Humana Inc (HUM) 2004 Q2 法說會逐字稿

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. (OPERATOR INSTRUCTIONS). I would now like to turn the call over to Regina Nethery, Vice President of Investor Relations. Thank you. You may begin your conference.

Thank you and good morning everyone. We appreciate your joining us this morning for a review of Humana's second-quarter 2004 performance and an update on our earnings guidance. Joining us for 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 website, Humana.com.

As we begin this morning's call I need to remind each you of 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 July 26, 2004, which is available via the Investor Relations page of our website. Call participants are also advised to read Humana's form 10-K for the year ended December 31, 2003 and our form 10-Q for the quarter ended March 31, 2004 as filed with the Securities and Exchange Commission. These SEC filings contain 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. Both a reconciliation from GAAP operating cash flows to the non-GAAP financial measures and management's explanation for the use of non-GAAP metrics are included in this morning's earnings press release. Please note that all references to earnings per share made during the course of this call represent diluted earnings per common share. Financial results for certain of the periods referred to in today's call and corresponding slide presentation include the effect of unusual items.

These unusual items and the related impact upon earnings are described in detail in the earnings press releases for the related periods. Humana's historical earnings press releases are available via the Investor Relations page of our website. Today's call includes a question-and-answer session for industry analysts, but we encourage the investing public and media to listen. And now I'll turn the call over to Humana's Chief Executive Officer, Mike McCallister.

Thank you, and good morning everyone. This morning Humana reported 2004 second-quarter earnings of 50 cents per share, a 16 percent increase over the same 2003 period. These results were 11 cents better than consensus estimates of 39 cents and better than our own internal estimates. Let me take a few moments to walk you through what changed from our first-quarter call.

First, our Medicare results have improved because our strategy of creating consumer choice product offerings as well as our investment in market expansions are producing better than anticipated results. Secondly, our TRICARE results improved because we were able to effectively deliver civilian health care services to the dependents of the additional reserve forces who were activated for our nation's war effort.

Finally although our commercial results are about what we expected we are seeing the beneficial effect of our clinical programs on medical cost trend. However, this favorable medical cost trend is being largely offset by the impact of reduced commercial enrollment, the result of a competitive pricing environment. As you conclude from my commentary we believe the diversity of our businesses is serving us well. It has long been our philosophy that a diversified portfolio of businesses provides us significant expansion opportunities while mitigating the risk associated with a single line of business.

Not only is our company diversified into two distinct segments but each segment is further divided among various lines of business. Our commercial segment, which includes products marketed to both employers and individuals is diversified among fully insured medical, self-funded and specialty products. In fact, our strategy is to move to more self-funded programs which will improve earning stability.

Our government segment includes the government-sponsored programs of MedicareAdvantage, TRICARE and Medicaid, each with its own unique characteristics. The size and stability of our government business provides a long-term solid base. This diversity mitigates the effect of any adverse developments in any one segment in any given year. For example, this year our strong government businesses offset the effects of our commercial pricing cycle on our consolidated results.

With those as the headlines, let's get into some of the details beginning with our Medicare line of business. Our Medicare results improved because of the implementation of programs, benefit designs and services that lead to improved health status and smarter use of health services by our Medicare consumers. Sales and retention results have also improved. We enhanced benefits that increased sales but more importantly helped prevent illnesses through increasing drug benefits and lowering costs to visit primary care physicians.

We also assisted our Medicare consumers in becoming more educated healthcare users through interactive tools and education, similar to our consumer choice efforts in the commercial space. We believe our knowledge of benefit design, distribution systems, provider relations and retention programs will be extraordinarily beneficial as we expand to new products and markets in 2005 and beyond.

Including the Ochsner acquisition our 2004 year-end Medicare membership will between 370 and 390,000. Growth opportunities stem not only from expanding our market share of the Medicare eligible population within our existing Medicare geographies, but also extend to new geographies where we already have a sizable commercial presence. As you can see from our commercial states highlighted on the slide, there's a great deal of synergy that can be achieved by simply taking advantage of our commercial network relationships.

In our commercial markets there are nearly 19 million Medicare eligibles with less than 2 million or just under 10 percent currently in MedicareAdvantage programs. Suffice it to say we are already leveraging our expertise in the commercial consumer choice offering to the over 65 demographic group. The MedicareAdvantage program enjoys bipartisan political support because it is so important to our nation's seniors. Campaign rhetoric aside, regardless of the outcome of the election, major changes to the Medicare Modernization Act in the coming year would be difficult. History suggest this complex law will not be easily or quickly undone; consensus under these conditions does not come easily or quickly. That said, we're comfortable with our strategy that takes this situation into consideration.

Turning to our TRICARE operations, our contract transition process is moving smoothly. As we mentioned before, this year represents a period of significant transition in our TRICARE program, and we recognize that it may be difficult tracking the financial impact of these transactions on our results. Most significant will be the phasing in of the new South region contract, uniting our current regions 3 and 4 with region 6. Let me take a moment to summarize the shift in TRICARE landscape for you.

On June 1st, the transition to the new TRICARE model began when another administrator began providing retail pharmacy services to TRICARE beneficiaries nationwide. At the same time the Department of Defense moved the responsibility for processing claims for our TRICARE for life beneficiaries in regions 2 and 5 to a new claims processor. This resulted in a 271,000 member decline. The revenue from this latter change affected our self-funded revenues but was not impactful sequentially. One of the reasons we chose not to bid on the carved out TRICARE for life business was that the associated reimbursement made us only marginally profitable.

On July 1st, we transferred all remaining TRICARE responsibilities and the associated 1.1 million members from region 2 and 5 to HealthNet for administration under the North region TRICARE contract. On August 1st, we will begin our new South region contract but only in our current regions 3 and 4. We think up the rest of the South region on November 1st when we takeover region 6 from HealthNet adding at that time approximately one million members. When all the dust settles we forecast our TRICARE membership will total 2.75 million with approximately 2 billion in revenues this year.

Jim will walk you through a graph of our estimated quarterly TRICARE revenues given the moving pieces. Importantly our margins for this business will still be in line with our historical results. Beyond what Jim will discuss relative to the economics, the major takeaway from this entire TRICARE transition is that for Humana the operational and integration risks are not high since our new region consists of our existing 3 and 4 areas, and region 6 where we already have material business and market experience in other business lines.

Now let's turn our attention to Humana's commercial segment. We are continuously moving our commercial portfolio toward full replacement, self-funded and individual membership. As a result we believe the underlying mechanics of our commercial lines of business are positioned for meaningful additional progress. However, during 2004 we are experiencing a significant drag on our results related to the large governmental account we have discussed with you in the past. With six months of claims data now under our belts, the impact of this account on our results for the year remains significant but is not forecast to be materially different from what we shared with you in our first-quarter call.

Importantly we have held firm to our strategy outlined above to bid this account for 2005 under different risk dynamics. Under any of the possible alternatives for this account, for replacement fully insured, self-funded or termination from the account altogether. The negative impact this account is having upon 2004 earnings will be gone in 2005.

We are committed to maintaining our pricing diligence. We constantly evaluate the competitive marketplace dynamics against our offerings and make decisions which result in profitable growth. This has resulted in our revising our commercial enrollment growth targets downward this quarter due to the competitive environment in certain of our markets. Generally we are seeing the most aggressive pricing on the smaller case size which is 3 to 300 life. In addition to these smaller case size reductions we have also severed our relationship with two large government accounts comprising approximately 75,000 members which would not have met our future profit targets. Although we had anticipated losing these members in our prior guidance our actions on these accounts are a further demonstration of our commitment to grow membership only in line with our profit expectations.

To summarize it all we are not going to match competitor positions which don't make financial sense. Later in the call Jim will walk you through a comprehensive discussion of our premium yields and improving medical cost trends. Right now I'm going to spend some time on the medical costs specific to our Smart products since as you all know, I never pass up a chance to brag about our innovative solution to the employer's problem. Our medical cost transfer, the Smart plans, continue to hold in the mid-single digit range with hospital admissions declining by over 10 percent. These results are emerging from a rather sizable block with the most mature actuarial data among the industry's growing consumer choice offerings.

As a result of this favorable experience we feel confident and have begun offering a second-year rate cap of 9.9 percent in a program we call Smart Assurance. We believe the elements of the consumer choice plan which create consumer behavior modification include product design, education, actionable information and risk selection management all powered by technology. We believe our Smart offerings are the only such comprehensive solution. Some competitors have been advertising that their consumer plans have experienced remarkably low medical cost trends. The results achieved by a consumer plan offered on a slice basis or which significantly buys down benefits standalone can easily be taken out of context. These will not achieve the long-term goal of controlling medical cost trends. We are pleased to see them join the consumer parade, but we believe our approach is better.

Because our Smart plan offerings have historically been targeted to larger companies, which generally renew on January first, the membership in our Smart plans did not change substantially during the quarter. We have already sold several large January 2005 customers on this offering; interest in the product and retention rates remain high.

Effective in the fourth quarter we plan to introduce this innovative offering to the smaller sized customer market. Smart plan membership is approximately 10 percent of our larger accounts block, and we anticipate doubling that during 2005. In summary, 2004 will be a record year because of our diversification strategy, as well as our growing knowledge of consumer engagement. It is that strategy that has helped us raise our earnings guidance for the year today, and we are pleased to forecast for growth in earnings per share for 2004 in the mid to upper teens.

As we look ahead to 2005 we are very encouraged. Medicare opportunities are significantly expanding. Our growing commercial self-funded and individual lines will further diversify our medical membership. We are eliminating some specific unprofitable accounts, and our TRICARE transition will be behind us. Additionally our integration of the Ochsner Health Plan is on schedule; in fact, approximately half of their commercial membership is already migrated to our platform and is expected to be fully integrated by December 31st.

We are positioned to further acquire and integrate other plans as additional revenues for growth. We will continue to evaluate acquisition opportunities and pursue those that we deem to be appropriate. All these factors, combined with the opportunities created by our consumer choice offerings and good old day-to-day blocking and tackling, lead us to forecast growth in earnings per share for 2005 of approximately 15 percent. As we achieve greater visibility on all of the moving parts toward the end of the year, we will provide more detailed guidance. With that I will turn the call over to Jim Bloem for discussion of the financials.

Thanks, Mike, and good morning everyone. Let's begin by analyzing two things. First, today's reported second-quarter earnings of 50 cents per share which exceeded First Call consensus by 11 cents and second, the change in our 2004 earnings per share guidance on the former range of $1.60 to $1.65 to the current range of $l.63 to $1.67 per share. Reported 50 cents per share for the quarter included a 7 cent investment gain and 3 cents of unusual expenses. A 4 cent net beneficial effect. Subtracting this 4 cents from the 50 cents reported yields 46 cents, which initially should be compared with a 39 cents consensus estimate for the second quarter, a favorable difference of 7 cents.

Of the 7 cent improvement, 3 cents relates to better than expected performance in TRICARE, which will be offset in the second half of the year. We will talk more about TRICARE second half earnings later. The remaining 4 cents is attributable to a moderation in both commercial and Medicare medical cost trends which we expect to continue in the second half. However, this medical cost trend improvement in subsequent quarters will be largely offset by a lower forecasted commercial membership during the third and fourth quarters. As a result, we've increased our 2004 earnings per share guidance by 3 cents per share at the lower end of the range and 2 cents per share at the upper end of the range.

Now let's continue our review of the financial results and guidances by first looking in greater detail at each of our two reporting segments, commercial and government. After which we will move to the second-quarter consolidated report, consolidated results reported this morning. Starting with our commercial segment, premium and administrative fees of $1.8 billion were up 10 percent compared to the second quarter of 2003. This increase is the combined effect of both a 13 percent increase in medical membership and premium yields in the 6 to 8 percent range. Second-quarter commercial segment premium and administrative fees accounted for 54 percent of total premiums and administrative fees.

The sequentially slightly lower premium yield for the second quarter reflects the continued shift in the mix of commercial business to a higher proportion of individual membership, which is now approaching 5 percent of total commercial fully insured membership. That is compared to less than 1 percent a year ago. Our lower premium yield projections for the year reflect continuing growth in this line of business which we expect to be over 6 percent of our fully insured membership by year end. Remember that due to the individual product benefit design, individual premium per member is substantially less than our other fully insured products.

We continue to be encouraged by our progress in both the lower risk ASO and individual markets. And we've lowered our expectation for the higher risk fully insured membership for the second half of the year. Accordingly, we now expect total year 2004 commercial premium yields in the range of 6.5 to 8.5 percent. Our second-quarter commercial segment medical expense ratio increased 160 basis points year-over-year, reflecting both the planned differential in our premium yield and medical cost trend plus the impact of the 85,000 member government account we've described in the past two quarters. Except for hospital inpatient costs, our commercial medical cost trend components are substantially unchanged.

We've seen moderation in terms of hospital inpatient admission trends, as well as some lowering of our hospital unit cost trends. Combined with our membership shift toward individual products we now expect full-year 2004 commercial medical cost trends in the range of 7 to 9 percent. Our commercial segment SG&A ratio improved 60 basis points over the second quarter of 2003. Although we slightly increased our guidance for the full year 2004 SG&A ratio, the increase only includes the impact of unusual items in the second, third and fourth quarters, which were referenced in this morning's press release. But on a run rate basis there is no change to our SG&A expense ratio guidance.

So to summarize our commercial segment in four points, one, the forecasted 2004 impact of the 85,000 member government account is essentially unchanged. Two, while our expected 2004 enrollment gains are being reduced on an organic basis, they still are significant given our second-quarter Ochsner acquisition. Third, some moderation of hospital cost trends is offsetting our reduction in forecasted membership, and finally the reduction in our SG&A expense ratio remains in line with our expectation. Together these four factors allow us to reaffirm our guidance for 2004 commercial segment pretax earnings of approximately $140 million.

Turning next to the government segment, premium and administrative fees accounted for approximately 46 percent of the second quarter's consolidated premiums and administrative fees, increasing year-over-year by 18 percent to approximately $1.6 billion. Both MedicareAdvantage and TRICARE contributed to the increase. Looking first at MedicareAdvantage, premiums increased by 23 percent in the second quarter as compared to the same period a year ago totally $775 million. Second quarter premium yields for this line of business held firm in the 9 to 11 percent range. And we continue to forecast them to remain in that range for the full year of 2004.

Likewise, we expect full year 2004 MedicareAdvantage medical cost trends also will be in the same 9 to 11 percent range. Our MedicareAdvantage membership levels progressed well due largely to the acquisition of Ochsner increasing 14 percent over the prior years' quarter and 12 percent year-to-date. As was the case in last quarter and as Mike just mentioned, we expect MedicareAdvantage membership of 370,000 to 390,000 by the end of the year.

Moving on to TRICARE, as expected TRICARE premiums and administrative service fees increased 14 percent over the second-quarter of 2003 but declined sequentially by about 4 percent as the scheduled transition of certain of our members to other contractors began. Looking ahead to the rest of the year, we anticipate that third and fourth quarter TRICARE premiums and administrative fees of between $375 million and $445 million quarterly. The graph in this morning's webcast is intended to provide some directional perspective.

Let's next consider how the transition to the new South contract from the expiring contracts will affect the pattern and variability of TRICARE quarterly earnings in the second half of this year. While the change in our quarterly TRICARE premium dollars is important, it is equally important to understand how the change from the expiring TRICARE contracts to the new South contract will impact our fourth quarter year-over-year earnings comparison. In this morning's slide presentation we are providing greater granularity around the factors which affect our quarterly TRICARE profits under both the old and new contracts.

Looking first at the old contracts, at a high-level historically the TRICARE premium on the expiring contracts was paid to us on a straight line basis. This, combined with other factors described on the slide, resulted in our reporting of 40 to 50 percent of our full year TRICARE earnings each year in the fourth quarter. In 2003 that fourth quarter percentage was even higher because of the increase we received in the second half of the year for increased beneficiary counts as additional reserve forces were activated. In contrast, our premiums for the new South contract will correspond to claims activity each quarter. This will reduce the variability of earnings from quarter to quarter. The combined effect of these two factors is that both are TRICARE and consolidated earnings comparisons for the fourth quarter of 2004 will be unfavorable year-over-year.

This was neither a surprise nor a change in forecast since our annual earnings guidance and expected TRICARE pretax margins had previously taken all of this into account. Our 2004 guidance for pretax TRICARE margin of between 2 and 3 percent is in line with TRICARE's performance for 2003.

Finally, with all the changes in TRICARE it's reasonable to ask about our ability to manage administrative costs through all these changes. There are three important points to remember. First, all of our TRICARE back office claims operations are outsourced to Blue Cross and Blue Shield of South Carolina. These services are based on a per claim processing fee. Plus as our membership adjusts up or down, so do the claims. And in turn the claims processing fees.

Second, you will receive reimbursement to our fixed administrative overhead costs beginning on the first day of the new South contract which is this Sunday. And finally as part of the transition we've reached an agreement with HealthNet member whereby they assume certain facilities and other assets from us on July first in reaches 2 and 5; we will assume similar assets from them in region 6 on November first. In addition to being a prudent approach for both companies, more importantly this agreement ensures high levels of service to TRICARE beneficiaries in both the North and South regions during the contract transitions.

Overall government segment MER improved year-over-year by 90 basis points to 84.2 percent. This improvement was due to the improvements in our TRICARE operations where we experienced moderating medical cost trends under the expiring contracts for the first half of 2004. Also as discussed above, we experienced a higher than normal TRICARE medical expense ratio in the first half of last year as military operations abroad increased our claims. Our government segment SG&A ratio improved 40 basis points year-over-year as the combination of growth in premiums and ASO fees outpaced administrative expense trends in each of our government business lines.

Now looking at our consolidated results, consolidated revenues of $3.4 billion in the second quarter increased just over 13 percent compared to the second quarter of 2003 revenues of $3 billion. This increase was driven by higher TRICARE revenues and additional reimbursement associated with the Medicare Modernization Act both as discussed above. Also as discussed above, our consolidated medical expense ratio increased 50 basis points year-over-year as planned primarily due to the increase in our commercial segment medical expense ratio. Similarly, the consolidated SG&A ratio declined 60 points year-over-year as premium and administrative fee growth outpaced administrative expense trends in all of our business lines. We've worked effectively to control all of our fixed discretionary administrative expenses year-over-year.

Other than for TRICARE, for which we are reimbursed, the increases we have experienced in total administrative expenses are associated with the Ochsner acquisition, greater ASO membership commissions and premium taxes. I.e. and all associated with revenue increases. Based on the foregoing, we are pleased to report a 20 basis point improvement in the consolidated pretax margin to 3.6 percent. This is the highest reported pretax margin in the past five years.

Turning briefly to the balance sheet, there are three items of note. First, we are pleased that we continue to have over 50 percent of our total assets in liquid assets as measured by the sum of cash plus investment securities as a percent of total assets. Second, our debt to total capitalization ratio improved by 70 basis points in the quarter and is now 24.6 percent. Our claims reserves continue to be booked last week, using the same conservative methodology as always which means that the results reported for the quarter do not include the benefit of any prior period reserve developments.

Our days in claims payable including the $71 million in reserves we acquired from Ochsner in the first day of the quarter remained flat with the prior quarter end at 47.4 days. Finally, we are continuing our 2004 full year cash flow from operations guidance of $475 to $525 million. While our 2004 second-quarter and six-month cash flow from operations trailed the comparable amounts in 2003, we continue to anticipate collection activity in the second half of the year, which will allow us to be comfortable in this range of operating cash flow guidance for the year.

In particular, we are anticipating the collection of a $100 million TRICARE bid price adjustment receivable during the third quarter. Last year in 2003 a similar receivable amount was collected in the second quarter. Finally, I like to take this opportunity to invite the analysts on today's call to our 2004 Investor Day which will be held in New York City on Thursday, December second. We will be webcasting the entire event so the investing public and the media will also have access to the full agenda presentations that day. We enjoy sharing the Humana story with the investment community and I am particularly pleased with today's reported results for the second quarter.

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

Josh Raskin.

Good morning and congratulations. Two questions for 2005. I guess what is the impetus for the second year rate guarantee on some of the Smart suite products? Help us understand how you have confidence, and I understand 9.9 is above what you are seeing in terms of cost trends currently in that book, but obviously we don't really have great sense I don't believe and to see that in 2005 cost trends. And also if you could talk a little bit more about the enrollment period for 1/1/05. It sounds like the percentage of products is expected to double to 10 percent. Maybe a couple of anecdotes about clients that have signed up or just bids that are out there, just some metrics that would help there as well.

First on the second year rate guarantee, this industry does have a history of multiyear rate guarantees not being a good thing. And we are cognizant of that. However, we are in such a unique position with this offering that we have, that we feel pretty confident about where we are going. In order for it to work, an employer has to sort of meet us halfway in terms of what they have to do different relative to their relationship with their employees, their benefits. And what we are offering up requires a little more work than they used to have to do, as long as they treated this as a commodity and just bid it, spread sheeted it, wasn't a whole lot to do and you picked the winner and that was it.

What we are saying to employers inside of all these Smart products is you have to be more thoughtful and you have to get your people to be more thoughtful, and you have to apply the various technologies and the enrollment processes, use the information, connect to the email system. So there's a number of requirements for them to actually be able to take advantage of that second year rate guarantee. But the kind of things that we know if we do, we have absolute confidence that the results will be well under what we are willing to guarantee.

As a matter-of-fact, inside of the Smart book we have today, it's about 250,000 members, something like that, we can see difference in performance in terms of how some of those companies apply the principles. So we know that when -- in football terminology I call it run the play -- I tell these employers if you run the play, I can show you how to get your cost trend down to 5. If you don't want to run the play then I am not going to talk to you about your second year, so that is how we get comfortable around that.

So, just (indiscernible) but it sounds like there are some significant requirements that the employer has to meet as well, similar to maybe on the ASO side where you guys guarantee fees, whether it is service metrics, et cetera. It sounds like this is not just as easy as though you got a 10 percent cap if you buy this product.

Absolutely not, I will give you a couple of examples. They have to do electronic enrollment. They have to use the wizard for selection purposes. They have to be willing to communicate through our entire communication package, everything all during the year. It all -- its not a onetime event, so there's about 8 things that are truly behavior changes on behalf of the employer that gives us the confidence that when they will do those things, then met us halfway and we are all going to win. It is not just throwing a rate out there because I think frankly that would be stupid. Relative to January first and I am not going to give you too much at this point, I can sell you we have a couple of pretty sizable accounts that have actually gone all the way and are going to use all of our Smart technologies.

One of them is a big self-funded account, but we will get more to you on that probably in the third quarter. But I think there is a fair number of people out there that wonder whether this consumer stuff really matters. I would suggest that it does, and I think that we're going to see some interesting uptick over the next 24 months in this space.

One last quick question for Jim, can you give us a split of earnings between commercial and government?

In the press release, we've done that for the year-to-day.

Okay. And in the quarter, just back out what you had the first quarter?

Yes, they are in there.

Thanks.

Charles Boorady of Smith Barney.

A couple questions. First, that large account that you mentioned your earning upwards of 30 million less in '04 than in '03; then you talked about your assessment of it to date and what is expected a little bit going forward. As you look at it today is it still marginally profitable, meaning is it at least covering the cost of running it?

No.

Okay, so you are basically losing money even taking into account the overhead that is being covered so that marginal loss on it. So if you dropped an account next year, your profits go up?

That would be correct.

And the Medicare business if you exclude the acquisition, how fast is that growing on an organic basis? Do you have a monthly net gain run rate? Because your guidance for the full year, the low-end of your guidance for the full year seemed pretty close to where you are right now.

We did grow organically for the fourth consecutive quarter without regard to Ochsner, but Ochsner was the most of it. It kind of comes -- it doesn't really come at a monthly run rate, but we are continuing really to -- we've improved our benefits, which include better pharmacy, better lower-cost doctor visits et cetera, and that is basically what is helping people move along in the program.

So what is an organic number; what was the change in the quarter excluding the Ochsner acquisition?

It was about 1500.

Is that accelerating from month to month, or like you said it's kind of choppy?

It is kind of choppy, it is less than -- remember I just said, we are up four quarters, it was the second most -- I think it was the second greatest one. The first quarter was I believe around 4800.

In terms of the guidance just looking at your third-quarter guidance and then your full year guidance implies a pretty big drop in the fourth quarter. I apologize if you already walked through the explanation, but can you hit the couple main reasons why the 4Q would be declining year-over-year and sequentially?

Basically the main explanation is around the TRICARE, and we spent a fair amount of time, if you go back through the slides you get lots of granularity there. But basically what I was saying was the fourth quarter every year is a big year, is before we go to 40 to 50 percent or our TRICARE earnings. Last year was even bigger because of the increase in beneficiary counts due to the Iraq war. And so we have now when we get to the fourth quarter this year we will be pretty much transitioned to the new contracts where our revenues in our slides, and if you did not get a chance, basically will decline. And therefore the comparison will be somewhat unfavorable.

What assumption does that make about what's going on in Iraq? Does that assume we just stop sending new people over or that we bring some back?

It is sort of status quo.

Okay, and the last question I have is on the free cash at the parent corp and what you expect in terms of your ability to dividend up to the parent or any needs to push down into subsidiaries, any cash for the full year '04.

I think we've pretty much looked at that. We've got, as you can see from the cash flow from operations guidance where all the cash originates, we are maintaining that guidance. Again, we are looking for a sizable TRICARE bid price adjustment in the third quarter, which we received in the second quarter last year. That's why the quarter and the year to date are slightly unfavorable. But we think that in terms of what's going to be required at each of the subsidiaries and moved up to the parent company shouldn't be less than last year.

Can you remind me of that number?

Was 399.

So should be at least 399 dividended into the parent and (multiple speakers).

That would be the year end cash balance at the parent company.

Okay, so you expect the balance to be the same -- at least as high this year, and the net that would be dividended from the subsidiaries?

That would suggest that there's no change from last year.

And you planned uses for it, share repurchase, acquisitions?

We've done basically both of those this year as well as our continued Capex. We purchased Ochsner. We have some contingency payments that we need to make in the rest, in the remainder of the year based on how certain things turn out, and then we have done Capex this year so far up 48. That's why we slightly increased our Capex guidance because that was against 42 at this time last year. And we've repurchased $48 million worth of stock.

Christine Arnold for Morgan Stanley.

First can you give us the same story yield excluding the impact of the business mix on the individual and commercial?

Basically what we said is one of the reasons that the premium yield on the medical cost trend got a half a point closer together was because of the individual but we don't break out the differences within our different lines within the commercial segment.

Where there any prior period developments related to your commercial business this quarter?

Again, there were no prior period developments that affected our earnings.

So you are saying the prior period developments positive for TRICARE non-TRICARE were fully replaced with new prior period developments?

That's correct.

Okay, and I am sorry I don't have access to the slides because it's blocked. How much SG&A do you think you can reduce associated with the reduction in TRICARE revenue? You talked about the factors. Could you quantify them for us?

The factors will get us into the point where we will have our pretax margin will be in the same range as it was last year. And what I was trying to say in those things was basically we have a highly variable cost structure with membership first on claims processing so if the claims aren't there then the expense isn't there. And then we get, beginning this Sunday when we switch to the new contract for the South region, we get an immediate payment of our fixed administrative overhead, or I can call it contemporaneous payment, pay-as-you-go. And then the last thing like I said is we've made a good switch with healthcare (ph) having them on both ends of the transaction, acquiring from them in November and transferring to them last month.

And then the 75,000 members from two government accounts that are gone, when do you lose them? Are they at risk or ASO?

They were at risk and they are lost during this quarter, some are already gone and some will leave later on.

The third quarter?

Yes.

Okay, and where they loss accounts, breakeven or profitable?

We were unsatisfied with the profitability, so we basically decided that we weren't going to renew them. It goes back to that pricing diligence that we talked about.

I understand that. Where they actually losing money?

We do not generally say about individual accounts. We talked about that one very large one, but again, there was a point where we got to where the MERs and the administrative load that went with them no longer made it feasible for us to continue to serve them.

It's not just were they losing money today? It is where you assume to be your trend into the next year, and can you get the trend and the margin you're looking for. So it's possible they could be conributing something around here in the short-term, but you do not want to get caught with them for another year when you know the cost trends are going to outstrip what they are willing to pay you.

If somebody is willing to take it, you let them (multiple speakers).

Maybe somebody else has got a different pricing strategy or they don't understand their line costs, I do not know why they do what they do but we look forward when we are pricing, not (multiple speakers).

And this 75,000 members does not include that one big account you're having issues with this year because that's an '05 renewal, correct?

No, correct.

Thank you.

Joe France of Banc of America Securities.

Two questions, one relates to the large government account that has been causing you problems; my understanding is that it's going to be reworked or you will just walk away from the account. Can you talk about the negotiation that is going on in that account right now?

Well, right now because it is going on it would not be good for us to do that but I think Mike mentioned all three alternatives you can get. You could have full replacement, fully insured at acceptable rates. You could have self-funded at acceptable rates or you could not have the account; until those are all part of our strategy at looking at that account but negotiations are going on are kind of contemporaneous with this conversation.

Can you give us some idea of which I realize there on negotiations so maybe this is a circular discussion -- but to what point we should expect that you would have an idea one way or the other what is going to happen?

We should definitely know by next call, we will probably know before then.

Great. The second related to pricing pressures generally that you discussed. Which markets and products primarily are you talking about?

That's in the smaller end, that's in the small group and it is in the smaller end of the midmarket. It is -- I wouldn't -- I use the word spotty because it is not everywhere, and it's not all companies, but we've seen some real aggression from one or two players in several markets. It's wide enough that I think there I is something going on here. But it is focused on a couple of companies.

Finally, the negotiations with Ochsner the tenant hospitals, is that effective immediately, or is that next year, or the hospitals that you dropped in the newer (indiscernible).

It's effective now. We continue to having discussions with them. It is not real material to that business down there so the outcome of that is interesting but not real important to us.

Matthew Borsch of Goldman Sachs.

A couple of quick questions to make sure I'm looking at the numbers right. Am I correct commercial enrollment declined by 44,000 on the same-store basis during the quarter?

That would be close, yes.

Okay, and in terms of your earnings outlook for the second half, when I was looking at it compared to your prior guidance, the high end of your range previously implied 85 cents of earnings for the back half. And when I look at it now it looks like if I add back 4 cents in accelerated depreciation like it's 80 cents, and I'm just trying to square that with your comments earlier that nothing had changed in your outlook for the progression of earnings through the year.

I am not sure we said that. Obviously the difference is the enrollment, and the first part of your question was really targeted at that because the enrollment declines that we are forecasting now will be with us in the third and fourth quarter. So that would cause some change to the earnings progression. The main thing that is going to change the earnings progression again comes back to what I said about TRICARE, what Mike said also.

Got it. And on a different topic, the jury is still out on this, but there appears to be some slowdown in the rate of benefit buydowns that employers are taking for 2005. How do you square that trend with building the momentum for Smart suite products and I realize that Smart suite goes well beyond just benefit buydowns, but are you seeing some -- are you seeing any sort of renewal of complacency by employers with respect to the cost of health care?

Absolutely. And if I look at that though over any extended period of time, in fact it doesn't really -- if you talk to an employer and I do all the time, and ask them how do you feel about a 10 percent cost trend as opposed to 15, they say well, that's nice and it's better, but 10 is still killing me. So I think that this issue of are they taking a breather here, are they kind of holding their breath relative to where things are going? Are some of the pricing things I talked about keeping them in place? Absolutely. But from the standpoint of our Company and the strategy of it, that is interesting. And I'm going to have to work through that.

But the big picture has not changed, and the underlying trends are pretty significant. They are way beyond what an employer can handle under any scenario we are currently talking about as an industry group, and so nothing has really changed. Has the pain slowed up a little bit? Yes. But the smart employers are looking to the future, and they know that they been through this before. All of us have that have been around have been through this before. They know trend will come streaming back because there is nothing from a structural perspective that is changing anything. And so the drivers of cost trend are still there, and are going to continue to beat on what the premiums look like for these people. And so the smart ones are looking ahead. So do we continue to sell Smart products? Yes. And who is buying it? Those that are looking beyond the next 12 months because it is a multiyear approach to solving their problem, it is not a onetime silver bullet.

Last question if I could, I know another analyst was asking about this previously, but could you just highlight a couple of states where you think the competition is particularly intense just to help us understand this? I realize its widespread, but are there a couple of states you can point to where its most intense?

It's been significant in Illinois and Texas.

Thank you.

Eric Veiel of Wachovia Securities.

Just to make sure I understand the quarter's events, it looks like if we balance out a couple of things that you said, Jim, at the beginning that the increase in guidance for the year is really just the 3 cents of overage from TRICARE for this quarter. Am I thinking about that correctly?

I think it's better said that the amount that the guidance has changed 3 cents on the bottom, 2 on the top is a combination of the lower forecasted medical membership, which is a negative and the positive which is the moderation in medical cost trends on the commercial side.

Okay. So I guess what I interpreted was that those two things sort of wash each other out and the guidance for the full year goes up, but the only thing that is left which is the amount that you beat by this quarter as you net out all the other things which would have been TRICARE.

No. Actually the moderation and trend beats out the decline in.

In membership?

Yes.

To help us sort through the noise on TRICARE can you give us a view as the 2005 premiums and fees and sort of how that will look quarterly so we can try and get past this bump in the road here? If that is the best way to describe it and think about what we're looking at next year and the year after maybe.

We describe it as a transition so we knew it was coming all along so we're working very hard to do that. The biggest thing I think is if you go back and look at those slides, I know we gave you a lot -- I did not want to read it all to you because it was long as it was. But if you go back and look at those slides, you see a of couple things. First thing is that the premium under the new contract is going to be, is going to vary with claims as opposed to being sort of an equal amount each month. And so that will have the biggest effect on cutting down on the variability or profitability if you think about it. And then basically going through these different membership changes and then finally coming down to rest on what the membership will be, that's kind of what makes us -- what precludes us from saying this is what we think the revenue itself will be next year, but we are saying that the variability will be less. And I think that will probably be welcomed by everybody on both sides of the call today.

Let me try to say that a little bit differently. At the end of the day I am so pleased to be getting into this new contractual relationship under this arrangement, because one of the things that it does it takes out the incredible variability from quarter to quarter because of the way the business was run before. So I think the things you need to look to are what are we saying about the annual revenue, what are we saying about the annual margin? And you can count on it being much more ratable by quarter than you ever have seen in the past.

So in response to that Mike, I am trying to get a sense of what am I looking at in terms of annual revenue.

We said for this year it would be 2.

Right, but for next year when we are on the better contract, it is less variable.

We haven't said but it is less variable.

All right. So I understand why it's better, but I guess I am having trouble figuring out how you guys are budgeting for it. Other than the volatility being better.

Well, the revenue is very hard to predict now because if you think about what's going on in the Middle East with the reserve call ups, how is that going to go. So I was not trying to be facetious I was just really trying to say what we know about this year is it's going to be 2 billion. If things stay along the same rate we said that we would be from 375 to 475 to 45 (ph) in each of the next two quarters. Then there will be, we will go to the next year when the transition will be over but then all those other variables will come into play; the governmental will, the Department of Justice will look at what the claims activity was. That will have an impact on what the premium is. They will look at what the deployments of the troops are and those will have an impact. So it makes it very difficult for us to say now what it would be.

Here is the way I think about it, Eric, I am not going to get into the business of trying to predict the implications of war. What I know today is that we've got about a $2 billion book of business here. If nothing was to change it would be in the same general area next year, but we don't know what's going to change or what is going to happen with enrollment and this sort of thing. So we said that the margin runs between 2 and 4, we fully expect that next year. As we sit here today that's what we have to tell you because we don't know what's going to happen in Iraq or anywhere else on this planet. And basically at this point the real take away is that it is a predictable business as we think about it at it's scale today. And the risk profile relative to the relationship here is very manageable and good and going forward it will have less of a swing in the implications to quarterly earnings. Beyond that, I do not know what else I can tell you.

I would say one more thing, too, just so that to make sure we are all on the same assumption set, based on all the factors I mentioned you rebase the premium every year. So that will cause a rebasing of the premium. So that is the other reason why we can't tell you what it is because we don't know ourselves, but we are highly confident we're going to return to those margin levels that we've had in the past.

Your point Mike, on the risk factors of the contract are better now. Is this more now of just a almost a fee-based contract with medical costs as a pass-through, or is there a way we should be thinking about the risk profile of this being different other than just the volatility on a quarterly basis?

It is still a mix but it's closer to being a fee-based relationship than it was in the old arrangement.

Okay, I will call you off line.

The slides talked about change orders and things like that, one against the other, too.

Okay.

Scott Fidel of J.P. Morgan.

Eric's questions on TRICARE actually answered most of mine, but just had one other question on Jim usually will walk through medical cost trends in the components relative to the overall 6 to 8 percent trend, wondering whether you can do that for the primary components.

Okay on the commercial side, and I try to do this in a (indiscernible) so I will make it real clear. On the hospital side there we did see some improvement, so we would rate that as sort of slightly higher than the aggregate trend. Positions are still better than the trend, and our RX is, of course, still higher than the trend. So, overall, looking at our new guidance, that is really -- the inpatient hospitalization, both utilization and unit cost trends, are the ones that really caused us to improve our outlook on medical cost trend for the year.

Okay, thank you.

Lee Cooperman (ph) of Omega Advisors.

This may be a little too complicated for this call or if you can have somebody call me, it would be fine. But despite the buyback, average shares are rising, and I kind of like stock repurchases when they're practiced by companies that have undervalued securities, but I also like it to result in reduction in shares outstanding. So if you'd discuss the moving parts that (indiscernible) this result, you know, dilutive shares in a capital structure, outstanding options, average (indiscernible) price, actual shares outstanding at June 30th.

And the question was asked, but I didn't get the specifics, the financial condition of the holding company in terms of what amount of cash is available for either dividends and/or stock repurchase in '04 and '05? And lastly -- and I apologize for the length in this; this is a very important question to me -- how much thought has been put into the stock repurchase decision, and what view was the Company expecting? Merely desiring to offset option dilution, or is it making a statement about how it views the value of the security in the market? And I'm happy if someone wants to call me offline if that's better for you.

Actually, I'd like to at least start here. You might remember me from a previous life, but we won't go into that.

I hope it was a favorable memory on your part.

It was favorable for you and me.

Terrific. Let's talk offline on that one.

Anyway, we will. You've asked, obviously, a lot of questions. The first thing, the first one you asked was around the question of when we look year-over-year, you can see that the company in the first half of this year bought back $48 million worth of its stock, but the number of outstanding shares is higher. That's really all a factor of common stock equivalents. The average share price in the second quarter was about 40 percent higher than it was in the second quarter; 40 percent higher this year than it was last year. And that caused a couple million shares to come into that calculation of EPS.

The other thing that I would go to as a more general to answer the rest of your questions would be, we take share repurchase very seriously, but we look at it last. The first thing we do is we look around and say, what can we invest in that will increase the returns of the Company. And we need to have those returns that are in excess of the Company's cost to capital. This year we did one of those; we found one of those in our Louisiana plan called Ochsner and we bought that at the beginning of this second quarter the one that we just are reporting today.

Then when that situation is done we also -- because you alluded to the holding company -- we have I believe probably a dozen and a half operating subsidiaries that have capital requirements that they have to maintain for the State Departments of Insurance. So we go through a very systematic review of those at the end of the year, basically takes about 120 days, the first 120 days of the calendar year to do that and the appropriate levels are determined. And then dividends from those operating subsidiaries are sent up to the holding company. And earlier questions on the call were around the question of so what to you think about the holding company's liquidity? The holding company's liquidity at the end of last year was around 400 million, and it was very substantial improvement each year over the last three years.

So then we also have, because we have publicly traded debt, the third thing we do is we have to make share that the rating agencies which are basically the debtors issued by the holding company so they take a look at what the appropriate liquidity is at the holding company level. So once we get through those three things, what can we buy that exceeds the cost of capital and make the Company more money? What do the states require us to do, what should we, what kind of liquidity should we have at the holding company to keep the rating agencies happy?

Then we get to and the first one is also acquisitions but it's also Capex counts from that. Then we get to the issue of share repurchase. And then you ask well what kind of statement are we making when we buy back $48 million worth of our stock? Are we just trying to avoid dilution? Because of employee benefit plans, or are we saying something greater than that. My answer to that is when you do all those things and you have leftover cash, then there's an appropriate level of capital the Company needs to have. And if you have more than that, then you can repurchase your shares at advantageous prices.

And that's really what we've done if you look at the prices that we've purchased shares over the last 2.5 years you will see that we purchased quite a bit of our stock and we are proud of the fact and generally beat the ninety-day average and things like that. So we are obviously have to comply with 10B18 and all the other rules about doing that. But to answer your question at the end of the day share repurchase is the last alternative to looking at what are the uses of cash that we can have while maintaining an appropriate level of capital for the business.

I guess you are making the determination the stock repurchase is preferable to paying a dividend. I assume if you thought your stock was overvalued you would be better off paying the cash dividend rather than buying back stock.

You could get to that but there is also one other hook in there, and that would be that the cash dividend -- and this is my personal opinion because it hasn't been discussed by our Board -- but the cash dividend of course then presents an obligation that becomes really a fixed obligation, whereas the share repurchase -- and again when we look at the things that will be affected by share repurchase -- gets us to a position where that is not a requirement. We do have from time to time in the open market.

Let me ask you a question do you think if you got into a position where a modest dividend relative to your earnings became questionable that your stock repurchase in retrospect would have looked smart? In other words if it turned out -- right now 80 percent of the S&P 500 is paying a dividend and 100 percent of the Dow Jones companies are paying a dividend. So if you resorted to a normal dividend relative to your normalized earnings it turned out that that normal dividend whatever the payout ratio is 20, 30 percent of earnings turned out to be ill-advised, I assume that you would have been very embarrassed by all the stock you bought back because the price level of the stock would be a hell of a lot lower than you paid for it in the buyback. But let's do (multiple speakers).

We will talk later. (multiple speakers)

Who should I call?

Regina Nethery and she'll set up a time for the three of us to get together.

Terrific. Thank you, and good luck.

John Szabo from CIBC.

Good morning. Just a quick question on the hospital cost moderation. I'm sorry if I missed this, but what was really driving that?

Basically what we said was we had moderation in both utilization trends and on the inpatient side, and on the inpatient unit cost trends, both of them of course are trends. This stuff never goes down.

Yes, but what was sort of the underlying reason for it?

I don't know that there's anyone. I wouldn't attribute it to any one single reason. We have continued to look all year at how to manage medical costs, which we're always doing. And we again seeing over a period of time why medical costs have been declining, so this is where we've come out.

One of the obvious ones is we do a lot of contracting work all the time and so we never really highlight that activity because it is sort of part of what we do. But we've had some good success over the last six to nine months, in actually the contracting space. So we've kind of held down and put a lid on some of the price increases that we've seen over the last few years.

And one other question on the MedicareAdvantage. Within those growth expectations for the year, is that essentially entirely consisting of growth in existing markets, or are you targeting some new geographies for expansion? And maybe you could just comment on the outlook over the next couple of years for funding in that program. That would be helpful.

We did do a couple of minor expansions back in January so we are getting some growth out of that, but in terms of the overall numbers for the year, it is largely organic growth and its whatever we picked up from Ochsner in that transaction. So we are continuing to invest and expand our sales capability. So we are not sitting back and just on cruise control here because we really think every Medicare member we add to this Company is a good thing. So you will see good progress in terms of both organic growth and expansions.

We, the map you saw probably had some new information for you if you saw where some of the stars were. We have been testing a lot of different things. We have fee for service Medicare programs in states where we don't do any other business. We are also looking at this point of very heavily what opportunities exist going forward under the new MedicareAdvantage rules and I am a believer that they are very significant. So we'll provide a lot more information about all this as we go forward. But we are going to continue to expand our Medicare business. We think it's a good business. We've had -- I've been beating this drum for a long time. It's a good business; we've done well. We are going to do well going into the future. We've got a significant infusion of both money and flexibility going forward to do different things. And I just find it remarkable, frankly, that so many people are skeptical about the PPO aspects of Medicare because it's the most popular form of health insurance in the United States is a PPO.

And so all of a sudden it's been encouraged and financed under this MedicareAdvantage bill. And so we're going to see where that makes sense to us, but I just think it would have -- I have always said it would be irresponsible from a business perspective to ignore the largest buyer of health services in the country. And so we will stay there, the demographics are working our way. The bill has come our way. We have a lot of experience. There's a lot of what we do in the consumer space that absolutely applies to the folks that are over 65. You don't turn your brain off when you get to be 65 years old, so we think there is an opportunity there to actually differentiate ourselves. So if I look at 2005 in Medicare I am very encouraged; if I look at 2006 I am even more excited about it. So we are very, very interested and the good part is the synergies we get from all the work and investment we've made around all the consumer stuff applies to Medicare as well as the commercial space.

So that you would hold regardless of the outcome of your election?

I do not lose one minute sleep about that. I think that it took an awful lot to get that prescription bill passed, and unwinding that despite all the rhetoric you're going to hear I think it's just not doable. But we will see. Politics are politics, but at the end of day I think singers in this country have been given a Medicare drug benefit for the first time. A Foundation has now been put under the traditional Medicare HMO, which basically reconnects it to some level of proper appreciation on revenues, and this whole avenue has been opened up relative to taking the products that the rest of the world uses to the segment. So I just thing going out and making a case -- that all of that should be unwound or materially changed is going to be just a little difficult politically. So I think this horse is out of the barn. I think the inertia and momentum on it is very significant. And so I think we are positioned well to take advantage of it.

Thanks very much. Congratulations.

I would now like to turn the call back over to Mr. McAllister.

Okay, why don't we just summarize by first thanking everybody that joined us this morning. I think 2004 is turning into an interesting story for Humana. I would like to remind everybody despite what you may have heard relative to some of these accounts we are actually growing our commercial earnings in 2004 over what we had in 2003. We are managing quite effectively through the TRICARE transition. We told you we would and we are. We've renewed our Puerto Rico contract for our Medicaid business this summer. We get continued strength coming from Medicare. We are absolutely leading this consumer wave, and we are pretty confident that it is the right direction for the business. Cash flow is strong again, and we are rapidly and successfully assimilating the Ochsner acquisition. If we look at 2005 I see Medicare upside which I just talked about. The consumer space I think continues to evolve, and I think the players in the space that are working in the consumer space are going to start separating from the pack.

The transfer will be over on TRICARE, so we'll be back to a good steady-state there. And we got nice opportunities on the commercial business in a number of ways, one is not having a couple of these accounts that are dragging us down this year but more importantly on going forward we have a lot of opportunities on doing things differently and taking a different premise to the marketplace.

Lastly I want to thank all the Humana people that are on the call for making this quarter possible, and I look forward to great success as we go forward. So thank you very much for being with us today.

This concludes today's teleconference. You may now disconnect.