Molina Healthcare Inc (MOH) 2018 Q2 法說會逐字稿

Good morning, and welcome to the Molina Healthcare Second Quarter 2018 Earnings Conference Call. (Operator Instructions) Please note, this event is being recorded.

I would now like to turn the conference over to Ryan Kubota, Assistant Vice President, Investor Relations.

Thank you, operator. Hello, everyone, and thank you for joining us.

The purpose of this call is to discuss Molina Healthcare's financial results for the second quarter ended June 30, 2018. The company issued its earnings release, reporting second quarter 2018 results last night after the market closed, and this release is now posted for viewing on our company website.

On the call with me today are Joe Zubretsky, our President and Chief Executive Officer; and Tom Tran, our Chief Financial Officer. After the completion of our prepared remarks, we will open the call to take your questions. (Operator Instructions)

Our comments today will contain forward-looking statements under the safe harbor provisions from the Private Securities Litigation Reform Act. All of our forward-looking statements are based on current expectations and assumptions, which are subject to numerous risk factors that could cause our actual results to differ materially.

A description of such risk factors can be found in our earnings release and in our reports filed with the Securities and Exchange Commission, including our Form 10-K annual report, our Form 10-Q quarterly reports and our Form 8-K current reports. These reports can be accessed under the Investor Relations tab of our company website or on the SEC's website.

All forward-looking statements made during today's call represent our judgment as of August 1, 2018, and we disclaim any obligation to update such statements except as required by the securities laws.

This call is being recorded, and a 30-day replay of the conference call will be available at our company's website, molinahealthcare.com.

I would now like to turn the call over to our Chief Executive Officer, Joe Zubretsky.

Thank you, Ryan, and thank you all for joining us this morning.

Last night, we reported second quarter earnings of $3.02 per diluted share. This includes a $79 million positive impact or $0.92 per diluted share from settling the 2017 Marketplace risk adjustment payment. This also includes $0.09 per diluted share negative impact of net expenses primarily related to restructuring and debt extinguishment.

Therefore, from a pure performance perspective, netting the $0.83 per share positive impact of these 2 items, we achieved second quarter fully diluted earnings per share of $2.19.

These financial results are a strong indication that the early stages of our margin recovery and sustainability plan are working, as our focus on managed care fundamentals and a more rigorous performance management process is reflected in our improved earnings.

Summarizing the key takeaways from the second quarter, our Medicaid line of business performed slightly ahead of our expectations, and performance improved sequentially in the TANF line of business. The primary driver of improvement was contained medical cost, particularly inpatient cost. Medicare continued to perform well in the second quarter as the medical care ratio remained flat at 85%, meeting our expectations for the first half of the year. Our SNP and MMP lines of business each contributed to this favorable result.

Our Marketplace business has continued to outperform our forecast. It is becoming clear that the price increases we placed in the market, along with improved retention of risk-adjusted revenue, are producing results that are projected to outperform our pretax target margin of 4.6%. From a local health plan perspective, our large high-performing plans have generally continued to perform well. Many of our previously underperforming plans have improved considerably. Additionally, our health plans that are expected to experience major membership transition are also performing well.

Our administrative cost ratio decreased to 6.9% in the second quarter and 7.2% year-to-date. This improvement is a combination of continued administrative cost containment and better-than-expected revenue, and we are committed to harvesting the benefits of administrative cost leverage over time.

Finally, we have continued our focus on optimizing our capital structure and business portfolio. We have further reduced our debt, repaid the outstanding balance on our revolving line of credit, simplified our capital structure and have contracted to sell a noncore operating asset to produce additional excess cash at the parent company.

Let me now provide a deeper look into the underlying operating levers and metrics. First, with respect to revenues, premium revenue increased by more than 4% from the first quarter of 2018. After setting aside the benefit from the 2017 Marketplace risk adjustment, premium revenue increased by more than 2% sequentially and met expectations for the quarter. The increased Medicaid revenue is largely attributable to the nearly 70,000 additional members we were awarded in the new state-wide Illinois contract that went live on April 1.

Second, with respect to our medical care ratio, after removing the impact of the 2017 risk adjustment and CSR subsidies for Marketplace, our consolidated medical care ratio decreased sequentially by approximately 20 basis points to 87% in the second quarter. Across all product lines, we managed to a medical care ratio favorable to our expectations despite cost pressures in our Washington and New Mexico plans. These results reflect the ongoing medical management improvements and provide our contracting initiatives that we outlined at Investor Day as well as a continuation of the stable medical cost trends that began to emerge in the first quarter.

Third, with respect to product line performance, our Medicaid business performed better-than-expected in the quarter. Medical cost trend was well managed, driven mainly by lower-than-expected inpatient cost. The medical care ratio improved sequentially by 100 basis points from 90.8% to 89.8%, with meaningful improvement in the TANF line of business. With a medical care ratio of 90.3% for the first half, our Medicaid product line is performing better than expected, though still with room for continued improvement.

Our Medicare line, comprising the SNP and MMP products, outperformed our expectation, and the medical care ratio was essentially flat compared to the first quarter at approximately 85%. We continue to demonstrate that we have a strong operational foundation for managing high-acuity members, and this point remains important as we contemplate the future growth phase of our long-term strategy.

Our Marketplace business has continued to outperform our expectations. As you will recall, despite pricing the business to a 4.6% pretax margin, we remained guarded in our assessment of the performance of this business at the end of the first quarter. Now, with the benefit of second quarter results, it is becoming clear that our Marketplace performance is exceeding our initial pricing target.

Among the factors contributing to this improved performance are 3 specific insights we have gained as we passed the halfway point of 2018. First, our membership is attriting more slowly than expected, so our premium volume is better than expected.

Second, we are outperforming our risk-adjusted revenue forecast. While the positive impact of the 2017 risk adjustment liability settlement is, in a sense, non-run-ratable, it does, however, indicate that we will likely outperform the risk adjustment pricing assumption for the 2018 underwriting year, which is now included in our revised guidance.

And third, the risk profile of our reduced membership base and the related medical cost experience are consistent with our pricing assumptions.

In summary, when scrubbed for the various out-of-period items, our Marketplace medical care ratio is approximately 69% for the quarter and approximately 66% for the first half of the year. This result is better than our pricing target and significantly better than our previous guidance.

I turn now to the individual performance of our local health plans. The majority of our large health plans have continued to perform well and have met or exceeded our expectations. California, Michigan, Ohio and Texas, representing more than 50% of our premium revenue base, continued to perform well across most lines of business, earning well in excess of our cost of capital.

Washington continued to experience inpatient cost pressures in its Medicaid line of business, though through intense performance management improvements, medical costs have stabilized. We should see improvement in the second half of the year, which will be especially important because our successful reprocurement will yield projected membership increases starting in early 2019.

Our 2 plans that are undergoing significant transitions due to contract losses, New Mexico and Florida, continued to produce respectable results. In New Mexico, the Medicaid line has been pressured by higher-than-expected behavioral cost trends, but Marketplace has exceeded our expectations. Florida is also continuing to experience improved performance sequentially. However, the core performance improvement has been more than offset by a 9-month retroactive increase through the EAPG outpatient fee schedule for $26 million on a pretax basis.

I turn now to administrative cost. We are continuing to improve our administrative cost structure and lower our G&A ratio through a number of ongoing initiatives. These ongoing efforts, timing effects and the leverage effect of incremental revenue have improved our G&A ratio in the quarter to 6.9%, down from 7.6% in the first quarter. Our near-term focus will be to extract the expenses related to the lost contracts in Florida and New Mexico and limit the impact of stranded fixed costs for 2019, an outcome we remain committed to achieving.

I turn now to the company's revenue and growth profile. We announced 3 significant RFP awards in the second quarter.

First, we won all 8 of our Washington reprocurement regions in May, maintaining our state-wide presence and adding behavioral health services in all regions. As a reminder, the state has fully carved out the pharmacy benefit effective July 1 of this year, which will cause our Washington revenue to decline in the second half by approximately $100 million. This should be offset by membership gains and the behavioral health benefit carve-in in 2019.

Second, we were awarded 2 regions in the Florida Medicaid reprocurement. We are pleased that our negotiations resulted in the award of regions 8 and 11, overcoming the initial loss of all of our Medicaid regions. In these 2 regions, we served approximately 100,000 members at the end of the second quarter with approximately $500 million of annualized revenue. Most importantly, this award preserves our ability to continue improving our margins in Florida while expanding our Marketplace and Medicare businesses in this most important Managed Care market.

Third, and most recently, in Puerto Rico, we secured an island-wide contract currently scheduled to commence in November. With respect to membership, we had 326,000 members at the end of the second quarter in our 2 current regions. We are projecting at least a similar number of members in the new program as we should be well positioned in the auto assignment process. We have also carefully analyzed the rate methodology to assess the profit potential of this market, and we are confident that we will be able to earn and sustain a return in excess of our cost of capital.

Finally, a brief update on our New Mexico protest. Our protest is expected to be heard by the court in September. In the interim, a temporary stay we secured allows us to participate in the Readiness Review process for the new contract award. Until a different outcome is determined, we continue to manage the business as though it is in a run-off status.

Changing topics to capital, we made significant progress in the quarter related to our capital structure and free cash flow at the parent. We repaid the outstanding $300 million balance on a revolving line of credit. We repurchased approximately 95 million of our 2020 convertible notes for a total cash outlay of approximately $210 million, reducing both our debt and the dilutive effects of the embedded call option.

And as we announced in June, we entered into a definitive agreement to sell Molina Medicaid Solutions to DXC Technology for $220 million. We expect this transaction to close sometime in the third quarter. Net of transaction costs and taxes, this sale will generate between $150 million and $180 million of additional parent company cash.

I turn now to our revised guidance. Our revised guidance for the year is $7.15 to $7.35 earnings per diluted share on a reported basis, an increase of $3 at the midpoint of our previous guidance range. However, from a pure operational performance perspective, we consider our full year guidance to be approximately $6.30 per diluted share.

Allow me to unpack some of the components of our revised guidance. Our first half earnings per diluted share was $4.68. Excluding nonoperating, non-run-ratable items, we view our pure operating performance in the first half to be $3.70 per diluted share. For the second half, we are projecting earnings of approximately $2.50 to $2.70 per diluted share. Therefore, our full year guidance based on pure operating performance is approximately $6.30 per diluted share at the midpoint. Adding back the $0.96 of previously reported nonoperating, non-run-ratable items, yields revised guidance of $7.15 to $7.35 per diluted share.

Through yet another lens, we view our $3 guidance raise as a $1.20 performance beat for the second quarter, a $1 performance raise for the second half and an $0.80 increase to the non-run-ratable items for the full year.

The net income margin in our guidance for the full year is now a range of approximately 2.5% to 2.6%. Excluding the non-run-ratable items of $0.96 per share mentioned previously, our guidance net income margin is approximately 2.2%, clearly exceeding our previous guidance range of 1.5% to 1.6%.

We are mindful that these results have emerged from improving basic utilization control, claims management, care management and revenue retention processes, all of which are now governed through detailed and rigorous performance management. However, we remain cautious in our outlook as we are still in the early stages of our margin recovery and sustainability plan.

We are pleased with the current trajectory of our financial results. If we continue to deliver on the elements of our turnaround plan for 2018, we will have built a strong baseline from which to achieve the 2019 and 2020 margin targets that we conveyed to you at our Investor Day in May.

With that, I will turn the call over to Tom Tran for more detail on the financials.

Thank you, Joe, and good morning.

As described in our earnings release last night, we report earnings per diluted share of $3.02 and adjusted earnings per diluted share of $3.08, excluding the amortization of intangible assets. As Joe comment, these results were largely driven by our margin recovery initiatives and disciplined performance management.

First, let me quickly highlight a few of the items that we call out in our earnings release. The incremental restructuring costs in the quarter are primarily related to the true-up of our initial lease abatement estimates as we continue to rationalize our office space. We will likely continue to see additional lease restructuring costs over the next few quarters as we continue to rationalize our office space. As part of the 2020 convertible notes and embedded call option repurchase, we incurred approximately $5 million of expenses. These costs are primarily related to the acceleration of the remaining interest payments on those notes.

I will now spend a few minutes discussing our reserve position. Our reserve approach remains consistent with prior quarters, and our position continues to be strong. The favorable development we experienced in 2018 from 2017 has held steady at approximately $220 million, including the explicit margin that we hold. We experienced intra-year favorable development in the quarter, but we intended to and believe that we have reestablished the same level of conservatism in the second quarter's days of service medical costs.

Days in claims payable are down approximately 4 days sequentially. The decrease is partially attributable to a reduction in the outstanding balance of provider settlements. Reducing our overall provider settlement balance is a testament to our focus on improving our claims handling protocols. Also contributing to the decrease were continued improvements in our claims handling abilities and improvements in speed of payment.

In addition, days in claim payable were also impacted by reserve related to flu costs that were established in the first quarter but released in the second quarter. And while this may have had a sequential quarterly earnings impact, it had no impact in our first half run rate earnings.

Turning to our capital structure and balance sheet, we will continue to look for strategic opportunities to delever the balance sheet as we outlined during Investor Day. As of June 30, 2018, the company had unrestricted cash and investments of approximately $350 million at the parent company. We intend to be more capital-efficient at the health plan level, ensuring a more consistent and regular dividend flow to the parent company. At the end of the second quarter, our health plans had aggregate statutory capital and surplus of approximately $2.2 billion, which represents approximately 350% of risk-based capital.

Let me offer some additional thoughts on our revised guidance. We have raised our full year guidance to a range of $7.15 to $7.35 per diluted share, an increase of $3 at the midpoint from our previous guidance issued on April 30. This increase is comprised of the following. We exceed our expectations in the second quarter by approximately $1.20 due to strong performance across all product lines.

Secondly, we're adding approximately $1 to our original guidance for the back half of the year. We are cautiously projecting that our businesses will continue to perform well even with the substantial seasonal effect of the Marketplace business. The Marketplace medical care ratio, excluding non-run-ratable items, was approximately 66% in the first half of the year. We expect the medical care ratio for the second half to be in the upper 70s as utilization is back-end loaded due to product design and (inaudible) in membership mix and acuity.

And third, adding approximately $0.80 to the nonoperational, non-run-rate items for the full year.

In developing a revised guidance, we have consider the experience from the first half of the year in projecting the second half. However, we have maintained a disciplined and cautious views of our lines of business throughout.

Now the bridge from our results in the first half of the year to our revised guidance in the second half. Our pretax income, excluding $84 million of non-run-rate items from our performance in the first half is approximately $400 million. This compares to pretax income of approximately $250 million in the second half. Approximately 2/3 of the difference in pretax income between the first and the second half of the year is related to the seasonality of Marketplace earnings. The remaining difference reflects higher administrative costs in the second half of the year due to the timing of technology and operation initiatives, marketing expenses and transition expenses in Florida and New Mexico.

Regarding tax, the full year effective tax rate is approximately 35% to 36%, which is lower than our previous estimate of 38% to 40%, due to a higher pretax income in our current guidance, which is taxed at our marginal tax rate of approximately 22%.

Finally, let me offer a few additional points of consideration relating to our revised guidance. The 2018 full year impact of our credit facility repayment and convertible notes repurchase, including the impact of the recent 2020 notes repurchase, is approximately $0.10 to $0.15 per diluted share. Based on the information we have today, we have not included any potential impact of a retroactive change in the California minimum medical care ratio related to the expansion business for the period July 1, 2016 through June 30, 2017.

The guidance assumes no prior period development and does not include any additional restructuring costs that we may incur in the back half of the year. Our guidance was developed on the basis of GAAP rather than adjusted earnings per diluted share, which would exclude the amortization of intangible assets.

This concludes our prepared remarks. Operator, we are now ready to take questions.

(Operator Instructions) The first question comes from Josh Raskin of Nephron Research.

I guess, the big question, I guess, for me is just the 1 quarter significant turn in the MLR and the operational improvements that you made. And I guess, I'm just curious, more color on exactly what you're doing. And if you could just give us some color on maybe denial rates or pre-authorizations or things like that, just so we understand what exactly is changing here, especially on the inpatient side.

Sure, Josh. At Investor Day, we laid out a very clear path to our margin expansion and -- expansion strategy and sustainability, and we identified a portfolio of nearly $500 million of profit improvements to be harvested over a 2- to 3-year period.

Many of those are raw execution at the local levels, tiering out high-cost providers, re-contracting ancillary services locally, achieving better and more consistent execution of basic utilization controls. This company had inconsistent processes. It had, in some cases, poor execution in some of our local health plans. And by a rigorous performance management process, leading indicators that identify the number of authorizations that are going in so that we can head off high-acuity inpatient trends that are emerging, all of these are contributing to the very favorable medical care ratios that we're experiencing in the first half.

And I will tell you that the more complicated end of those profit improvement initiatives: outsourcing, perhaps co-sourcing some of our specialty utilization controls and other things like that, including TBM re-contracting, are just in the planning stages, and we think provide more margin upside in future -- in the future. So at the early stages, we're executing well locally, and it's Managed Care fundamentals.

Got you. That's helpful. And it kind of leads into what my follow-up question would be, which is you know talk -- you guys are sort of that 2.2%, which is kind of your adjusted -- the $6.30 implies sort of a 2.2% margin, which is at the low end of that target range that you guys laid out for 2020 or 2021.

So it sounds as though you guys are 2, maybe even 3 years ahead of schedule. Your comments there make it sound like there's actually more opportunities. So I guess, as we think towards 2019, are we already in a position to say that, that 2.2% to 2.7% is too conservative? Is there more upside in the potential margin going forward?

At this early stage, Josh, we're willing to say and express a high degree of confidence in the margin ranges that we conveyed to you at Investor Day. I think as we get closer to developing our 2019 plan and look back -- look at where medical cost trends are landing, looking at the strength of the rates that we're receiving from the states, we'll be in a better position to perhaps update those target margins. But at this point, at this early stage, we will convey to you that we are expressing a high degree of confidence in the margins that we projected.

And one last one, I apologize for asking a third one. But the 2019, as you guys look at it today, assuming that maybe New Mexico doesn't go your way or what have you, do you know what is your run rate? What does your 2019 revenue run rate look like today, excluding any other additional changes?

I think if you take a look at the Investor Day projection, which included the complete loss of Florida Medicaid and the complete loss of New Mexico Medicaid and just pro forma back in $500 million to $550 million of recovery for regions 8 and 11 in Florida, that's probably the one adjustment I would make to the revenue outlook we gave you at Investor Day.

There's other puts and takes. Washington will probably have better membership next year due to our successful reprocurement. That might be aided by the behavioral benefit carve-in but offset by the pharmacy carve-out. So there's all types of puts and takes, but I think the major item would be regions 8 and 11, $500 million to $550 million of revenue in addition to the outlook we gave to you at Investor Day.

I'll offer one additional data point there is that we're obviously looking at the Marketplace, and there are 2 markets that we have filed rates for, which is Wisconsin and Utah, that we may consider a reentry. We won't make that decision until a little bit later in the year, but that is also a potential upside in our premium income as well.

The next question comes from Matt Borsch of BMO Capital Markets.

Maybe I'd just pick up on that last comment. What is it that you would be waiting to see regarding the decision to re-enter or not, Wisconsin and Utah?

Our decision to file the rates and then just pause until open -- you have until open enrollment to make that decision. And I just think it's prudent to see every bit of data off your 2018 performance.

The issues we had in Utah and Wisconsin were mostly related to a network that was too wide and too highly priced, and the team is working at developing a network that will support the prices that we filed. I would suffice it to say that I'm inclined to say that we would re-enter, but we don't have to make a decision until the end of the summer. We're going to watch every bit of data emerge on 2018 to make sure we have this right, and then we'll make the call at that point.

That makes sense. And can you just talk to us about the -- you mentioned probably not a huge thing, but the little bit of pressure in New Mexico from higher behavioral costs?

Yes. New Mexico obviously is experiencing an epidemic of sorts of opioid substance abuse, opioid use disorder, and the incidence rate is quite high. And it is putting pressure on the Medicaid line of business.

We're on it. We're delivering the services we need to deliver. It's really not been reflected in the rates we got, so it's putting pressure on the MLR. But it's really that, pure and simple, that's what it is.

Does that relate at all to the IMD exclusion lifting in terms of what might be new?

No. I don't believe so. I think it's, literally, it's just a one component of medical cost trend that is racing ahead of our price to expectation.

The next question comes from Justin Lake of Wolfe Research.

Joe, you mentioned being well positioned to hit 2019 and 2020 margin targets, but obviously, your current '18 guidance is already at the high end of the '19, 1.9% to 2.2% target. Obviously, a high-class problem to have, but I was hoping you can give us some color on where you think 2018 results may not be sustainable, like what portions of this '18 upside might not be sustainable in the '19. Particularly, can you tell us where exchange margins sit for '18 versus that 4.6% target?

Sure. With respect to the Marketplace business, the rates that we filed are no longer, what I'll call, corrective. The last 2 rate filings were clearly corrective rate filings to get our prices where they needed to be in order to have a margin that is in excess of our cost of capital.

The prices we put into the market this year that we filed are more reflective of the acuity of the members we think we'll attract, any benefit changes -- although that's pretty limited in this product line -- and medical cost trend.

The strategy for 2019 in the Marketplace was to optimize our contribution margin, not to grow membership considerably, but not to allow it to attrit considerably due to competitive pressures. So our outlook for 2019 Marketplace should be maximize margins, hold on to membership and let's see what happens so that we can perhaps grow this business more aggressively in 2020.

With respect to the core business, look, we're operating pretty well. Our Medicaid line of business at 90% for the first half. TANF at 90%, we think can still be a little bit better. ABD at 93%, we think there's more opportunity there. Expansion at 87% is probably where it needs to be. And our Medicare line of business at 85% is doing well from a medical margin point of view. The SG&A ratio is still a bit high.

So there is more opportunity here. It's all about the rates and the strength of the rates you get. And as we also said at Investor Day, we always put in a hedge for medical cost trend inflections that you don't anticipate or a bad rate here and there. So we remain guarded and cautious, but obviously, we're off to a good start, and we still think there's plenty of opportunity for improvement.

Got it. So if I could just follow up here. One, I'd ask about where your exchange margins are for '18 versus that 4.6% target. Can you tell -- can you give us an idea? I mean, are they closer to 10% than 5%? Included in the follow-up, I'm just trying to figure out magnitude.

Sure. On an adjusted basis, you really have to scrape out the CSR subsidies, the noise -- if you scrape out the noise, we did just under 10% for the first half. And I'll remind you that has the seasonality effect of the business. In the back half, we're projecting to be slightly over breakeven. And on the same basis of the target pricing margin of 4.6%, the guidance margin for Marketplace is just under 5.5%. So we're beating the 4 -- our guidance calls for a beat for our 4.6% target pricing margin.

Got it. So then the -- I guess the -- so if margins in exchanges aren't going to be that big a headwind, considering they're only slightly above your target and your pricing to your target next year, what is the big headwind in next year? Like, I think a lot of people when they look at these margins that you reported this year, that you updated guidance for, would look and say, "Geez, it looks like it gives you the opportunity to kind of get to the 2020 margin in 2019." What's going to keep -- in your mind, what are the key factors that kind of keep you from doing that? Are you going to guide to that 1.9% to 2.2%? Meaning, earnings is actually down next year versus this year? Because that's what it sounds like you're saying.

Sure. Obviously, we're not going to be giving 2019 guidance at this early stage. But in tracking the moving pieces, the major profit-improvement initiatives that are, what I call, enterprise-wide, re-contracting our PBM, perhaps re-contracting some of our specialty UM. Those types -- perhaps outsourcing or co-sourcing some of our IT and transaction services operations that would provide significant benefits, along the lines that we conveyed to you at Investor Day -- those are still in the planning stages and will provide benefit in '19 and '20.

I always remain cautious about the rates we're going to get. Right now, the rate environment is what I consider stable. It's mostly meeting the actuarially soundness standard. It generally reflects the trends we are experiencing, but I always just remain guarded on the strength of the rates we're going to get. So if the rate environment remains stable and strong and our profit improvements take hold as we think they will, perhaps there is upside. But again, it is too early in our turnaround plan to begin conveying expanded margins to what we conveyed to you at Investor Day. Let's wait until the end of the year, see how '18 plays out. And when we give you '19 guidance, hopefully, there could be a positive -- positive news there.

The next question comes from Ana Gupte of Leerink Partners.

So the first question was about the SG&A guidance that you reiterated rather than -- I thought might be there'd maybe be some improvements for '18. And can you give us any sense of the outlook into '19, given you've been ticking down a lot of your corporate overhead and the like?

Sure. We remain committed to the operating leverage. That is, we're holding our operators accountable to actually holding fixed costs fixed and only adding a variable cost when volume is involved.

Second, we continue to chip away. No major announcements, but every day, every month, we find new opportunities. In the quarter, our administrative costs were sort of flat quarter-over-quarter, so the reduction in the G&A ratio was actually a function of the revenue line rather than the cost line. And we do have a back-end loaded SG&A forecast.

The SG&A forecast is $50 million higher in the back half of the year than the front half, as we've deferred some improvement projects. We have the New Mexico and Florida transition costs to incur and Medicare marketing season opens, as you know, in October, November. So there's potential upside there. But right now, we're comfortable at our original guidance of 7.4%, and any reduction in that clearly is coming from the revenue line and not the cost line at this early stage.

That's helpful. So moving to revenue, can you give us an update on the Texas RFP and the resubmission by the 22nd? What is the timing on that? And what kind of convos are you having?

The resubmission was actually almost a nonevent. The RFP came out on July 23, I believe. We have 30 days, so it's late August when it's due. There was only one noticeable change. So there was no change to the very technical requirements. They only gave us 30 days to respond, so they couldn't change much technically. What they did include was a more subjective element to the evaluation process, to where the raters and the evaluators can inject more subjectivity and judgment into the raw scoring.

Rates are still not part of the bid. We were comfortable and confident in our original submission. We remain comfortable and confident with our resubmission. And we're still hopeful that our 6 regions in Texas can expand something north of 6 and south of 13, and we can expand our ABD revenue in Texas as a result of this. So we still remain very bullish and optimistic on the prospects there.

I would add one more data point to that, to what Joe said -- is that the go-live date has been pushed back by approximately 5 months. So it is now June 1, 2020.

And the awards will still be in October to choose? I couldn't find that on the website.

They have not given a date -- they have not updated the date that they indicated they would announce the award. So we don't actually know.

Got it. One last one then. Just you're getting to a point, where just within a pretty short period of time, you've shown remarkable turnaround, but there still seems a lot of runway for MLR improvements and broader margin expansion. Would you consider maybe as new RFPs like North Carolina, in particular, which is coming any day, bidding for that at this point? Or might you just stick with the let's get through our margin turnaround and be cautious and that does put a dent a little on the potential growth for 2020?

It's -- Ana, it's the latter. We have to stay focused and committed to our margin recovery, and the key word here is sustainability. That's the key question for us, that's the key question for you. And we actually think we are at the early stages of improving our core processes, the infrastructure to support the complexity of the revenue we take on in order to sustain these margins. And as I've mentioned before, if we continue to be in a stable and actuarially sound rate environment and those profit improvement initiatives we conveyed to you at Investor Day, there could be a margin upside here.

But we remain committed and focused to the sustainability in margin expansion. And we have enough revenue right now to consider this a very solid franchise. We have a Mississippi implementation going in. We have an Idaho expansion. There's a potential aid LTSS opportunity in Ohio a year, 1.5 years out. So there's plenty of growth opportunity in our existing footprint that we can focus on as we expand our margins and not get distracted with greenfield opportunities.

The next question comes from Steve Tanal of Goldman Sachs.

I guess, just on the risk adjustment side, while certainly, I guess, non-run-ratable at this level, it does seem like you'd be setting up for another risk adjustment gain next year for -- related to this plan year. So how do you suggest we sort of think about that year-to-year step down given the smaller overall footprint? And is that something you'd include in guidance as you approach next year?

Well, I think, Steve, I would make 2 comments.

One, getting better at accounting for it is only half the battle. We actually have to get better at doing it and getting risk awards that are commensurate with the acuity of our population. We clearly got better at accounting for it, but we are actually getting better at actually doing it and having a profit improvement emerge out of the improved risk scores that we're harvesting.

I would tell you that the first half of 2018, our revenue profile, the revenue that we booked for the first half is reflective of the experience we -- that emerged off of 2017. Whether there's upside to that or not, we'd have to wait and see. But the 2018 revenue is being recorded on the same basis of the experience that emerged out of 2017.

Got it. And so would you -- would '19 guidance include some expectation of how that will run rate next year? Or would you exclude that from guidance kind of going forward?

Well, I would -- I'd answer the question maybe slightly differently than you even asked it. It's the question of how did we price? And again, when you're filing rates 3, 4 months into a year that its experience is yet to emerge, you're forced to be cautious and conservative. So the '19 rates that we filed actually included a risk adjustment outlook that was pretty consistent with the '17 experience that emerged into '18 and the '18 experience that we have currently. If we get better at actually harvesting the risk adjustment scores, that would be upside to our 2019 performance.

Understood. That's helpful. Okay. And then just excluding the risk adjustment, it would still look like there was a big pop in Marketplace to MTMs especially sequentially, I guess, is the way we'd look at that. And I'm kind of curious to understand what drove that. And I guess, in doing that math, are we correct to adjust the CSR out of expenses as opposed to premiums?

That's correct, Steve. CSR is really a adjustment to the medical cost. And if you look at the Q2 premium for Marketplace, it is benefited from the risk adjustment from 2017. So that's why it had a little bit of a artificial lift, if you will. If you adjust it out, then Q1, Q2 -- but fairly, fairly stable. Q1 stepping up to Q2 slightly, roughly about $15 million, $16 million. So that's really the picture.

Okay. As a follow-up -- it looks like a bigger step up to us, but okay. And just lastly from me, in Washington, can you give us a flavor for the PMPM value of the RX carve-out versus the behavioral carve-in? Are those pretty similar? And then maybe just a little color on sort of the net impact of both of those as well as the membership gains as you enter '19. Those, it sounds like you're saying, are net positive overall. And that's all I had.

Yes. Let me comment on the pharmacy carve-out, which was effective July 1 of this year. So as Joe commented before, it's approximately $100 million of back-half premium reduction. So behavioral health, on the other side, does not kick in until the first part of 2019. So there is a timing issue there. But what Joe commented before is that we feel optimistic that we will expand membership in '19. So on top of picking up the behavioral health premium, then it will -- it possibly may more than balance out the loss of the pharmacy revenue.

The behavioral carve-in was worth about 10 percentage points in the rate. If you can use that in your model, that might help.

The next question comes from Sarah James of Piper Jaffray.

I appreciate the detail on the clean EPS. That's very helpful, but I was hoping you could also put the progress in terms of the $400 million to $600 million savings target laid out at Investor Day. And then which buckets would you say you're close to hitting the goal on? So for example, it sounded like network and payment integrity were maybe the furthest along. Those were laid out as being maybe up to $85 million. So if you could give us some perspective on those buckets and where you are in achieving them?

Sure. I would say in the early stages here. The profit improvement is emerging out of better execution of utilization management on the front lines and the local health plans, one.

Second, re-contracting, tiering out high-cost facilities, re-contracting -- we've re-contracted behavioral services in various geographies with outsourced vendors. So re-contracting, utilization control; and we've gotten a lot better at claims handling. When we say there's less going into the provider settlement pot, I mean, that gets expensive. And so we're just getting better at straight-through processing, auto-adjudication, our rework rates are down, our provider settlements are down. More to go there, but it's all contributing to the early success we're experiencing here.

I'd say those were the 3 major categories -- and better risk retention -- risk-adjusted revenue retention. Those are the 4 categories that we're probably hitting hard right now. The enterprise-wide initiatives, all the re-contracting, potential outsourcing, in the works, plans in place, execution for '19 and '20.

Can you comment to where you are towards hitting the $400 million to $600 million target?

It's really hard to say. Many of the, let's say, locally deployed initiatives are hitting. The bigger ticket ones are not. But clearly, when we developed our 2018 plan and looked at the strength of our rates, we know we needed more locally deployed profit improvement initiatives. In fact, when Pam Sedmak joined us, we added over 100 basis points of revenue to everybody's profit improvement plan.

So it's hard to say how much of the $500 million we've actually harvested to date. But most of this is raw execution on the front lines, on the 3 or 4 core processes that I mentioned. When we develop our '19 plan or perhaps at our next Investor Day, we'll do a re-accounting for the $500 million of opportunity, so you know how much is left. But I would tell you that a significant portion of that, the enterprise-wide initiatives, has yet to have been harvested.

That's helpful. And then on California, it looked like there was a good improvement on MLR there. I wanted to understand was that just (inaudible)-related? Or was there a meaningful improvement on the Medicaid side or anything out of period impacting California?

It's just -- there is a basic fundamental of execution on our plan, and that's why you see California has some improvements. There's also some -- if you look at California, first half, first quarter, second quarter, I mean, loss ratio improved quite a bit. And that's pretty much across a lot of our lines of business as well.

The next question comes from Dave Windley of Jefferies.

So Joe, in your prepared remarks, you talked about the better performance on risk adjustment and that you expected that to flow through and that that was specifically in -- now incorporated into your guidance. And so I guess, I'm wanting to perhaps parse apart the benefit that I believe you're calling out for 2Q from 2017 risk adjustment and perhaps, the benefit that maybe you're including as run ratable in 2018 that would have come from what I believe you're saying is a lower risk adjustment payable accrual for 2018. Am I understanding that correctly?

Yes. I think it's fair to say that our first half results, there's always puts and takes for the quarter as you adjust your outlook. But the first half results are a fair reflection of the strength of our risk adjustment position for 2018. So I would ask that as we talked about a $3.70 pure performance first half, that is reflective of our 2018 risk-adjusted revenue outlook for the Marketplace.

Got it. And similarly, all incorporated into the 5.5% that you answered to Justin?

That is correct.

Right. Okay. And looking at some of your variance around your rates in the exchange business, you have a couple of states where it looks like you're looking for double digits and a couple of states where you're bigger, you're looking, Texas, Washington, for example, in the low double digits and New Mexico, Michigan, maybe closer to flat. Can we think about kind of specifically in exchange, those being reflective of, particularly the lower ones where maybe you're kind of over-earning and believing that you're hitting caps and essentially bidding back to a normal margin?

Fair point. The only plan where we're bumping up against the minimum MLR is New Mexico because it's a 3-year rolling average. We still have enough of the old experience in the calculation where we're generally avoiding that for this year and probably for next.

It's a very fair characterization that our rates are no longer corrective. They are now reflective of the acuity of the membership we believe we will attract, of the trends we are experiencing and always, with an outlook of where the competitors are. So this is a blind-bidding process as you know. So you could talk to yourself and convince yourself that your rates are okay, and you'll attract membership. But you always have to have an outlook of where is your product price juxtaposed against the competitors, where do you think they'll land? So you have an outlook of what type of membership.

So we do a very detailed elasticity of demand study on where our pricing is, and that's how we prepare our rates. Whether they're mid-single digits or low double digits, it's always reflecting trend and then juxtaposed against where do we think our competitive pricing is and where the competitors will land, so we can attract the membership we plan to attract.

I appreciate that. And then last one real quickly. As you've now made substantial progress in cleaning up the balance sheet and you're obviously focused on profit improvement and organic operations here, but as you start to generate some cash flow and don't have balance sheet applications for that in the immediate, what do you -- how do you think about capital allocation beyond, say, beyond the very near term?

Well, right now, we're still focused on our recovering sustainability plan. We are not really looking for inorganic opportunities.

I will tell you that in the near-term opportunities that we've identified in some of our existing footprint, if we can harvest that revenue over the next year or 2, it will require risk-based capital to be deployed in our local health plans. So as we outlined to you at Investor Day, there's $1.5 billion to $3 billion of opportunity. We only squeezed $600 million out per year for each of the following 2 years. If we went more aggressively at that, figure around 10% to 15% of that revenue being tucked away as statutory capital, which by the way, is the highest and best use of excess cash flow as it produces north of 30% levered returns. So we're very focused on driving the value of our business through our existing footprint first. We will look to then greenfield opportunities later. And if our currency trades well and we can get back in the M&A game on some future date, then we would do there.

But right now, we're focusing on inorganic -- organic growth opportunities that would require our free and excess cash flow to be deployed locally as statutory capital.

The next question comes from Kevin Fischbeck of Bank of America Merrill Lynch.

Great. Just wanted to kind of follow up on one -- some of the earlier lines of questioning just because the order of magnitude of performance and improvement this year is pretty surprising. So I just wanted to understand if there is anything else kind of this year that looks maybe onetime in nature. I guess, you mentioned $26 million of Florida retroactive payments. But is there anything like that, that says that this base might not be quite the starting point when thinking about 2019?

No. We tried to give you all a very clear picture over how the business was performing. And we actually think that first half sort of pure performance picture of $400 million pretax, $240-plus million after-tax and $3.70 is a very clean and accurate view of how the business is performing. There's puts and takes all over, but for the most part, with respect to our product lines, our local health plans, all aggregated to the consolidated view, we think that's a pretty good picture.

I would also add to what Joe said, I'm sorry. But we have a very high visibility to our premium rates already for the year. So that's pretty good locked in, pretty close to 100% that we know about. So the balance is really managing our medical cost structure. So we have a good sense on that side, so that gives us comfort level to look at second half of the year.

Okay. And then with the Medicaid Solutions sales, it looks that didn't generate much gross profit at all. Does that mean that it was losing money on a net income basis so divesting that business is going to be accretive even before you take into account what you do with that cash?

No. It's pretty much a push on the EPS line. If you assume you're going to repay debt with the proceeds, it's a push on the EPS line. It generated about $30 million of EBITDA and $7 million of EBIT on an annualized basis. So the multiple we got for it was actually quite attractive, but it's a push on the EPS line if you assume we'll repay debt.

The next question comes from Steven Valiquette of Barclays.

So you touched on this a little bit, but for the Marketplace business, just to kind of clarify a little bit further. Separate from your decision whether or not to re-enter Utah and Wisconsin, just based on your pricing strategy, are you budgeting right now for membership growth in the Marketplace in 2019 in the existing states? Or do you anticipate just based on your pricing strategy, it's more likely it could be down or it's still really just too early to tell?

It is too early to tell. But I can only tell you what we strove to achieve in our pricing strategy, which was to -- except for Utah and Wisconsin, which are separate, to maintain the membership profile that we have and maximize the contribution margin dollars. And so for the price and the market that remain competitive, juxtaposed against the competitors that would show well on the exchange, maintain the membership (inaudible) , don't try to grow it but make sure it doesn't attrit and maximize the contribution margin dollars. That was the strategy. And then of course, if we're successful in launching Utah and Wisconsin, that would be added membership. But the strategy wasn't to grow it or let it attrit, it was to maintain it and maximize profit.

Okay. That's helpful. Then just a real quick housekeeping question. For the $79 million risk adjustment payment, thinking about how that may have been allocated by state, is it safe to assume that some of the states where you had the lowest Marketplace MLRs, like in California and Florida, probably had the heaviest weighting of the risk adjustment payment in 2Q '18? I mean, you obviously had a 28% Marketplace, similar in Cali, 39% in Florida. But then Texas is your biggest state, but you had -- that actually had one of the highest state MLRs in the Marketplace had 73%. So I was just kind of curious as to kind of confirm what's probably obvious around the allocation there.

Sure, sure. Very fair question. And the bulk of this risk adjustment item from '17 pertain to the larger states, such as Texas, and the rest I won't go into the detail of that. But certainly, if you look at -- from an allocation perspective, the typical market share that you see from our Marketplace state-by-state, that will be a way to look at. But Texas is certainly the lion's share of that adjustment.

The next question comes from Gary Taylor of JPMorgan.

A lot of my questions have been answered. Just one quick one on the Florida out-of-period benefit, which looks like it would have been $0.31. I mean, the reason you don't, I guess, sort of back that out of kind of the clean earnings number or the go-forward number is just that there's probably other smaller positive, negative adjustments throughout the quarter or various quarters. Is that why that wasn't explicitly sort of backed out like the $0.96 was?

Gary, I'm not sure -- when you say the Florida adjustment, I'm not sure...

Yes, maybe we didn't understand. This was an earlier comment. But I thought you'd said the quarter included $26 million pretax of out-of-period payments in Florida-related to, I think, the higher outpatient fee schedule, which...

Yes, that's correct. Yes. The industry in Florida was handed $185 million update, the EAPG fee schedule, $26 million of it related to us. We recorded it in the quarter. Yes. There were other -- I mean, there's so many other puts and takes in the quarter. We thought we'd call it out because it's sort of an industry phenomenon, and it was sort of known out there and clearly, something that masked the true performance. The core performance of Florida is actually pretty good this year, and it sort of masked that, so we thought we'd call it out. But that's what that's related to.

Okay. And then my other question is as we think about, Joe, you had mentioned this limiting, minimizing the impact of stranded cost as you exit New Mexico and Florida Medicaid revenues, have -- and you said you're committed to that. I guess, the question is how should we think about that in terms of a 2019 headwind. When you say limit the impact, is it plausible to get that to something that's fairly de minimis in terms of EPS impact? Or is it -- it's going to be a measurable impact regardless but you're going to get it as low as possible?

Well, if you recall in our margin projection, we included $50 million pretax of a headwind in '19 due to stranded fixed cost for the combination of New Mexico and Florida. The fact that we've actually now retained over $500 million of our Florida revenue, that $50 million is more like $40 million. So it's already included in our margin forecast for 2019, but I'm not satisfied until we actually try to solve for it. We just thought it was prudent and cautious to say it could get stranded, but we have teams of people who are working on extracting the variable cost, the step-variable cost and the next step would be get at the fixed cost that could get stranded if we don't get at it quickly. So we're committed to trying to outperform that assumption, but it was already included in our 2019 margin projection.

That's a good reminder. I appreciate it. And last follow-on to that would be New Mexico, I think, has been unprofitable from a Medicaid perspective. You talked about behavioral being an issue, so I'm presuming kind of all-in, that's still unprofitable. So is there a measurable EPS tailwind as you exit the New Mexico Medicaid? Or that's sort of encapsulated in some of the stranded cost estimate also on a net basis?

No. When we projected 2019 margins, we extracted the contribution margin from the Medicaid business, and as I said, included the stranded fixed cost. So that's already been embedded in there. Yes, it's already been embedded in our forecast.

The next question comes from Zack Sopcak of Morgan Stanley.

Could I just ask quickly on cash flows in the quarter. Operating cash flow turned negative after a strong first quarter. Anything in there surprising? Or was that in line with how you were thinking about how they would sequence through the year?

Mostly timing of -- I'll kick it to Tom. But mostly just timing of cash flows related to some of the receivables we carry. Tom, you want to elaborate?

Sure, sure. I mean, you look at the operating cash flow, it was down, definitely. And primarily related to the receivable and the timing that we see the premium in certain states. Some of our larger states, California, Florida, Ohio, Washington, they're more or less temporary in nature. And also, we have HIF, our health insurance fees, a receivable that we don't get settled, let's say, until later part of the year. And one other data point is that with the reduction in our Marketplace membership, it went down by more than half, you would see that medical claims payable related to that also came down, therefore, it affected cash flows as well.

Okay. That makes a lot of sense. It helps. And quickly, just the -- one of the first questions asked about 2019 revenue discussion you had at Investor Day, and you talked about potentially a tailwind from Florida, and you talked about puts and takes on Washington. Is Puerto Rico expansion at all factored into that? Or is it too early to have an idea of what impact that could have for next year?

Puerto Rico could provide some upside, but we did not include any upside. At the time we prepared our forecast, it was unclear whether we'd even be successful in Puerto Rico. Now that we have been, we're actually pretty confident that we'll do very well in the auto assignment process for the Commonwealth. And we could see some membership growth from our 320,000 members. But that was not included in our forecast at the time nor was any loss of membership. We pretty much forecasted status quo.

This concludes today's question-and-answer session and today's conference call. Thank you for attending today's presentation. You may now disconnect.