Humana Inc (HUM) 2005 Q1 法說會逐字稿

Good day ladies and gentlemen, and welcome to your quarter one 2005 KMG America Corporation earnings conference call. My name is Jean, I'll be your conference coordinator today.

[Operator Instructions]

At this time I will turn the call over to your host Mr. Kenneth Kuk, Chairman and Chief Executive Officer. Sir over to you.

Thank you, good morning. Welcome to KMG America's first quarter earnings conference call. I have with me this morning Scott DeLong, our CFO; Jim Nelson, General Counsel; Tom Sass, who is Senior VP of Operations; and Bob Matthews (ph), CFO of Kanawha.

Before we begin, I want to mention that certain statements made during this call relating to KMG America's future operations, performance, growth plans, and expectations of future developments are forward-looking statements under federal securities laws. These statements are based on various assumptions and estimates that are subject to a number of risks and uncertainties. These risks are discussed in our first quarter earnings release issued this morning, our Form 10-Q to be filed later today and our Form 10-K filed on March 31, 2005. In light of these risks, actual results may differ materially from those expressed in any forward-looking statements made during this call, and should be considered carefully.

Also during this call, we will be discussing certain non-GAAP financial measures, such as operating income and proforma financial information that we believe is useful for evaluating the performance of the business. This information should not be viewed in isolation, or considered as a substitute for the financial information prepared in accordance with GAAP. A reconciliation of the non-GAAP financial measures to the most comparable GAAP measures is contained in the earnings release.

While it's only been 45 days since our last conference call, there are several important operational items I would like to update. But first a few words about earnings for the quarter. Scott DeLong our CFO will have the more complete report in a few minutes.

KMG America earned $0.05 per share in the first quarter, which is consistent with our recent expectations but below our original plan. The bulk of the short fall is attributable to two decisions we made, which we expect will accrue benefits well into the future. First, at the time of the IPO, a major risk factor related to our ability to recruit a large productive sales organization. As I have previously reported to ensure our hiring goals are achieved we recruited substantially larger number of reps in the first quarter at cost to our budget. This was the correct decision for many reasons including the energy and enthusiasm we created within KMG America, the brokerage community, and the industry. Our pace of hiring has been intentionally slowed, but the pace of recruiting hasn't. We are now carefully sequencing future hires of sales reps, so the full year objective of 22 should be achieved in the third quarter. This will permit us to fully staff in anticipation of January 1 renewals. I can report that the quality of the sales staff is second to none in the group and worksite area, and clearly a valuable new asset for KMC America. We currently have 12 reps on board with several more prepared to join us.

The other area is investments. Also as I previously reported we invested about 25 million of our cash position during a minor spike upward in interest rates in the first quarter. That left roughly a $100 million of cash. You won't find a $100 million in cash on our balance sheet because we've bought some short term bonds that show as long term investments. The decision now is where to invest on yield curve. Given the recent flattening of the curve and general expectations that the Fed will continue to raise the discount rate, we think it's prudent to remain relatively short. We recently advised our asset manager to employ another 20 million in roughly 24-month duration assets that will yield something under 4.5%.

If the Fed continues to raise rates we expect one of two outcomes. Either all rates will rise or the yield curve will further flatten. Under one scenario we will invest long and benefit, or under the other, we should be able to realize yields on shorter assets equal to what we could have achieved today by investing much longer. Both alternatives argue for us to move to move slowly. This is an important long-term decision for KMG America and we are resisting the easy decision to invest today, thus realizing a near term benefit at the expense of future earnings.

I have excellent news report on product development initiatives. As I reported previously, our stop loss products will be filed in most states this month. Currently it's filed and approved in approximately 28 states. Our new group life product is also on target and will be approved in most states by early June. Anyone familiar with the product development and filing process will appreciate what an exceptional job or product compliance people have done. They are to be commended. There is a lot more work to be done because we need a new disability product, and a whole life voluntary product in the near term. But this is another area where KMG America is demonstrating the ability to achieve our objectives.

There are many other important initiatives under way. For example, we are studying each of Kanawha's existing books of business seeking more productive alternatives. This is a high priority given that many of these blocks are producing minimal returns. This will be an ongoing activity that I will report on periodically.

We are also reviewing existing Kanawha distribution for profitability and fit with KMG America's primary growth strategy. We recently were forced to terminate several management level producers in Kanawha's legacy voluntary worksite distribution system as we aligned that operation with a new sales organization being built. We expect the move to have a minor impact on '05 and '06 sales but a positive impact on earnings.

A few words about sales. We track sales at two levels, business submitted and business issue. For external reporting, sales will refer to policies that are issued. This is consistent with industry practice. In March, I reported that we had already experienced sales successes in the market having sold several small cases on a submitted basis. That number continues to grow but we will not report submitted sales. In the second quarter, we will report issued policies. However, we are well ahead of expectations on the sales front.

I believe we have eliminated many of the perceived risks we discussed at the time of the IPO. The Kanawha acquisition was completed and we successfully integrated the two operations. Our management team is totally in place including outstanding sales and underwriting management, which didn't exist when we went public. We have demonstrated that we can built an excellent sales organization and develop the required products on a timely basis. I think we are also demonstrating that we are a driven, determined organization committed to achieving our objectives.

We understand that we have yet to quantitatively demonstrate a couple of key factors, that is production per rep and our ability to administer business at required level of production. That's what lies between KMG America today in the substantial national company we are becoming. We are confident that in the near future, we will produce evidence those risks are eliminated as well. We continued to be very optimistic about KMG America's future. Now I'll turn the session over to Scott DeLong.

Our earnings release went out earlier this morning and the 10-Q will be filed later today. Let me start with a few words about our financial statement presentation in the press release and my view on period-over-period comparisons of financial results.

First, because the IPO on Kanawha acquisition close late in December last year, the acquisition has been accounted for as if it took place on December 31. This is therefore the first quarter in which earnings have been adjusted to purchase accounting or PGAAP. This does complicate comparisons to Kanawha's predecessor earnings for 2004, which are required to be presented in the 10-Q in accordance with Kanawha's historic GAAP accounting or HGAAP. Thus we have apples-to-oranges comparisons of 2005 to 2004 this year. To facilitate period-to-period comparisons across these years, we have also provided in our press release pro forma Kanawha earnings for 2004 adjusted to PGAAP. We plan to continue this approach throughout 2005. Once we start reporting 2006 results we will have both current and prior periods presented on PGAAP and will have no further need to prepare pro forma earnings.

Second, we are providing 2004 results for comparison purposes for both the first and fourth quarters. Therefore you can look at both year-over-year and sequential quarter trends.

Third, we have added some extra lines to the income statements in order to isolate the expenses relating to the Kanawha legacy business from the expenses relating to the new KMG America executive office, holding company, and the build out of the sales and underwriting, product development and other home office support functions that will focus on the larger employer group and voluntary worksite market. This, too, will facilitate period-to-period trend comparisons and will help you observe the income statement effect of this important new activity.

With this introduction, let me now get to first quarter results. Operating income was $0.05 per fully diluted share in line with analyst recent consensus estimate of $0.05. This is a bit below our original expectation last fall because of the accelerated hiring of sales reps and related staff, lower interest rates and somewhat higher than projected costs associated with being a new public company.

The $0.05 in this year's first quarter compares to pro forma operating earnings of $0.04 per diluted share in the fourth quarter of 2004, and $0.14 in the first quarter last year. If we remove the expenses relating to the new KMG America activity then the performance of just the Kanawha legacy business contributed $0.11 per share this year versus $0.08 in the fourth quarter of 2004. The improvement over the fourth quarter is due to higher investment income resulting from more invested assets in a somewhat lower expense ratio, partially offset by a somewhat higher benefits ratio. Compared to the first quarter of last year, earnings for the Kanawha legacy business are down in this year's first quarter because of lower investment yield rates, a higher expense ratio in the legacy Worksite segment and a higher benefits ratio in the Senior segment. The earnings impact of the significantly lower investment yield in the first quarter of this year compared to the first quarter of last year was more than offset by the increased invested assets this year. Clearly however earnings this year would have been much higher if interest rates had risen during 2004 as most of us had expected and we were able to get the excess cash from the IPO invested earlier. Again this commentary applies to the performance of the Kanawha legacy business.

I'd like to talk next about the ramp up of expenses associated with the new KMG America activity. We incurred a total of $2.3 million of this type of expense in the first quarter, up from $1.1 million in the fourth quarter. These expenses reduced operating income in the first quarter by $0.07 a share and $0.03 per share in the fourth quarter of 2004. Of the incremental $2.3 million of expense in the current quarter, about $0.9 million relates to the expenses of the new sales and underwriting organization with the balance of $1.4 million associated with the holding company executive office and various public company compliance and insurance cost such as independent audit, Sarbanes-Oxley and corporate liability insurance. $1.1 million of expense in the fourth quarter consists of, in roughly equal proportion, expenses relating to hiring the KMG America executive staff and various costs incurred in Kanawha related to the change in control. These incremental expenses will continue throughout this year as we hire sales reps and other personnel and the expense outlay for Sarbanes-Oxley activity continues through next March. As we have said already, we think the more rapid recruitment of high-quality sales reps along with the underwriters and other home office personnel that supports them, is an advantageous trade off for us, as we should be very well positioned for very strong revenue and earnings growth in 2006. And in 2005, we should see an increasing offset from incremental premium revenue from new sales production as we progress through the year especially in the fourth quarter.

As far as the holding company costs associated with public company compliance and liability insurance, these are non-discretionary cost we simply have to bear. We now believe Sarbanes costs will be more than double what we initially thought and our independent auditor fees will also increase rather significantly during the initial year of compliance in response to this activity. These are big-ticket expense items. The good news is that these costs can logically be expected to come down sharply after the initial year compliance and for us that will be 2006. High D&O and E&O liability insurance premiums are probably here to stay and we likely won't see much relief in future years. In spite of the increase in these public company costs we are making excellent progress on our SOX compliance work and expect to be finished as originally scheduled.

I'd like to talk next about the current impact on investment income from continuing low interest rates, as well as the outlook for the next year or two. Recall that we have no spread-managed products currently, so increases and decreases in investment income due to portfolio yield changes fall directly to the bottom line. That's a very good thing when rates rise, but makes for difficult earnings comparisons when rates fall or remain low. We provide some average portfolio yield rates in the press release for each of the three quarters we show financial statement data. These calculations of average yields are not perfect, but they are indicative. By looking at the difference between the PGAAP and HGAAP yields in 2004 that are shown, you can see that the yield haircut from marking the investment portfolio to market on the purchase date and amortizing the $18 million of capital gains over the remaining term to maturity is about 35 basis points. You will recall we said, at the time of the IPO, that the Kanawha investment strategy as a privately-owned company was not entirely suited to public company ownership. As a portion, of the portfolio was geared to a total return strategy. By reallocating about 20% of the portfolio into high quality public and private assets we believe we can have 30 to 50 basis points of yield. Therefore we should be able to replace 35 basis point yield year cut from PGAAP. If we use the ten year treasury as a benchmark, we believe we can add a 100 to 125 basis points of yield, depending on the spreads over treasuries available to us among the various targeted asset types. The issue for us right now is we don't know where ten year rates are headed, although it seems clear that expected Fed actions will continue to push up the short-end of the yield curve.

Now if you look at the average portfolio yield for the first quarter of 2005 in the press release, you see that we earned 4.6%, at least 140 basis points short of our initial target yield. On an after tax basis, this cost us about $1.3 million in earnings for the quarter or $0.06 a share. This shortfall is due to two factors. First, we have remained very liquid throughout the first four months of this year because rates have remained stubbornly low. Second, we have been cautious about investing in the private asset classes, as planned even when rates spiked up temporarily in March. That's because the long funding lag, combined with the volatility and uncertainty of where rates will be 90 days out has made investment commitment decisions problematic. In light of this, we have remained shorter and more liquid than we had originally planned at this point of the year, but we believe this is absolutely the right decision to make. It is costing us near term earnings but it is giving us the flexibility to wait for the right investments in order to maximize our longer term earnings objectives.

All in all we think the factors that are afflecting current earnings are short term in nature with the possible exception of interest rates. The important thing to focus on is that we are getting our new sales and underwriting organization in place earlier than we thought, and the quality of the renewal recruited personnel is every bit is good, if not better, than we had planned. Key products are getting developed, filed and approved as planned. We are positioned for strong revenue and earnings growth 2006. If interest rates move up, that will make our outlook for earnings even better.

With that I will turn it back to Ken for the Q&A session.

Thank you, Scott and we would be open to questions now.

[Operator Instructions]

I will take a question from the David Lewis, SunTrust Robinson Humphrey.

Thank you and good morning. Just so I'm clear on the investment income are you indicating that if rates were where you originally anticipated six or whatever months ago that you would have had an additional $1.3 million or $0.06 per share in earnings?

This is Scott DeLong responding. David, we did anticipate a lag factor in terms of investing the IPO proceeds, as well as implementing the new investment strategy. So the $1.3 million that I mentioned is the number, as if we are able to, on the date of acquisition put all of that into effect. We didn't expect to do that so relative to our initial plan, the 1.3 million would be a lower number because of the expected lag that we had factored in.

And that assumption is coming up in that calculation is 6.5% yield is that correct?

No it would be based on a target yield of ` 6% versus the 4.6% that we show as the average portfolio yield in the first quarter.

Okay that's helpful. And assuming rates aren't too much on the long end for the balance of the second quarter, should we assume that something in that 4.6 range is good even though you are investing $20 million somewhere just below 4.5 or would that grow up modestly?

This is Ken Kuk. We will continue to advise the asset manager to invest at the sweet spot of the yield curve, wherever we believe that might be. Right now we would have the bias towards 2 or 3-year type of paper if the yield curve flattens more that would reinforce that decision. 4.5 is probably the top of the range we can achieve today if rates at the short end go up. We might get something more than that, but it's difficult to say exactly how much.

Where the $20 million presumably was already invested in something higher than the 4.5'ish range, correct? I mean lower.

That's correct. That would have been invested in short-term instrument that are yielding approximately 3%.

Okay. So it is possible we could see a modest bump-up from the 4.6% or no?

Slightly, but I don't think it would be material.

Okay that's helpful. And can you talk about some more details regarding any changes you might do with the Kanawha side to enhance the profitability in those existing operations, or is it too really to give us much detail?

This is Ken Kuk. We are looking at the blocks of business and the distribution systems. The blocks of business we want to manage more proactively than we may have in the past. We are looking at every alternative on each block of business to try to determine if there is a more efficient way to proceed. That could include being more aggressive with pricing changes, it could include or trying to get out of some of those blocks of business, potentially even sell some of those blocks of business. The point is we want to be aggressive and proactive in managing those blocks. From the distribution perspective, I think we could assume that the existing distribution business's would not be material to the company long term.

Consequently we are looking at some of those distribution systems to see if it makes sense to proceed even in the short term. As an example, the long-term care block of business is not all that attractive to us, and we may elect to more quickly with that the distribution system than we might have originally planned. We've made no decisions, but we have indicated even to the organization that we are reviewing those operations. The worksite operation at Kanawha had significant growth in both staffing and sales. We think we can bring that distribution system closer to the new organization that's being built. Not totally integrated but partially integrated, reduce some expenses in the short term and not suffer from the sales and in the long term. So those of the kind of initiatives that we have got underway.

One final question for now Scott do you know what the pre FAS115 book value was at the end of March, that make up the accumulated depreciation, come back with that if you would like?

Yes there was you know the rates did spike up at the end of March, and which put in place some unrealized losses, let's see my colleague is looking that up right now.

We will go into another question and then you can come back, as the reason I am asking that actually declined from the fourth quarter to first quarter I assume that was the reason.

That's right, there was about the unrealized loss of about 7 million pretax 4.4 aftertax I'm told.

Right, thank you.

A few little math here, but I think you've got what you need.

Yes thank you.

We will take a question from Stewart Johnson at FBR.

Yes, good morning, I have a question regarding products rollout, its sounds to me like not only is the product rollout on track, but maybe a little ahead of where you thought it might be at the time of your last investors call. Can you make some comments as to whether that's accurate or not.

This is Ken Kuk, I would say we are slightly ahead of schedule, but not to the extent, it would have a material impact on results.

Okay, but its sounds like you are going to have both the group life product and stop-loss product ready for the last month in the second quarter, does that sound right.

That's correct. And I had that we have already had some sales of stop loss on a submitted basis not on issued basis.

Okay, all right, great thank you.

[Operator Instructions]

We will take another question from David Lewis.

Thanks, couple of other factors Scott what do you now expect your Sox cost to be for 2005 or through March of '06. I think you indicated it was double but I don't recall from what.

Well our original expectation was somewhere around $800,000, and what we are looking at now was probably closer to $2 million.

Okay, and how quick Ken Kuk do you anticipate the sales rep hirings to occur? I think you indicated that you have the 22 on board by the end of the third quarter, does that mean most of the hires will happen in the third quarter?

We expect to be between 15 and 18 by the end of the second quarter, and at the 22 number by the end of the third quarter. The 22 number you will recall is down from 25 we feel that we have more than adequate capability of achieving our plan for next year with 22 reps as supposed to 25 we had in our original plan.

Okay. And, can your legal council give us any update on the ING lawsuit?

We are in the midst of discovery right now. And effectively we have some document production that's through this week. And depositions will likely be scheduled in the next few weeks. And I guess, a normal course through the litigation, nothing has come up to I think, change our view of this case as being a non-event. We don't feel that we've done anything that was wrong. And I think, it's consistent with what Ken has discussed previously.

That's great. And just a final question, is, I know a lot of numbers Scott that you have provided for us, but as we kind of think, through the year's quarterly earnings, I assume we still have an upward slope kind of developing with everything. But, at a flatter type of level than what we might originally assumed? Is that a good way to put it?

Well, I think if we look at that in, let's say three different views. First of all, the Kanawha legacy business I think, that is true although you know, probably the slope is little flatter than we might have thought earlier. In terms of KMG America I think, or the new activity, we will see more expenses going forward and towards the end of the year they will be partially offset by increased revenues. And then the third component would be investment income. That is a significant earnings driver we've talked about that at length. If rates rise from where we are today, we are able to get a better yield on the assets obviously that's going to be, that will be good for earnings over the coming quarters and we'll just keep our fingers crossed that the conditions that everybody expected will in fact come to pass.

And just finally going back to the revenue acceleration in the very latter part of the year really won't the bulk of that really come starting in the first quarter of '06 since it's the January 1, renewal or do you feel like you get some premium starting in late '05?

This is Scott. You're right about that, the big benefit will be in 2006 but nevertheless in terms of sales, issued sales activity and even premium revenue we should start to see that showing up in the end of the year particularly the fourth quarter. But 2006 of course, will be where we will really see that.

Good, thank you very much.

We will take a question from Dan Hooper, Peninsula Capital.

Yes, most of our questions have been answered. Can you just tell us where you, we joined the call late, where you stand in terms of sales reps at the end of Q1?

This is Ken Kuk. At the end of the first quarter we were at ten. We hired, we have two more onboard and we have several that our hired and in the queue for start dates in June and July.

Thanks very much.

[Operator Instructions]

I see no questions at this time. I'll turn the call over to Mr. Kenneth Kuk.

Thank you. Thanks for joining us this morning. As you can see we are proceeding aggressively at implementing our plan. We've been negatively impacted by a couple of environmental factors. I think that is more than offset by the positives associated with reps, products and so forth. Our modeling for example shows the costs associated with incremental rep-hiring this year, are more than paid back in 2006. So we will proceed with our plan, anxious to talk with you again after the second quarter, so that we can demonstrate once more that we are eliminating risks associated with this transaction and I think it won't be more than a quarter or two and we will be able to demonstrate that our revenue per rep numbers are reasonable as well. And at that point I think that it's just a matter of continuing to run our business. I don't think we have much to demonstrate at that point. So again thanks for joining us and we look forward to talking to you again in near future.

Ladies and gentlemen thank you for joining us on the call. You may now disconnect.