Humana Inc (HUM) 2004 Q3 法說會逐字稿

Good morning. My name is Matthew and I will be your conference facilitator. At this time, I would like to welcome to everyone to Humana's third-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. (OPERATOR INSTRUCTIONS) I would now like to turn the call over to Ms. Regina Nethery, Vice President of Investor Relations.

Thank you. Good morning, everyone, and thank you for joining us. During this morning's call, Mike McCallister, our CEO, and Jim Bloem, our CFO, will be discussing Humana's third-quarter 2004 performance, as well as our latest forecasts for future earnings performance. At the conclusion of our prepared remarks, we will open up the line so that industry analysts may ask questions of our management team. We encourage the investing public and media to listen into both the Company's commentary and the related Q&A with analysts.

This call is being recorded for replay purposes. That replay will be available on the Investor Relations page of our Company website later today. This call is also being simulcast via the Internet along with a virtual slide presentation. For those of you who may have company firewall issues and cannot access the live presentation, copies of today's slides have been posted to the Investor Relations section of our Company website.

Before we begin our discussion, I need to remind each of you of our cautionary statement. Certain of the matters discussed in this conference call are forward-looking and involve a number of 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, November 1, 2004, which, along with our historical earnings press releases, is available via our website. To the extent unusual items affect any period's earnings, those are described in detail in the corresponding press release.

Call participants are also advised to read Humana's Form 10-K for the year ended December 31, 2003, and our Form 10-Qs for the quarters ended March 31, 2004 and June 30, 2004, as file 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, or GAAP. Consequently, today's release includes a reconciliation from GAAP operating cash flows to the non-GAAP measure, as well as management's explanation for the use of non-GAAP metrics. Finally, please note that all references to earnings per share made during the course of this call represent diluted earnings per common share.

With that, I will turn the call over to our Chief Executive Officer, Mike McCallister.

Thank you and good morning. This morning, Humana reported another excellent quarter. Earnings per share rose 37 percent over the third quarter of 2003 to 52 cents. Earnings grew substantially over the prior year's quarter in both our segments, with the government segment increasing 32 percent and the commercial segment up by 49 percent.

A number of factors drove our results this quarter -- solid performance in our Medicare business, the impact of a more profitable commercial account portfolio, the continuation of a smooth transition to our new TRICARE contract, higher-than-expected TRICARE bid price adjustments, and our ongoing commitment to administrative cost discipline.

Today, we are increasing our guidance for 2004 earnings per share. We now anticipate earnings of between $1.66 and $1.69 per share this year, equating to an increase of between 18 and 20 percent over 2003's EPS of $1.41. Moving into 2005, we are projecting earnings per share in the range of $1.90 to $1.95 per share, consistent with our previous projections for a 15 percent increase, another record high year in our history as a health benefits company.

The diversification of our business lines and the steady contributions each makes to our earnings gives me confidence in our ability to achieve these increases. By strategically diversifying our businesses, we expand the opportunities for earnings growth, while simultaneously mitigating the risks associated with any one particular line of business.

From a commercial perspective, our innovative consumer products are broadening horizons for employers, providing them with new options that engage their employees while expanding the choices offered to each individual. Last month, we expanded our SmartPlan offerings to include SmartExpress, a product designed to specifically offer the small employer the advantages normally available only to large companies. Consumer guidance tools like Maximizer Benefit, which suggests lower-cost drug alternatives to SmartExpress members, enable these plans to give small employers, for the first time, a real solution to their health cost dilemma, thus bringing a new dynamic to the competitive 3 to 300 life space.

Medical cost trends for our SmartSuite products continue to average in the mid single digits, with the most recent results at 5.3 percent. We now have more than 110 groups with enough claims history to evaluate -- clearly, the richest set of data in our sector. SmartPlan sales for 2005 are going very well, and we currently anticipate adding approximately 100,000 Smart members in January, 2005, 80 percent of which are new customers.

We have amplified the diversification of our membership base, not only through our Smart products, but also by expanding in the ASO space, launching the individual product and broadening our participation in MedicareAdvantage. While we expect our Smart products will become a driver of growth in the years ahead, we are enhancing the products that compromise (ph) the bulk of our commercial portfolio today by applying our consumer innovation across all lines of our business. We are leading the consumer wave in health benefits as we continually expand our commitment to driving consumerism throughout this Company.

From the political campaigns this fall, it is clear that both parties are espousing what we have been saying for the past three to four years, the rise in health cost is unsustainable and consumer engagement is essential to controlling costs. Given the current health care climate in the U.S., more and more consumers are getting engaged in how they pay for their health care. Humana can and does work collaboratively with employers and their employees in keeping their health care costs as low as possible, while providing them with an improved health plan experience.

Turning to our government products, we are pleased that we have a significant piece of our portfolio that is not subject to the commercial pricing environment. Further, we continue to be well positioned for future opportunities with the largest purchaser of health care in the United States, the federal government. Not only do we do business with the government, we do it very well and have done so for many years, a statement I will expand upon fully in just a moment.

Now let's get back to a discussion of our segment operations, the related performance in the quarter and why each is well positioned for the future. First, our government segment. We are very enthusiastic about our Medicare-related opportunities and believe the future is bright for Medicare, regardless of which candidate wins tomorrow. Seniors like the private sector Medicare offerings and the Medicare Modernization Act was a result of a bipartisan effort. The changes to MedicareAdvantage, the new private market options, and the new prescription drug benefit all reflect the desires of America's senior population. Consequently, we think it is unlikely that Congress will either rescind the MMA or make major programmatic changes.

Remember that Humana has been a major participant in the Medicare program for approximately 20 years. In the last two decades, we have worked with virtually every combination of political parties in the White House and Congress, and we are confident we can continue to do so moving forward.

Our Medicare HMO program has been increasing its membership for several quarters now and we expect that to continue. However, we have a much broader vision for MedicareAdvantage growth than just through the HMO product. We are also anticipating growth in the Medicare PPO space. Humana recently filed for local PPOs in a number of locations, primarily where we already have a strong foothold of either Medicare HMO and/or commercial membership.

Remember that while PPOs are the most popular form of health insurance in the United States today, the senior population has not been afforded the opportunity to participate in PPO options until now. We anticipate that this higher premium option with more flexibility than the HMO model allows will appeal to a different segment of the senior population. This corresponds to the demographics of the under-65 population that choose PPOs. We are still waiting for CMS to define the regional PPO territories, and we expect to participate at some level in that program as well.

A third Medicare option that has gone relatively unnoticed is our Private Fee for Service option. Through this product, we are entering new geographies and offering a privatized offering to seniors who previously had only a choice of standard Medicare or a Medicare supplement plan. The value we provide includes drug coverage and simplification of health care paperwork, and members maintain access to their same Medicare providers. We've recently expanded our Private Fee for Service participation into six new states and expect to see growth in this product in 2005.

Turning now to TRICARE. Today we complete the membership transition for our South region contract as we begin serving approximately one million new members in Texas, Oklahoma, Arkansas, and Louisiana. This takes TRICARE's membership to 2.8 million and Humana's total medical membership back to approximately 7 million. As we expected, the transition between the old and new TRICARE contracts has gone very well. TRICARE has been a great business for us for many years and we look forward to working with the Department of Defense for many more years ahead.

With respect to our commercial segment, as we discussed in our second quarter call, there were a number of moving pieces and parts during the third quarter which have begun to have a positive impact and which we expect will continue to positively impact future quarters. I will briefly address the status of both the large, unprofitable account and expectations for 2005 membership, given both this movement and the current competitive environment.

Let's begin with the results of the bidding process for the 89,000 member money-losing account. As we shared with you last quarter, we priced our bid for 2005 in line with our 2004 claims experience and our corresponding medical cost expectations for the coming year. We were determined that if we retained this account, it would meet our objectives for financial performance. The customer has chosen not to renew its contract with Humana for 2005, and so we move on.

As for our 2005 membership expectations, we are projecting slightly higher commercial medical membership in 2005, excluding the lapse of this significantly sized account. As we looked at 2005, we assumed status quo for the competitive environment that exists today.

We've spoken in the past about our position that the pricing market is tight, and this trend appears to be holding steady -- not getting better, not getting worse. The fact that we have experienced significant growth in the self-funded space tells us that our cost structure is competitive, as all the call structure cards on the table, so to speak, during the self-funded bidding process. Thus, as long as the pricing environment remains somewhat rational, we can grow. Looking down the road, we foresee a commercial mix comprised predominantly of individual business, full replacement insured business in a smaller and midsize group space, and self-funded larger groups.

So how does all this translate into our earnings expectations for the commercial segment for 2005? We expect a combination of the beneficial effect of the lapse of the 89,000 member account to more than offset a lower average membership base, given the competitive environment I've just described. We believe that should translate to growth in our commercial segment of earnings of 10 to 15 percent next year.

Now I would like to spend a moment on an area where our consumer strategy meets clinical innovation, our unique Personal Nurse program. Unlike similar nurse help programs in other companies, we've differentiated Personal Nurse in two crucial ways. First, we use next-generation predictive modeling techniques to identify the often-ignored pre-sick population more accurately than anyone else, people who are apparently healthy, but actually measurably at risk for serious medical interventions. And then we effectively guide those members to change their behavior, reducing episodes of care.

Personal Nurses develop one-on-one relationships with identified members through regular phone and Internet communications. Our studies of consumer psychology have led us to develop a proprietary model of interaction in which, over time, a member's Personal Nurse is able to identify and build on moment of motivation that result in permanent, positive major change, yielding better health for at-risk individuals and lower cost for the companies that employ them.

Before summarizing this quarter's results, let the briefly mention the investigation concerning sales commissions and incentives, which have received significant media attention of late. We have reviewed our policies and practices and have found nothing to (indiscernible) our use of brokers as part of our sales distribution channel mirrors industry norms, as does the payment of some incentives or overrides based on sales activity. Such payments represent less than one-half of one percent of our commercial premium revenue and less than one quarter of one percent of our total Company premium. We have not been subpoenaed on these matters.

If any of our regulators or other government entities look into these industry practices, we intend to fully cooperate with them. In addition, press reports have indicated that the National Association of Insurance Commissioners is in the process of coming up with some recommendations in this area of the industry practice, which we will immediately review.

In closing, let me highlight five points of differentiation between Humana and our competitors. First, we have the longest experience with the Medicare program of any of our peers, a record of success that goes back two decades. We have thrived in this program regardless of who is in the White House or which party controls Congress.

Second, we are leading in the growing consumer space, and have the most robust evidence of anyone in our industry to show that our brand of consumer choice SmartPlans, when combined with the guidance processes that surrounds them, work uniquely well when it comes to significantly reducing trend.

Third, our approach to predictive modeling is ahead of the curve. By accurately identifying and then effectively intervening with the pre-sick, we've established a competitive advantage that makes a practical difference on both the cost and care side of the medical equation.

Fourth, with the rapid growth of our HumanaOne individual product, we are well positioned to take advantage of the increasing migration of small group business to individual. And finally, with membership evenly divided between government and commercial and further levels of diversification under that, no one can match the breadth or depth of our membership mix, producing varied growth opportunities while at the same time cushioning us from negative developments in individual segments or subsegments of our business.

With that, I will turn the call over to Jim Bloem for a discussion of the financials.

Thanks, Mike, and good morning, everyone. We are pleased with our 2004 third-quarter earnings results of 52 cents per share, and recognize that these results were 8 cents per share higher than our previous guidance. Let's begin by reviewing what changed since last quarter's call.

In our second-quarter call on July 26, we forecasted a third-quarter earnings per share range of 43 to 44 cents. Since then, two positive items resulted in Humana exceeding third-quarter expectations. First, we received higher-than-expected Medicare premium, which better reflects the risk profile of our membership base. Our well-established processes for helping ensure providers submit all relevant Medicare utilization data to CMS was a key factor in receiving this higher revenue. The net effect of this higher revenue represents the majority of the 8-cent difference.

Second, certain TRICARE bid price adjustment discussions were concluded in the third quarter. The related revenue came in higher than we previously had forecast, resulting in the remainder of the upside performance.

In view of the unfolding opportunities in the new Medicare programs, which Mike described, our management team has decided to increase fourth-quarter investment spending for marketing and related sales support expenses as we expand our Medicare geographic presence. This fourth-quarter investment spending will offset much of the earned upside in the third quarter.

The effect of these three changes enables us to raise our 2004 full-year earnings per share guidance to a range of $1.66 to $1.69 cents per share. Our (technical difficulty) group. Year-to-date through September, consolidated pretax margin is 80 basis points higher than for all of 2003, despite both a tough commercial pricing environment and the adverse effect of the large unprofitable account we have discussed all year.

Turning to revenues, on a consolidated basis, our revenues increased just over 2 percent during the third quarter compared to last year's third quarter. This modest increase reflects lower TRICARE revenues associated with the transition period to the new contract. On a year-to-date basis, 2004 consolidated revenues increased 9 percent.

Looking next at the commercial segment, our adherence to strict underwriting and pricing discipline has resulted in this segment's earnings continuing to grow. This adherence has caused us to continuously refine the profitability versus membership trade-off throughout the past 12 months. As a result, third-quarter pretax commercial earnings rose 49 percent versus last year's third quarter, and this improvement was driven by the lapse of certain underperforming accounts with total membership of approximately 94,000.

Our mix of commercial members in the fully-insured accounts continues to lessen. Fully-insured membership was 69 percent of the total commercial book at the end of the third quarter versus 77 percent at the end of 2003. Thus, administrative services' only membership has grown from 23 to 31 percent of our total commercial membership during the last nine months. Additionally, the lower-risk individual product continues to comprise a greater portion of our fully-insured business and now accounts for over 5 percent of all of our risk-based members.

Our commercial medical expense ratio improved by 10 basis points year-over-year during the third quarter. The effect of the lapse of the previously described 94,000 members in underperforming accounts partially was offset by continuing losses associated with a large government entity account we have discussed throughout the year. We also continued to see slight moderation in medical cost trends during the quarter, primarily driven by both unit costs and utilization in the hospital inpatient category.

Full-year 2004 composite medical cost trend for our commercial business is forecast to be in the range of 6.5 to 8.5 percent. As in prior quarters, this includes our at-risk book of business. Our individual membership lowers the composite medical cost trend by approximately 200 basis points. Accordingly, the medical cost trend for our aggregate commercial group book is 8.5 to 10.5 percent. As for the specific components of our medical cost trend, the trend for inpatient and outpatient hospital combined continues to run higher than the overall average, as does pharmacy, while our physician cost trend remains lower than the overall trend.

Turning now to the government segment, third-quarter pretax earnings rose 32 percent compared to the prior year, with the previously described additional contributions from both our Medicare and TRICARE operations accounting for the improvement.

Our Medicare premium yield for the third quarter of 2004 was 12 to 14 percent, and includes the revenues from CMS related to the risk adjustment premiums I described a few moments ago. Consequently, this improved yield should taper off in the fourth quarter, leaving this Medicare yield for the full year in the previously forecasted 9 to 11 percent range.

Looking next at our TRICARE operations, the transition of membership associated with the new TRICARE contract continued to progress smoothly. As planned, we received monthly reimbursement for fixed administrative costs beginning on the August 1 start date of the contract. Bid price adjustment revenue in the quarter offset the negative impact of claims from both higher enrollment counts and lower military treatment facility usage than was assumed in our original bid. We expect that our underwriting margins will be adjusted to reflect these changes in circumstances when we rebase our option Period 2 premium effective April 1, 2005. Accordingly, we expect our TRICARE operations will have higher earnings in 2005.

Further in 2005, we expect smoother quarter-to-quarter TRICARE margins under the terms of the new contract. This will continue to improve the increasing stability of quarterly TRICARE earnings that we've experienced over the last two years.

The 240 basis point improvement in the 2004 third-quarter medical expense ratio for the government segment was again driven by both higher Medicare and TRICARE premiums. Remember that bid price adjustment revenue was recorded in the second quarter of 2003, compared to the third quarter of this year.

Our consolidated selling, general and administrative expense ratio of 14.5 percent for the first nine months of 2004 is 80 basis points lower than the comparable period in 2003. We do not expect this ratio to be significantly different when we report our full-year results.

Turning now to the balance sheet, we are pleased with both our overall liquidity and debt-to-total-book capitalization ratio. Our days and claims payable rose by more than 4 days sequentially during the quarter, but we would expect this figure to drop back down in the fourth quarter, since 2.9 days of the increase primarily is due to the TRICARE contract transition. Simply stated, there still are some runoff claims associated with benefits covered under the old contract that have yet to be paid. As with all claims runoff, the effect is absorbed into reserves over time. As in prior quarters, a detailed analysis of our medical claims reserves is contained in the last three pages of this morning's press release.

Looking next at the effectiveness of our use of capital, our year-to-date return on invested capital now exceeds our weighted average cost of capital by 380 basis points, continuing an increase in the progress we have made over the last two years. Similarly, our return on average shareholders' equity also has continued to progress, moving to 16.1 percent for the nine months ended September 30, 2004, compared with 13.3 percent for the full year 2003.

Finally, as expected, cash flows from operations were particularly strong in the third quarter as we collected approximately 150 million in TRICARE bid price adjustment receivables. The collection of these receivables more than compensated for the negative impact of the August 1 TRICARE membership transition to the reimbursement model of the new contract.

We anticipate a similar member conversion negative cash flow impact to occur beginning today related to the one million members we are gaining as a complete the TRICARE contract transition. Thus, we expect 2004 non-GAAP cash flows from operations, as outlined in this morning's press release, to be in the range of 500 million to $550 million.

Also of note is the fact that for the first nine months of 2004, GAAP operating cash flows were 1.4 times net income and our standard non-GAAP operating cash flow measured 2.3 times net income. We continue to anticipate cash flows from operations will well exceed net income for the full year 2004, and we believe this is another objective measure of the quality of our reported results.

In summary, we had an outstanding quarter marked by significant continued financial progress and we look forward to the numerous opportunities which lie ahead. On a final note, we hope to see all analysts and portfolio managers at our Investment Day in New York City on December 2. This event also will be webcast at Humana.com. Now with that, we will open the lines for your questions.

(OPERATOR INSTRUCTIONS) Matthew Borsch with Goldman Sachs.

My first question relates to the outlook for commercial enrollment for next year. If you could just give us a sense -- any color on what you expect during the year. It looks like, based on your supply presentation, that you're looking for maybe 25,000 new members, excluding the large account attrition or the large account culling. How do you think that's going to shake out during the year? Is enrollment actually going to be down after January? Can you just comment on that?

We're, of course, still during the enrollment period. Right now, we are 60 days out from being done, and this industry has a history of everyone waiting around toward the last minute, so it's hard to really say. But we did say that if you take the 89,000 away, that we would be up slightly, and we would expect to show strong enrollment in terms of the types of members that we listed -- the lower-risk individual self-funded accounts -- in the January enrollment period.

There are two big things you need to think about, Matt. One of the story around Humana is becoming a story of mix more than just gross top-line membership, because at this point it is very clear that we have interest in segments; and so that's the first piece. Two is that we have no way to project what our competition may or may not do relative to their pricing strategies for next year, so we've taken a relatively conservative approach to it and said, all right, they are not going to change anything - and they have been reasonably aggressive. I've been outspoken about the fact that pricing has been pretty aggressive.

So until they change that behavior, it would be irresponsible, I think, to project a lot of earnings growth in the insured space where that plays out. That's why I included in my comments the idea of the self-funded space. Because the question ultimately has to be, can you be competitive or not. And if you have underlying cost in the network and administrative costs that are competitive, which does play out in its absolute purist form in the self-funded space, you have to wonder what would happen in the insured side. And at this point, I'm not willing to be too aggressive about assuming my competitors are going to act any differently. So that's where we are.

That seems reasonable. On the related question, which is what are you seeing in terms of the appetite for employers for self-funding versus fully insured? Are still seeing a continued shift gradually towards self-funding, and if you could also comment on the level of benefit buydowns that you expect for 2005 relative to how they came in this year.

I will take the first part and give the second to Jim. I think there is definitely a continued trend. It is not a big rush, but there is a trend toward self-self-funding, and the bigger they get, obviously the more inclined they are to do that. Around here, we always ask ourselves why would someone that has a big employee base be fully insured. And sometimes that has to do with the fact that they are just risk averse. But the fact is, they get more flexibility and they have more opportunity to work with their benefits if they're self-funded, and they do get some benefit around the cash flow implications of all that. So it is one of the -- in the process of underwriting and selling, when somebody really big comes in fully insured, you have to first ask, that seems odd and I wonder why.

Okay, got it.

And then looking at the level of buydowns. As you know the level of buydowns on large group are generally lower as a percentage of the gross premium and on small group, they're higher. And as we are migrating, as Mike said, to more fully insured, in our overall -- self-funded, when we look at our overall thing, we don't think that there will be a difference year-to-year that is measurable.

If I could just ask one last follow up here. Looks like you're looking at a strong outlook on Medicare and TRICARE for next year. Could just comment on the Medicaid contract in Puerto Rico and how that is running?

There is no change. It is a multi-year relationship and we do not anticipate any significant shifts down there, and we are not interested in Medicaid elsewhere. So it is a status quo story.

Great, thank you.

Josh Raskin with Lehman Brothers.

Good morning. Two questions. The first one relating to the commercial expectations for next year. I think you were sizing (ph) it sort of 10 to 15 percent growth, so let's call it 15 to 20 millionish range there. That I guess is a little bit surprising in light of the fact that there was a $30 million loss in one specific account that is going away next year. So should we think about the change there as a mix shift to the ASO, which is slightly less dollar profits but better margin, or are there competitive factors that I am seeing there? And I have a follow-up as well.

You're right about those things, but also we're projecting forward a pretty competitive price environment in the 3 to 300 space. So we think that is going to be a challenge segment for us, and so it is a combination of those things.

So that is where some of that membership reduction is coming in next year as well?

Yes. You don't just lose bad business. You also occasionally lose good business when price competition heats up. So we have some profitable business as we look at some of our segments and we look at what our competitors are doing, and we have to say to ourselves, barring some change in behavior, it is going to be challenged. So it's a net of everything -- growing ASO business which while has a higher margin, has lower real dollars in it -- so mix is overall combined with a pretty competitive pricing environment in the smaller end of the insured space.

Just a quick detail question. On the cash flow statement, it looked like there was another 45 or 50 million in cash paid for acquisitions. Is that additional runoff on Ochsner or what was that number for?

There was a contingency in the purchase price that resolved itself in the third quarter, and that is really with that is. And it all went to goodwill, as you have probably seen.

That was Ochsner?

Correct.

Okay, thanks.

Charles Boorady with Smith Barney.

The first question is just a quick one on depreciation and amortization. Are you still on track for the 4 cents added expense in third and fourth quarters related to the retirement of software?

Yes, two of that was in this quarter and two will be -- two was in the third, two more will be in this quarter.

Great. And then my next question for MedicareAdvantage, again, looking to '05. With the premium yields coming down next year versus this year, I just want to understand the expectations for the acceleration and enrollment growth in '05. And I know at least one part of it comes from what you mentioned in the press release, and in specific, the higher fourth-quarter '04 marketing expenses. Can you give us a rough range on that in terms of how much you expect to spend in the fourth quarter on marketing for MedicareAdvantage and how different that is from last year's fourth quarter, and then also what you would expect going forward annually in the fourth quarter for MedicareAdvantage marketing?

For this year's fourth quarter, we would expect to spend 10 million more than we did last year. And we would say that for next year, it is kind of hard to tell yet because you are going to get all the information that is going to come around, what the regions are going to be, both for the drug benefit and for the PPO. So it's hard to say going forward, but this is a time for us to -- as we've said, we have done more markets in Private Fee for Service. We're looking at the local PPO options and that has a February deadline on it, and we are continuing of course to invest in the growth of our HMO product as well.

Should we assume a lower med/loss ratio in MedicareAdvantage in '05 versus '04 in light of the premium yields coming down, of course offset by the faster customer growth on a bottom-line level? But is it reasonable to infer that your guidance would imply a higher med/loss ratio?

Actually, what we will do is we will contain look at the design of the benefits and look at the premium yield, which we have said is five to seven, and the medical cost, which is also five to seven. So we will continue to do our designing around those things. That is one of the reasons that the 20 years that Mike mentioned, that is really one of the things that we have become organizationally quite proficient in.

Last question and it is on the same topic. The 10 million additional in the fourth quarter versus previous year. Just the nature of MedicareAdvantage isn't an annual thing per se, right? So I'm curious, going forward in '05, is there also higher level of marketing spend or is it just a fourth-quarter '04 glitch and then you go back to your normal spend rate in '05 versus what you had in the first three quarters of this year?

I will take it. As Jim said, the new things relative to the regional PPOs and other things may change the game somewhere during the year. But as we sit here today, we're going to have a bit of a blip here in the fourth quarter and return to much more of a normal run rate for next year, barring new information relative to the new opportunities.

You probably have noticed we haven't said exactly where we're going to be in the PPO nor do we want to do that at this point for competitive reasons. But the fact is we're going to be taking Medicare PPOs into some places where we do not have Medicare business today. And the reason for the blip and the short-term nature of the ramp-up is to introduce ourselves to the senior population in a material way ahead of the PPO rolling out. So I think that is where we are with it.

I see. And in terms of definition of those markets, are you still waiting for a final determination on how the regions are going to be defined or any other information before you make that --?

Remember, you have two agendas; you have local PPOs and regional PPOs. Local PPOs, where we're going to be competitively will be determined earlier than it will be on the regional PPOs. What we're talking about is a ramp-up in the fourth quarter relative to roll-out of our local PPOs. We do not know what the regional PPO situational will look like until we get more granularity around the regulations and the definition of geography.

But the local ones you know everything you need to?

We're ready to go.

Okay, thanks.

Christina Arnold with Morgan Stanley.

A couple follow-ups. First, a follow-up on the commercial enrollment guidance. Last year entering the year, you added about 200,000 self-insured members, and if that happened again, it implies that you would have a really big January offset by enrollment declines on fully insured for the rest the year. Is that the right way to think about commercial earnings progression? And then I have a (indiscernible) question.

Remember now, the guidance for the full year is for modest increase. So you are going to see some pretty good sales numbers in the first of the year, primarily January. And I think it is reasonable then to expect a similar run of things as the year goes on. The smaller groups tend to be a little more ratable, and if in fact, the market looks like it has been going forward, then that is exactly what will happen.

Is 200,000 ASO members entering the year reasonable for first quarter?

We have not guided to that yet. We will let you know later.

All right. TRICARE. Can you help me with how TRICARE is going to look before April? It sounds like in April some of the issues with the military treatment facilities and there being more membership and potentially higher costs than you expected when you bid will get washed out. What about fourth quarter and first quarter? Will the bid price adjustments you will get then offset these issues or should we expect declining earnings in TRICARE and then they uptick? How do we think about that?

What we said was -- and again, I think it pays to go back and look at what we said last time, and we didn't want to make this so long it would take forever to go over it all. But if you look at the slides last time, Slide number 24, 25 and 26, we talked about premium and admin fees for the fourth quarter and we pretty much explained why the fourth quarter is going to be a lower quarter in terms of earnings and also cash flow.

Then when you go to the -- because basically, we are going to be still in a transition in this quarter and we still have the higher enrollment and the lower military treatment facility utilization. We think that early in the year of the new year, then we look for some more BPA activity. And then in the second quarter, we look for the rebasing that we talked about.

So fourth quarter, you're not expecting this higher BPA to increase TRICARE earnings in the fourth quarter the way it did in the third relative to expectations?

That is correct. And that is why I made that allusion to the stuff we talked about last time, because basically the whole explanation regarding earnings in the fourth quarter versus the fourth quarter year ago is TRICARE and it is this subject.

Okay. And then bid price adjustments in the first quarter will bring up first quarter relative to fourth quarter TRICARE earnings?

That is what we are expecting, yes.

Joseph France with Banc of America.

Thank you. Jim, if I could just follow up on your comment about the bid price adjustments and the rebasing in April. First of all, what was the amount of the total bid price adjustments that you received in the third quarter? And second, would you mind walking us through the math, what you mean about what happens over the next couple of quarters.

Okay, in the third quarter, the bid price adjustment was $150 million. Now, you have got to remember with bid price adjustments being $150 million is you always have risk share there, and you have 2 kinds of risk share. One if with the Department of Defense and the other is with subcontractors. So the 150 there is one of the reasons we had the very strong cash flow in the quarter, and again in the second quarter we talked all about how we expected that in the third quarter and it, in fact, happened. And that also helped earnings and cash flow.

Now, going into this quarter we don't expect the BPA lift, but we still have the higher enrollment and we still anticipate the lower military treatment facility utilization, and then we think that as we go into the first quarter, we will work that through with BPA, so that the first quarter before the rebasing starts at the beginning of the second quarter we'll have higher earnings for TRICARE in the first and second quarter, and again higher than their counterparts in the preceding year and also again more reflective of being totally transitioned onto the new contract.

Great, thank you. Just one quick follow-up; regarding the 94,000 lives that lapsed during the third quarter, you characterized them as being, I think, underperforming. How many accounts did that involve? Were they losing money and what was the MLR impact?

We call them underperforming because they don't meet our profitability objective. That doesn't mean that we lost money on every single one of them, but we are very careful in terms of the strict underwriting discipline and the pricing that we do in terms of what our objectives are for profitability. And that is the trade-off I alluded to before when I said we had been sort of doing this all year round. There are 4 or 5 of these kind of accounts that account for the 94,000 members. They are really spread throughout the country. They don't really have any one particular place, but they are the subject of the criteria that I mentioned with respect to profitability.

And the impact on MLR of those accounts going away?

I don't have a number that I could give you right off the top of my head, but again, looking at the fact that they are below our profitability targets, you know there will be a pickup if they are not here next year, which they won't be.

Thank you, Jim.

Eric Veiel with Wachovia.

Just a question on the timing of MedicareAdvantage growth from a membership perspective in 2005? Should we think about this, since there's a big push on the marketing side in the fourth quarter of '04, for an outsize gain in enrollment in 1Q '05, or do you think it's going to take a little longer for the investment and marketing to pay off during the course of the year?

It will take a little longer. There's not going to be a huge spike. We understand the senior population pretty well, and they don't respond real quickly to changes. But they are very thoughtful, and once they spend some time understanding what is available and the trade-offs of PPOs model versus HMO versus whatever premium we are going to charge, it takes them a while to get through that. So I think it will ramp up throughout the course of the year, but there won't be a spike at any point in time.

Great. And just to understand -- make sure I'm perfectly clear -- the whole notion of lower membership in the 3 to 30K is just strictly the more competitive pricing environment or is there something else there too?

That's it. We just seem to have competitors looking for marketshare.

Grade, thank you.

It is a tough segment for employers to keep paying the medical cost inflation.

(indiscernible)

First question just had to do -- I know there's been a couple question with TRICARE, but just given that this is pretty difficult to forecast with all the changes here, can you actually guide us to your expectations for revenue for TRICARE in '05?

Not at this time.

Okay, makes that easy. And then second question just has to do on -- you gave your overall outlook for commercial cost trend for next year. Can you just talk about whether you expect to see any changes in the components next year, and then also, specifically, how the hospital unit pricing contracting went for next year and whether you did see any improvements on that front.

I'll speak to the hospital pricing contracting. I would suggest there's no really news there. We have had some good success year recontracting with hospitals. We have not talked about it a lot because it is sort of what we do and I don't consider it to be news, frankly, But it has been pretty good. We've settled into a pretty steady state with most hospital contracts that are meaningful to us and we don't anticipate any major movement one way or another.

We look at hospital contracting and all contracting, frankly, from the standpoint of we just need to make sure we are competitive with other competitors in the market. No one is going to win in this business by outnegotiating someone else anymore. Those days are long behind us. So I think no real news to come from that.

As far as the components are concerned, we don't see a big change there either. Generally looking at the three components, they don't really move much as a total percentage -- as their respective percentage of the total health care cost, so we don't see a big change there as well.

Also on the pharmacy side, any thoughts on the impact with Vioxx going away, and it looks like there is still continued negative headlines coming out of that. And have you looked at -- what your thoughts on the removal of Vioxx and potentially other COX-2s could do for Rx trend next year?

We take them one at a time. And on September 30, when Merck withdrew Vioxx, obviously, as you've mentioned, there are other COX-2 inhibitors that people can go to. So again, we think that until there is new (ph) news on that, there really is not going to be a big -- there's not a big, discernible effect with respect to Vioxx alone.

Okay, thanks.

Ed Kroll with SG Cohen.

Good morning. I am trying to get the quarterly EPS trend clear for myself here. So the 8 cents that you beat consensus by in Q3, how much of that is recurring in Q4? Is it 0?

Generally speaking, yes, it's very little if it because of the fact that I said before the majority of it was Medicare. That Medicare piece has a residual maybe 1 cent or so that will go through each of the next four quarters. The TRICARE thing stood on its own. We are not expecting BPAs in the fourth quarter. So that one, basically you'd say there's very little carryover, is how I would characterize it -- 1 cent maybe out of 8.

Okay, so is it fair to say that the recurring quarterly number was 44 cents, then, in this quarter?

Well, because of the things I mentioned that are going to be quite unusual in the fourth quarter, starting with an unfavorable comparison, that is all TRICARE related, it is very hard to say that the stuff that is lying underneath is really changing. I think the way to look at it is that TRICARE is going to be quite a bit different in the fourth quarter, as we have said in the last call and today, and that is really what is going to cause the fourth quarter, in then we are going to be all set for '05.

Okay. So it looks to me like at least for Q4 of '04, TRICARE is not going to be as profitable as it was in Q3. And then how much is -- is that 10 million incremental Medicare marketing spend, was that pretax or after-tax?

It is pretax, and you are right about the TRICARE. TRICARE is a very big difference that explains basically the difference between last year's 41 and this year, what we're saying 23 to 26.

Okay. So it's just those two items then, the TRICARE and the incremental Medicare spend. But it sounds like the TRICARE is a much bigger factor.

That is correct and that is really the thing -- if you put the two calls together and what we have been saying is very consistent. The Medicare is the new thing today. The other thing was discussed last time and today.

Okay, thank you.

David Brinmeyer (ph) with Wells Capital Management.

I just want to understand a little bit how much you will change your share repurchase and your debt reduction over the next -- with the additional cash flows?

Okay, in share repurchase, we been given $100 million authorization, of which we have spent about 64 and there's about 36 left. It is dollar-denominated, and we used it as the last thing in the following three other things. First of all, we always make sure our liquidity is up-to-date. And as I mentioned, 56 percent now total assets is our overall liquidity in terms of cash and investment securities. And then we look at what the DOIs and the debt rating agencies look for, and that one of the things that they will be concentrating on as we move toward the end of the year.

We have also really signaled today that cash flow for the fourth quarter is not going to be very robust compared to what it has been the first three quarters. Again, it's still going to be a very high multiple of income and it's going to be the strongest we've ever had, but because of the TRICARE situation we've been describing, that is why that is that way. So we also this year purchased a health plan in Louisiana, where we've spent net of cash 116 million. And we have a CapEx budget of between 100 and 110.

So if you take all those things together, the 64 we've put with respect to share repurchase, the improvement in liquidity to 56 percent -- that was 100 million, we've spent 73 million so far in CapEx and we put 116 in the acquisition, that really accounts for the cash flow that we've generated this year. So going forward, again, our share repurchases are in the open market from time to time and they're dollar-denominated, so as we have cash, we look and see first of all those other three things and then last of all share repurchase.

Okay. Then can you also talk a little bit about your medical costs forecast for the Medicare? This year, you said it was going to 9 to 11 percent, and next year you thought it would drop to 5 to 7 percent. What accounts for that difference?

Well, there's a lot of things in the new law that was passed last December that really -- where the government has changed the way it is reimbursing MedicareAdvantage. And a lot of those things have been seen now and we have talked about them, and they were fairly substantial improvements over last year. For example, we said in the third quarter, 12 to 14 was our premium yield. And we said that for the year, though, we're going to go back to 9 to 11.

And so, so that's basically -- again, looking to next year, we could expect then smaller premium yield and smaller medical cost trend because of the fact that we had had this one large event, particularly in this quarter, and then returning to more normal. If you look at our performance in Medicare over the years, you can see that, again, we're pretty adroit at a set of benefits and designing benefits that go with the premium yield that we receive.

Okay, thank you.

A follow-up from Matthew Borsch.

Thank you. I just had a follow-up looking at your individual markets through the state insurance filings, and in particular, a question on the Ochsner acquisition. And it looked from the filing like the performance slipped in the second quarter. Is that due to some one-time items or can you comment on that at all?

I am not personally familiar with every detail of that filing, but I would say that there were a number of things booked in the second quarter that had to do with the acquisition. Remember, the acquisition date started April 1, and so that could be that booking those kinds of expenses, which have to do with acquisition and things and integration could have well made that be that way. Ochsner is doing very well and we are very happy with where we are with it in terms of the integration. We will have it all done by the end of this year.

Great. And last thing on a different topic. It looked like you had a little bit of negative prior-period reserve development from last year in your commercial business. Can you just comment on what that related to during the quarter?

We believe that our reserves are always booked consistently and conservatively. We use the same methodology at all times, of course, because what we're trying to is estimate medical expense. And the level of marginal redundancy that we had at 12/31 is the same as we have had, so there has been no P&L impact.

Okay, thank you.

At this time, there are no further questions. I would like to now turn it back over to Mr. Mike McCallister for any closing remarks.

Let me just summarize the quarter on a couple key points. We are pleased that we could raise our overall guidance for '04. We are also pleased that we could raise our guidance for '05. I think the takeaways about Humana at this point is that TRICARE, as we have been telling you for 1.5 years, that this transition would go well. It has gone well. We've completed most of that work and the membership is back in our membership numbers today.

In the Medicare area, our work in the risk-adjustment area, as well as the continuing refinement of benefit design, leveraging off what we've learned from our consumer research, is beginning to have real positive effect in Medicare. And our commercial mix continues to get better as we grow the individual and the self-funded business. So we are real pleased with where we are. We appreciate you all joining us today, and I want to thank the Humana associates who are on the call today for making this all possible. Thank you very much.

This concludes Humana's third-quarter earnings release conference call. You may now disconnect.