K for the year ended December 31, 2003 as filed with the Securities and Exchange Commission. Our 10-K contains detailed discussions of important risk factors.

This morning's earnings press release includes operating cash flow measurements that are not in accordance with generally accepted accounting principles. A reconciliation from GAAP operating cash flows to the non-GAAP financial measures is included in this morning's earnings press release, as well as management's explanations. That release is available via the Investor Relations' page of Humana's Web site.

Please note that all references to earnings per share made during the course of this call represent diluted earnings per common share. Also, all forecasts exclude Humana's pending acquisition of Ochsner Health Plan of Louisiana. 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'll turn the call over to Humana's Chief Executive Officer, Mike McCallister.

Thank you and good morning. Today Humana reported earnings of $0.41 per share for the first quarter of 2004 compared to $0.19 per share in the first quarter of 2003. Revenues were up 12% to a record $3.3b. Total medical membership increased 6% to $7m and our pre-tax margin of 3.1% rose 150 bps from the 1.6% pre-tax margin in the first quarter of 2003. These results represent continued progress across a number of key operational fronts and we expect 2004 revenue, earnings and cash flows to be the highest Human's history as a Health Benefits Company.

We are reiterating our guidance for EPS in the range of $1.60 to $1.65 for 2004. Recent achievements which contribute to our 2004 earnings guidance include first growth in our MedicareAdvantage Plans. The first quarter of 2004 was the third consecutive quarter in which our Medicare membership increased. On April 1 we added 31,000 Medicare members through the acquisition of Ochsner Health Plan. Thus we are now forecasting membership to grow to between 370,000 and 390,000 by the end of the year. This will be our highest membership level since the fourth quarter of 2001.

CMS approved all our MedicareAdvantage Plans filed in February and recently announced Medicare rates for 2005. Given that risk adjusters have a 50% impact next year our initial expectation is for 2005 net Medicare rate increases to be slightly less than the programs overall average of 6.6. It's far too early to project the specific premium rate for next year.

Our insight into consumer behavior and the extensive expertise we have developed through our continued participation in this program over the last several years will help us effectively design benefits and premiums to extend Humana's Medicare growth in 2005 and beyond.

Second, membership in our innovative Smart products now exceeds 220,000 and interest from the employer and broker communities continues to be high. During the second quarter we will be introducing creative tools and pricing programs to further maximize our opportunities with this suite of products. We are on track to equal or exceed 2003's close ratio in the high teens. Our membership retention rate of 95% confirms the loyalty associated with this product and its appeal to both employers and consumers as a total solution to the healthcare cost dilemma.

We continue to monitor medical cost trends for our Smart products as participating customers gain sufficient claims experience to produce meaningful data. While the trend generally fluctuates around the mid single digits we are encouraged that our most recent analysis indicates and even lower trend of less than 4%, well under half of the national average increase in healthcare premiums.

Third, our individual product sales have also been accelerating with membership over the past year increasing from less than 10,000 at the end of last year's first quarter to about 75,000 at March 31. This is a significant milestone particularly considering that the product is fully underwritten. Given our current run rate growth for this product we expect the individual membership to double by the end of the year to approximately 150,000.

Fourth, our commercial ASO products were another area of appreciable membership growth. We now have nearly one million ASO members, up more than 50% over the prior year's quarter. As we indicated in last quarter's call we are now a significant participant in the ASO business and the results we are reporting today bear that out. Approximately 285,000 new members were added in the first three months of this year. On average our per member per month fees for our commercial ASO medical product are running in the mid teens. This is approximately 2% higher than in 2003 based on a same-store analysis.

Fifth, Our TRICARE unit was awarded the contract to administer health benefits for beneficiaries on the island of Puerto Rico. This ASO contract is scheduled to begin May 1 and includes a term of nearly four years with annual renewal periods. While relatively small in potential annual revenues this opportunity further leverages our Puerto Rico operations.

Finally, on April 1 we closed on our acquisition of Ochsner Health Plan of Louisiana. This gives us an established position in the Louisiana market and we are excited about the opportunity to bring our innovative products to employers state wide. In addition the acquisition brings synergies with our existing Texas business. We believe employers will be receptive to our new products and the initial response from the broker community has been very positive. Further, these members have access to a provider network with a solid reputation, which is expanding even further throughout the state. The integration of this entity has already begun and we continue to anticipate results from the Louisiana market to be neutral to earnings in 2004.

While we are encouraged by these progress points, 2004 also presents certain challenges. First, as we shared with you in the last quarter's call we have a unique situation with a large governmental account in the commercial segment. Our analysis of claims data for this account leads us to project the full $30m year-over-year negative impact that we advised you of last quarter. As we said then, the situation with this account is unique in our book of business with risk dynamics that were altered when a competitor exited after bids were submitted.

This contract expires at the end of this year and at that point this issue will be behind us. We have already advised this customer that we will not be participating in the bidding process for 2005 unless the rules of the bid process are changed dramatically. The key takeaway here is that commercial earnings in 2005 will not experience the drag from this account we see in 2004, with or without this account going forward.

Second, and more importantly, an industry-wide challenge that is currently brewing relates to pricing. In our opinion there are some competitors who are now clearly pricing for market share. This is most heavily focused in the smaller group end of the commercial market and is causing some pressure on our fully insured membership block as demonstrated by a net decline of 54,000 sequentially this quarter. We will not play the market share pricing game and will continue to price our business for bottom line profitability. We are nonetheless comfortable with our ability to achieve overall organic growth for commercial membership this year in the range of 6% to 8%.

Given these two constraints, one specific to us the other general to the industry, commercial segment pre-tax earnings for 2004 are now forecast to approximate $140m.

Looking ahead to next year and beyond we continually evaluate our commercial accounts, bearing in mind our longer-term vision of a portfolio mix that includes a larger percentage of fully insured members from individual, small group and the middle market size customers and self-funded members in the larger account space. With this in mind we have specifically targeted certain larger fully insured accounts and anticipate appropriate renewal discussion with those customers for 2005.

To summarize. Our commercial segment's performance is progressing, despite the issues I've described, due in large measure to the growth of our Smart products and our individual and self-funded businesses. Medicare is a renewed opportunity and we are moving aggressively to maximize our experience and position. Our TRICARE business has been solidified by the award of the south contract and it is expected to continue to be a solid contributor both this year and into the future.

We are pleased to report increased earnings for our shareholders in the first quarter of 2004 and forecast earnings for the full year of between $1.60 and $1.65 per share. As we look to 2005 we again are forecasting increases in the results for each of our operating segments.

With that I will turn the call over to our Chief Financial Officer, Jim Bloem for a run through of the financials. Jim?

Thanks, Mike, and good morning everyone. Let's again begin this morning's discussion of the financials with our top line. Consolidated revenues of $3.3b increased 12% versus Q1 of 2003. About 70% of the increase came from higher premiums and administrative fees in our government segment, and the remaining nearly 30% came from the commercial segment.

Higher year-over-year commercial segment revenues primarily were the result of TRICARE contractual increases which became effective in the second half of 2003, with some additional benefit from the renewed growth in Medicare membership which Mike described earlier. Commercial segment premiums and administrative fees grew by approximately 6% as per member premium increases partially were offset by membership attrition in our fully insured business, a result of a pricing environment Mike also described a few moments ago.

Our full year 2004 commercial premium yield projections of between 7.5% and 9.5% reflects the growth we are seeing in our individual products which have a distinctively lower per member premium than our other products.

Premium yield projections for the MedicareAdvantage business have increased slightly as we see more of our growth in the higher reimbursement counties that we previously expected. We now are forecasting Medicare premium yields in the range of 9% to 11% for 2004.

TRICARE revenues now are forecast to be approximately $2b in 2004 as we've refined our estimate to reflect the latest information available about the transition of pharmacy benefits. The first half of the year is projected to account for about 65% of the full year premium revenue as well as all of the TRICARE ASO revenue for the year. Despite the projected Q3 decline in average members TRICARE insured revenues for the remainder of the year are projected to be only slightly weighted toward Q4 given the timing of the individual contract transitions to [TMex.]

Turning next to the expense components of our earnings, our consolidated medical expense ratio for the quarter increased by 100 bps year-over-year in line with our previous expectations. 2004 commercial segment medical cost trends are now expected to be in the range of 8.5% to 10.5% as the mix of our membership shifts to a slightly higher proportion of individual members. The commercial segment MER for the full year continues to be projected in a range of 100 bps to 130 bps higher than that of 2003. This also is consistent with our previous guidance.

As for the components of commercial medical cost trends for our large and small groups, we are not seeing any material movement in our hospital, physician or pharmacy trends relative to what we experienced in the latter part of 2003. MedicareAdvantage medical cost trends are expected to be in line with the corresponding premium yields as we have used the additional premiums we have received through a Medicare Modernization Act for increased member benefit s and provider reimbursements.

Looking at our SG&A expenses we also achieved the expected 100 bps improvement in our consolidated SG&A ratio, fully offsetting the increase in consolidated MER and helping to drive the improved earnings for the quarter. Improvements in our 2004 consolidated SG&A ratio should continue to substantially offset the forecast increase in our consolidated MER.

Despite this year's $30m negative impact from the large governmental account Mike described, we anticipate pre-tax earnings for the commercial segment to be approximately $140m. As an aside, some of the participants in today's call have struggled with how a $30m profitability decline can occur in a single account. Some quick math may be helpful. The MER for this account is coming in around 1200 bps higher than in 2003. This level of increase on $255m in annual premium yields the $30m profitability decline. In spite of this one account we continue to expect record results for consolidated EPS in 2004, with less volatility in our quarterly commercial pre-tax earnings. As we described in the last quarter's call the impact of leap year, as well as the shift to more individual and ASO membership, together with the elimination of certain large fully insured accounts in the second half of the year, all will contribute to a reduction in the volatility of our commercial pre-tax earnings this year.

Turning now to cash flow. Our first quarter 2004 earnings also helped generate solid cash flows from operations. Our first quarter 2004 non-GAAP measurement of operating cash flows, which gives effect to the timing of the CMS premium receipt, totaled $172m, 2.5 times the quarter's net income, and an increase of 76% over Q1 of 2003. This improvement is further noteworthy because we also cracked the four days claims on hand inventory barrier. The 3.9 days of claims on hand that we had at March 31 2004 compares with 4.4 days and 5.2 days on March 31, 2003 and 2002 respectively. We believe this rapid claims handling provides a competitive advantage with customers, consumers and providers.

Accordingly, we are maintaining our full-year cash flow projections of between $475m and $525m versus $413m in 2003.

Finally, our balance sheet liquidity also remains strong with 54% of our total assets in the form of cash and investment securities on March 31 2004. The debt to total capitalization ratio decline by 60 bps sequentially to 25.3% at the end of Q1. Our claims reserves continue to be booked using the same conservative methodology as in the past. This means that earnings reported for this quarter do not include the benefit of any prior period favorable reserve development. Based on our most recent look-back analysis of our medical claims incurred in prior periods, it appears that 2003's consolidated results were slightly better than we originally estimated.

In summary, we are pleased with the financial results we're reporting today and believe that the future holds many additional opportunities for Human's stockholders.

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

The first call comes from Matthew Borsch of Goldman Sachs.

Good morning. Thank you. If I could just -- my first question is on the pricing environment and your comments there, and I wanted to see if you could -- I know you want to stay away from naming specific competitors, but maybe give us some additional color on the type of competitors that may be pricing for market share, whether it's more the public companies or perhaps the non-public blues? And then secondly on the ASO business, if you could talk about how the per member revenue on the new business compares to the per member revenue on your existing business? And maybe how the growth came through in enrolment during the quarter? Thank you.

Let me start with pricing - this is Mike. I've read what you've written about the non-profit blues Matt, I would suggest to you that our comments this morning go beyond that. We have some public companies that are being quite aggressive in some locations and it's not isolated to one, it's two or three of them. So it's not everywhere and I've been saying for a long time when asked the cycle question, what I thought of that, and I've said for a long time that I don't think we will see the type of cycles we've had historically for a lot of reasons relative to the number of competitors and the fact many of these blues have become for profit companies etc. But there is no question right now I am seeing pricing that cannot be rationalized relative to any kind of a network pricing advantage or anything else you could look at, it's pretty aggressive right now.

The second piece on the ASO, we added a couple of very large accounts. In our ASO business we're about one million members, but we are not big enough that as we get into this really big space the actual deals we do with some of the these accounts makes a difference in terms of your yields. So for example we have one very large ASO account that has a network relationship with us and a couple of other lower fee-based types of things. So it's a mixed bag. There's a whole roster of things people can buy from us and they can generate fees from $11 to $40 depending on what they ultimately purchase. And so the scale of our business right now has that moving around quite a bit based on the type of business we are getting. We are now dealing with some very large accounts, and that was not the ASO space we were in before.

The yield on one particular case that we have is lower than we historically had on our ASO business. Overall this is a very good business and our margin in this and all the pieces, new business, old business, all of it is really solid double-digit. So we will keep you posted as best we can going forward about the nuances of that, but it's a great opportunity for us, we are growing nicely and it's quite profitable.

Great. And if I could just ask one follow up. Did you see much switching by your say large group fully insured into ASO? Was that a dynamic at play this quarter?

Not more than we had previously anticipated.

Okay. Great. Thank you.

Your next question comes from Charles Boorady with Smith Barney.

Hey, good morning, Charles Boorady. First question on the Medicare yield. I'm just curious when the new rates took effect exactly what the date was and whether we should expect to see the yields ramp up and how over the next three quarters of this year?

They were approved effective March 1 and then they were retroacted back to January 1. We will continue to see them again, the premium yield and the medical cost trend be in line with each other because pursuant to the law we're using the increased premium we will get to improve benefits and to strengthen the provider networks.

Got it. And the next question on TRICARE, can you walk us through how we should model the changeover in TRICARE? I know there are a lot of steps, but maybe at least just hit on the big items in terms of what we should expect in our models and whether there'd be any additional expenses related to the changing over? Or if there would be a charge related to sort of discontinuing in some markets and starting up in other markets?

Okay, you're right, there are a lot of steps involved. I won't cover them all but the basics are, the first group of variables to look at is the transition times with each of the contracts. So we're going to lose the 2.5 and we're going to gain the 6, and as you know the 6 becomes effective on November 1 and the 2.5 goes away on 7/1. So that's the biggest hole to be filled so to speak when we start looking at the problem that way. And that's why we made the comment of 65% of the full year TRICARE insured revenue is going to be in the first half.

Having said that, though, the 3.4 makes the transition on 8/1, goes from old to new, and immediately we begin to get administrative cost reimbursements etc. The reimbursements on the 3.4 are higher than on the 6 that we are going to pick up, so we get that advantage right away. The other thing is as well, you noted from the dates I gave you that two quarters are really affected because of the 8/1 and 11/1. So one month of the third quarter we get, you know, everything is missing the 2.5, but we make the switch on 3.4. So again looking at those reimbursements and figuring all the things together, and then you ask the question, well what about the transition. Well the good news about the transition is our transitions really will help that. We are picking up what they are leaving off and vice versa, so we don't have unrelated parties to deal with in terms of doing the negotiations.

And then finally we don't expect that there will be any charge associated with the transition either way.

I see. While the transition is taking place, what's the earnings impact that we can expect from it? So is this part of why the 2Q is going to be down sequentially from 1Q for example on the bottom line?

No, in term of -- first of all, all the TRICARE movement there are a lot of variables that I have just mentioned, and we've incorporated all of those in our annual guidance. We are not sure the way everything will play out exactly. As we get closer to it, we'll obviously get further opinion and give further guidance when we get there if we need to change what we've done. But again we think that there's been a lot of discussion around this topic, and again I'd just like to emphasize that our annual guidance, again because it's in two different quarters basically shows what we think is going to be the effect of making the transition in TRICARE this year.

The sequential drop, though, from 2Q to 1Q you're taking has no impact from TRICARE built in there?

It has none that's been changed this time, but 2Q to 1Q basically revolves around -- if you look at last year what happened in TRICARE that's one thing, but if you're looking at the sequential change that's basically around the normal commercial ratability.

Okay. So the sequential drop is related to the commercial. Last year there was a sequential pretty sharp bump up Q1 to Q2 and that's what I'm trying to say, the change in seasonality. My assumption was it was a TRICARE related drop but it sounds like TRICARE is not having a negative impact in 2Q?

Charles if you go back in history you've got to go back to our normal cycle of earnings. Last year was odd because of the timing of some TRICARE issues, but if you go back and look at the way our quarters have played out and you go back a number of years, the second quarter is always slightly lower than the first quarter.

Okay, great. And the uses of free cash in terms of share repurchase or potential acquisitions or anything else?

What we did is we mentioned in the press release that we purchased just under 700,000 shares in Q1. We have $100m authorization, $81m of that is still left. We also in the second quarter on the first day completed the Ochsner acquisition and that is a use of cash also. So what we do is we continue to use our normal strategy of looking for investments that will improve the earnings and the value of the company and then using what's left over from that to round out the necessary capital we have using share repurchase.

Okay. Thanks.

Your next question comes from Josh Raskin of Lehman Brothers.

Thanks, good morning. First question just on the new ASO wins that you guys are taking, could you just give us a little bit of color around what types of accounts these are? Are these large national employers or are these more regional based or are these slice accounts that are picking a couple of regional plans, etc?

There tends to be some pretty large national companies, but they are buying sort of regionally. The wins have been situations where we have been able to show the value of our network, where there's good geographic overlay. And so, and I've said for a very long time, proprietary networks in good markets are hard to beat from a rental network perspective, and I've said for a long time, if your strategy relies on a rental network you've got a problem. So it's because we are playing in the ASO space and becoming known as a participant and somebody to talk to, we get a chance to look at some of these big companies from the standpoint of what our network looks like and the other services we can provide them that we didn't have two or three years ago.

So I've said all along some of this is showing up at the process, so we get a chance, we get into the process and we're able to lay our network next to others and we're finding opportunity in all that. So it's a combination. We have a couple of very big ones in that book that are national type accounts but their geography fits us pretty well. And then we have some mid sized things as well. So it's across the board. I think the ASO story for Humana is really simple. We were not aggressive participant in that space up until about 18 to 24 months ago. We now have infrastructure of people, capabilities, our reporting capabilities to these customers are as good or better than anyone's. Everything else we do from the standpoint of supporting commercial companies is delivered to these companies as well. And our capabilities across the board are pretty good, so we can be very competitive here and you are seeing some early results relative to that.

And we have the ability to sell whatever services they need, everything from network to utilization management to data management etc. So it's all there for them.

So it sounds like these plans are -- I don't want to call them slice accounts, maybe they are full replacement for specific geographies where you guys will take over a specific region because your networks are more effective in that region. Is that fair to say?

A mixed bag. I would say that the percentage of the business you saw come in the first quarter was full replacement.

Okay. Next question, just one other question. On the days claims payable, it came up about a day, a little over a day I guess even despite some of the prior period reserve development that we saw. Two question - one, was that just because you guys were sort of adding back to the IBNR in the first quarter? And I then I guess the second question; I think Jim you had said right at the end of your comments that the earnings that you reported did not include the prior period, or -- I think I may have missed what you said, or at least misunderstood it. If you could help us out with that.

First of all let's go to the second one first. The quarter did not have any beneficial effect from any prior period favorable development. Let's take a look. If you have the press release and you look at the medical claims reserve details, I think this is a good chance to just go through this. One of the things we always do is we breakout our incurred related to prior years with respect to TRICARE and with respect to non-TRICARE. And you notice if you start with the footnote number one, the non-TRICARE there was a 15.6 favorable development there; it went from 33m to almost 49m. But then in the TRICARE, and it's probably where your question is coming, it had an unfavorable 1.7m and then it was compared to a favorable of 42.6m at the end of 2003.

We were quite surprised at the end of 2003 that the TRICARE had really developed that favorably. It had developed by $42.6m. But that $44.3m swing tells why we separate TRICARE from non-TRICARE, because the TRICARE piece really only 20% of that is ours because of the risk share, the government gets the other 80%, we get 20%. So if I take the $44.3m difference, the $1.7m from the [indiscernible] $42.6m and I take that, I have basically $8.8m. Basically then TRICARE results were helped by $8.8m. But then if I subtract that $8.8m from the $15.6m that the non-TRICARE developed that gives rise to my statement that the overall results are favorable by 2% to 3%. In other words we under-reported earnings in 2003 by $0.02 to $0.03 per share.

Okay, so we should think about the differential in -- the differential in what you -- the prior period development this year is only that $8m number? And we should also assume that the large majority of last year's -- at least a 33.4 on the non-TRICARE business of that portion, that was all probably -- almost all in the first quarter, is that fair to say as well?

Yes, well obviously the look-back to 2003 was performed in the first quarter and gave that. But again we look at our reserves every quarter, we do this every quarter and we're again very much consistent now. We do this, and we're conservative on how we do it.

Okay, thanks.

There was really no effect, no net benefit of any favorable prior-period developments.

I hope that came through, as a non-accountant I was listening to that. That's the takeaway, there was no prior-period effect in these results, period.

Your next question comes from Christine Arnold with Morgan Stanley.

Good morning. I still need help on TRICARE. It looks like we've got about a $2.7b run rate in TRICARE revenue and yet full year is going to be $2b and we're going to get rid of ASO which traditionally has a higher margin. How do we think about specifically the variables that get you to a 2% margin versus the 4% this year? How do you eliminate SG&A? Can you give us some more help on that?

Well first of all ASO and TRICARE doesn't always necessarily have a higher margin. Because we have a lot of different moving pieces, there are things we do that others do for us. There's also the whole thing like I said, we're going from $2.7b down to $2b basically. Most of that we clarified last time when we took the estimate from the $2.7b run rate to $2.1b. The Last 100 of that basically had to do with the pharmacy benefit and that was changed. We had originally been told that that was going to switch over on 5/1, then we were told it was going to switch over on 8/1 and now I believe that's what we're hearing now -- oh it's June 1, it's now June 1. So we're sort of going back and forth and back again.

Okay. But if we're going from -- if the revenue is going to fall this much from first quarter to third and fourth help me understand how you eliminate the SG&A such that you could be not detrimentally impacted on the earnings?

Well because of the fact we're working both sides with the -- you know we work from both sides of the equation with Health Net, that is very helpful. Because like I said before, if we had unrelated people they wouldn't really care when we [indiscernible] they would just want to want to get in if we were leaving and they were taking over, and then vice versa. So having them helps us smooth that trade. So it's all really been assumed in the guidance that we've given for the year.

So is there some kind of an arrangement between you and Health Net that helps to carry that SG&A?

Well it's just a matter of we will do it as long as we're responsible for it and they will do it after that. So in other words if you were leaving something, if you were going to cut out a line of business and you had to do this on your own, you're right then you would have to go and cut your own SG&A or you'd have to do something along those lines in order to do it. Then I believe the question would be -- it would be harder for us to do that. So what I am saying is, I am not as concerned about it, and it's in the guidance because of the fact we are able to transition on both sides with the same partner.

I understand it from the guidance, I just don't understand how we get to -- what are the variables that get you to a 4% margin versus the 2% in TRICARE? That's a pretty wide margin on a pretty significant reduction in revenue.

That range of margin is a historical margin, year after year after year. Given this year is transition year I think we've all said we'd be in the lower end of that range, and that's again in the guidance.

Right, thanks.

Your next question comes from William McKeever of UBS.

A couple of quick questions on the yield. The 7.5% to 9.5% that you are talking about, if I were to take out the government piece that's impacting your business, is there a number that we can think of in terms of the 8.5% to 10.5% cost trend? I'm just trying to get an idea of the spread if you accept that government contract, between your yields and your medical costs.

Well that's generally what we've been saying has been the principal difference between the fact that on that on the commercial side the premium yield, the range is outside, they don't totally overlap. One is 7.5% to 9.5% and the other one is 8.5% to 10.5%, the cost side. And that commercial account is generally what we've attributed to that difference. Now we've been through this over the last couple of quarters and I think it probably is worth repeating. A year ago we were talking about 12% to 14% premium yield and cost trend. How did we ever get way down to these numbers, particularly us as a company? And gain Mike has given us really what his vision is for the commercial business, what our vision is. But let's just sort of trace through how those work.

The first one is people make benefit changes, and there's been a lot of benefit buy-downs in the last year. then we've also switched -- we had a lot of our customers, high premium, high cost customers switch from fully insured to ASO. That affects both the premium and the claims. Then I alluded to the fact that we were going to term some large poorly performing accounts later this year, that's also in our guidance for premium and claims. And again the premium affect has a corresponding impact in claims. Then we said individual is becoming a greater part of our business, and that also again affects both sides. Then Mike mentioned competitive pricing; that obviously affects both sides. And so really the last thing then is that large account as you pointed out. But you have to look at all these variables, and that's how basically over a year ago we've made the transition in premium yield and medical cost trends to where we are today.

But what I think we're saying as a company is that many of these, the fully insured to ASO, the individual, the more ASO period, the terming of large accounts, those lower the risk profile of the company, lower the earnings volatility of the company. And again couple those with Smart products, that really gives us real confidence in our future with respect to risk reward in this business.

Great, thank you for that, that's helpful. And then on the cost trend side you've mentioned in your preliminary remarks that you really hadn't seen any change. But I'm just wondering if you could give us any flavor in the -- some companies have reported a slight moderation in cost trends in the first quarter over the fourth quarter; some haven't seen any. Are you seeing any nuance at all in the various categories?

I think that would be a good word for it, it would be nuance if we saw it at all. We continue to really work on rates, particularly in the hospital setting, but we haven't really seen a lot in utilization despite what you might have read elsewhere or anything else. So I think the key is your word nuance because again we are really saying the same kind of thing we've been saying since the latter half of 2003.

Okay, thank you. And then the last question is on the share count. The fully diluted shares were virtually up over the fourth quarter so I am assuming that there's some options plans going on. When might we see an absolute reduction in shares? I know you obviously buyback stock.

Yes, good question. Actually the reason that shares were up principally had to do with the share price. The share price a year ago I think as we're seeing here today is probably under $10. And so we get more common stock equivalents obviously at the current price. And during the first quarter the 90-day moving average was about 21.86 so it was even higher than it stands today. So that's the principal reason that share count is up. But also worth of note is we did buy back about the number that the share count is up in the first quarter so we hope to see that part of it ameliorated going forward.

Okay. Thanks again.

Your next question comes from Eric Veiel of Wachovia.

Thank you. I just wanted to go back to the $30m related to this one large customer. Can you give us a sense of your confidence that we won't see another downward adjustment in this? And then maybe you could also, as part of that, give us a sense of what the chances are that this maybe this won't be the full $30m? In other words, how much flexibility do you think there is around that $30m number?

Well it's really early yet, but we want to say that we've taken what we think is a conservative step here in evaluating this account and saying that the $30m will be recognized. You know right now on the 26 April, we've seen January and February claims, a fair amount of March claims, but the year has got a ways to run yet. So I don't want to say that it's all over, but we believe that we've taken a very conservative step here with respect to this account and what we've announced on the $30m profitability [indiscernible].

Okay, that's helpful. And then if you could give us a sense, as we think about on the commercial side of the business with the membership and the fully insured side dropping, so there's going to be a bit of a revenue impact there. How do we think about the SG&A ratio coming down through the back half of the year? Can you give us a little bit more granularity on the actual cost saves?

Again we're pleased with the progress we are making on our SG&A. Sequentially we made some pretty good moves from the fourth quarter, but obviously some good ones year-over-year. ASO, when we look at the -- if you sort of adjust for the special charges last year you can see that admin though as dollar admin went up $22m. A lot of that relates to the fact that we have more ASO business now than we've ever had before. We had the 285,000 that we added in the first quarter. And the rest of it is sort of variable costs. So what we're doing in ASO to keep everything the way it is we're really chipping away at the fixed indirect of the company. And we have our variable cost challenges, and those are premium taxes and commissions and insurance is one of those as well. But again we feel that we're making very good progress and you can see that we've continued to guide lower SG&A ratios.

I would also say we spent $17m in total dollars, 2.7% less than we did in the fourth quarter sequentially also. So SG&A has got a real focus around here and we're redoubling all of our efforts to get at our fixed indirect cost.

Just to follow up on that, just so I can understand. So as you chip away and those fixed indirect, are there any significant events that are going to help in terms of call center consolidation left for 2004? Maybe a claims system conversion that will finish up in '04 that's going to significantly help that number, or is this just sort of belt tightening up and down the enterprise?

Not in '04. You've given me a good opportunity to talk here, you know. We worked very hard on lowering administrative expense, especially in the pricing environment that we are in. But one thing we don't give up on is service. Service is a big part of the administrative expense, and again as I said we got out claims, our days claims on hand and claims inventories down to a number I never thought quite frankly we would ever get. But it does prove when you start measuring stuff you get better results. The four days claims thing for me was sort of like the four minute mile was in the 1950s, people just didn't think you could do that, if you think about having a claim in your house only four days. So that part of SG&A pertained to service centers and that kind of thing, we did most of that last year. We don't see a big pick up there.

What we're also working on is to get the company to a single platform, but that's not going to happen in 2004.

Let me add something to that Eric. There's an absolute march underway here relative to productivity gains across the board. Last year we closed three of our big service operations because frankly we just didn't need the physical plants and we'd gained enough productivity elsewhere to be able to do this. We've been investing heavily for a long time in technology around self-service to every aspect of our customer base and improving the processes and systems inside of our own operations. To the point now where productivity continues to grow quarter-by-quarter. So there's still some headroom there and I'm pretty optimistic that we don't have any major events in '04 that are going to move the water level dramatically. But you're going to see continued progression along a very positive path.

Okay, great. Thank you very much.

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

Thank you, Jim, for helping to explain the math on the government account. Can you tell us what kind of change in the rules would avoid sort of this level of magnitude of an adverse selection?

You know we've also said this was a sliced case, and I think the number one change as we think about both this account and a small handful of others we're working in, it's really simple. You can handle an insured case like this as long as you are not caught up in some risk selection dynamic. So I think we are working with this account now about what next year looks like. I think the thing we would look for at a minimum is if we are going to participate in any part of it, it will be on a full replacement basis to avoid that sort of dynamic again. And I think that just generally is an operating principle we've been heading down that road for a long time, we just have a little bit of clean up left to do. But that's basically -- I have said for a long time this slice business is challenging, it always has been. And I say to employers when I talk to them that the game of playing a slice business and leveraging companies against each other is basically over. And you can see it play out in cases like this.

Thank you, Mike, just one last question on the cash flow, which more than doubled sequentially and more than doubled year-over-year. What's driving that magnitude of an increase given that there's no change in your full-year forecast?

Well basically again the timing of things is important. Again that's why we got --

I mean adjusted for the CMS payment?

I'm not counting that, I'm just saying the timing is important because different types of expenses come in different quarters. And if you look at our quarterly cash flow that's why we signal for the full year. We haven't changed the guidance from $475m to $525m because you can have quarters that can exceed -- they're same quarter to prior year just by what day the quarter ends on and things like that. Again I'm leaving aside the CMS premium. So that's why when we do this we say -- generally I've been saying to people our cash flow from operations tends to be approaching two times our net income, and that's generally my rule of thumb. We were 2.5 this time, but again because we didn't change the outside guidance it's really we're saying that we think we are going to stay in the same pattern that we've been in. It's how many days there are in the quarter, what day the quarter ends on. If you look at all the obvious things that control cash flow from operations other than that timing; that has a lot to do with it.

Thank you.

Your last question comes from Ed Kroll with SG Cowan.

Good morning. I just wanted to clarify on the -- I think on the pricing, your guidance for '04 being just a little bit less. I think, Mike you said that was a mix shift to the small group business. Is it the same thing on the medical cost trend guidance being tweaked downward on the commercial?

Actually I referred to the individual business having an impact on that.

Okay, I'm sorry, I meant to say individual.

These things are running together. I mean there as benefits buy-down occur and as the business mix changes inside the company and as premium yields come down the cost trends go right with it. They run very tightly together.

Got it. And then on the TRICARE transition, In the full-year cash flow guidance will there be any lumpiness in how that comes in throughout the year, throughout Q's 2, 3 and 4 due to the TRICARE transition?

As I said in the previous question, I think the reason we haven't changed the overall guidance is because we believe that the year total is going to be where we thought it was before and not really reflective of the fact that we had a very good first quarter or that the TRICARE transition is going to somehow take it down. But quarters, again we do monthly cash forecasts up to the day before the month ends and there still is variability in those. So again there's a lot of moving parts in there and that's why we signal that yes we had very good results in the first quarter. Yes we know that we have issues with respect of TRICARE transition, but all of them are fully encompassed in the guidance.

Okay, and then just one last thing back on the commercial side on the enrolment. I think you said you will have a couple of commercial full risk accounts coming off in the second half of the year. Is it possible that the full risk commercial enrolment could be down slightly between June 30 and September 30?

Yes, that would be possible.

Okay. Thanks.

At this time I will now turn the call back over to Mike McCallister.

Well thanks everyone for joining us this morning. Let me close this by wrapping up where we are as a company in general. The first quarter I think was pretty high quality for us. We are please with progress along a number of fronts. We are pleased with where we are from an ASO perspective; we're growing strongly in the individual business. Profits up, cash flow is strong, and I think we're in a tremendous position to compete on the back of our newer products. The performance there is very good, so new products, individual, self-funded is where we're growing and doing quite well. And our Medicare business represents a really nice renewed opportunity for us over the next few years which we are going to maximize for our shareholders.

So with that I will close the call by thanking all the Humana people that are on this call for your work that makes it all possible. Thank you very much.

Thank you. That concludes Humana's first quarter earning release conference call, you may now disconnect.