Molina Healthcare Inc (MOH) 2005 Q2 法說會逐字稿

Ladies and gentlemen, thank you for standing by. Welcome to the Molina Healthcare second-quarter conference call. During the presentation, all participants will be in a listen-only mode. Afterwards, we will conduct a question-and-answer session. (OPERATOR INSTRUCTIONS). As a reminder, this conference is being recorded Monday, August 8, 2005. I would now like to turn the call over to Juan Jose Orellana, Director of Investor Relations.

Thank you, Aisha. Hello, everyone, and thank you for joining us. The purpose of this call is to discuss Molina Healthcare's results for the second quarter of 2005. The Company's results were issued today after the market closed, and they can be viewed at our company website. I am joined today by our President and Chief Executive Officer, Dr. Mario Molina; our Chief Financial Officer, John Molina; and our Chief Medical Officer, Dr. William Bracciodieta. They will be offering prepared remarks related to our results, and then we will open the call to take your questions.

I would like to remind everyone that our comments today include forward-looking statements as defined under the Private Securities Litigation Reform Act of 1995. Except for the historical information referred to in this call, all forward-looking statements are predictions by the Company's management and are subject to numerous risk factors that may cause actual results to differ materially from management's current expectations.

Such risk factors include the Company's ability to identify and address medical care cost issues; the Company's ability to accurately estimate incurred but not reported medical costs; the Company's ability to accurately estimate for fiscal year 2005 such financial results as its earnings per diluted share, net income, revenues, medical care costs and administrative expenses; the Company's ability to accurately predict and effectively manage health benefits and operating expenses; high dollar claims related to catastrophic illness; potential reductions in funding for Medicaid and other government-sponsored health care programs; the successful renewal of the Company's government contracts; the favorable resolution or settlement of pending litigation or arbitration; the implementation of rate increases; the Company's ability to obtain regulatory approvals for acquisitions or to successfully integrate its completed acquisitions; the ability to enter into more favorable hospital or provider contracts; changes in health care practices, technologies or utilization; changes in federal or state laws or regulations or the interpretation thereof; risks associated with the Company's start-up operations in these states; inflation; disasters; major epidemics or a flu pandemic; and other risks and uncertainties as detailed in the Company's reports and filings with the Securities and Exchange Commission, which are available on its website at www.SEC.gov.

All forward-looking statements made during this call or in replays of this call represent the Company's judgment as of the date of August 8, 2005. The Company disclaims any obligation to update any forward-looking statement to conform the statement to actual results or changes in the Company's expectations.

This call is being recorded, and a 30-day replay of the conference call will be available over the Internet through the Company's website at www.MolinaHealthcare.com.

I would now like to turn the call to Dr. Mario Molina.

Thank you, Juan Jose, and hello, everyone. Before John addresses our financial results in greater detail, I would like to briefly offer my thoughts on our second-quarter performance. Consistent with our preliminary report of a few weeks ago, the second quarter of 2005 was clearly a disappointment. Based on developments in the second quarter, we revised our earnings outlook for all of fiscal year 2005 to take account of the developments. Today, we want to explain the key factors that led to our disappointing results and what we're doing to improve results in the future.

I am very disappointed by the Company's results. I want to remind you that the Molina family still owns 60% of the Company's stock. Despite the results, the family remains deeply committed to the Company and its mission. The drop in the Company's earnings for the second quarter is primarily the result of medical costs that were significantly higher than anticipated. We had expected our performance in the second quarter of 2005 to be similar to our performance during the same period in past years.

However, results were unexpectedly affected by medical costs that exceeded our forecast. We have launched an extensive review to identify contributing factors and to develop an action plan. Our review has revealed that there were a number of critical factors that contributed to the substantially higher-than-expected medical costs. As indicated in our release, these factors we have identified include higher hospital costs, increased incidence of catastrophic cases, increased maternity costs and increased outpatient utilization, which was caused in part by a greater-than-expected incidence of flulike illness.

Before going into detail on the factors contributing to higher medical costs, I want to emphasize two important points. First, as we analyzed results for the second quarter of 2005, we became aware of $13.4 million in medical costs attributable to services delivered in the first quarter of 2005. Second, in response to rising medical costs, the Company believes it is prudent to increase our reserves by $12 million.

The first factor I want to discuss is higher hospital costs. For the most part, our hospital contracts have not changed from one year to the next. However, member demographics and patterns of utilization have changed. Specifically, we have seen a growth in membership and utilization in areas with less favorable hospital contracts. Even without a change in overall hospital utilization, if a patient seeks service from a higher-cost facility, our medical costs will increase.

The second factor I want to discuss is the increase in the incidence of catastrophic cases. A comparison of our paid claims in 2005 to paid claims in 2004 after adjusting for our increased membership shows that dollars associated with catastrophic cases, those requiring payments in excess of $100,000, have increased faster than our membership. Catastrophic cases, as the name suggests, are difficult to predict in both frequency and magnitude. Our planning process reserves for such events based on historical trends. The frequency and acuity of catastrophic cases we experienced in 2005 far exceeded what historical trends would have suggested.

Let me offer a concrete example from Washington. We had a very small number of hemophiliac patients in Washington that accounted for over $3 million in claims during the first half of the year. When we look back at historical costs for these patients in 2004, it was far less. So what happened? Hemophilia is a hereditary disorder in which the patient cannot make the protein Factor VIII, which is needed for normal blood clotting. We therefore need to give the patient Factor VIII. One patient developed an antibody against Factor VIII. The result of this was that the patient required much larger doses of Factor VIII replacement, approximately 10 times as much as before. One episode of care lasting for nearly a week for this single patient cost 10 times as much as the same patient's care through the entire previous year.

We're working with the State of Washington to ensure that our Washington health plan does not bear a disproportionate share of the cost of serving such seriously ill patients. However, for the remainder of 2005, we're taking a conservative approach in assuming that the levels of high dollar or catastrophic claims observed during the first half of the year will remain in effect for the remainder of year.

The third factor we have encountered had to do with increased maternity costs. We have seen an increase in the frequency of maternity cases in certain of our Medicaid populations. In Michigan, for example, birth rates have increased approximately 33% after adjusting for changes in our membership. The impact on our Michigan plan of this increased rate in the number of births is compounded by the fact that our Michigan enrollment has grown by approximately 69%.

A higher rate of utilization combined with membership growth results, of course, in much higher costs, and you can see how maternity costs can climb quickly. In April 2005, the State of Michigan increased the rate that our Michigan health plan pays hospitals for medical services rendered for maternity care. This has resulted in a net 7% increase to our delivery costs.

However, no corresponding increase was made to our reimbursement rate received by our health plan for maternity care. Giving the higher costs, our delivery margins have narrowed and the effect has been magnified as the result of the high number of births, as I related previously.

Finally, a heavy flu season increased our medical care cost. When speaking about the flu, I'm referring to respiratory illness that are characterized by cough and fever, known in layman's terms as the flu. These illnesses are generally caused by viruses, which may or may not actually be the influenza virus.

The flu season this year was particularly severe in Washington and Michigan and seems to have come later than expected. This affected our forecast of incurred but not reported claims, or IBNR. For example, respiratory illness in Washington increased roughly 60% for the first two quarters of 2005 as compared to the first two quarters of 2004. But our membership in Washington increased by only 30%.

These discordant results indicate that the flu season in Washington was more severe than in past years. A difficulty in detecting this trend early relates to the fact that office visits for respiratory illness do not require prior authorization from the health plan. As a result, we could not take such office visits into account in our financial modeling until we actually received the claims.

Another difficulty preventing us from detecting earlier the increased office visits for the flu relates to pharmacy claims. In prior years, one of the best predictive indicators that we have had for outpatient services has been pharmacy claims. We did see an expected rise in pharmacy claims in the second quarter, consistent with previous years. But such claims did not rise in proportion to the number of visits for respiratory illness.

As many of you may know, the medical community has undertaken a vigorous education program over the past two years, aimed at both physicians and patients, to curtail the unnecessary use of antibiotics. Since these flulike illnesses are largely viral and do not respond to antibiotics, it may be that these educational efforts have been somewhat successful, resulting in fewer pharmacy claims for flulike illness.

As John will discuss in greater detail, these circumstances have contributed to higher-than-expected medical care ratio, affecting our earnings for the second-quarter 2005. Now that I have discussed what happened to our business, I would like to now discuss what we're doing to improve our results in the future.

Although we continue to analyze data as it becomes available, we have taken immediate action on many fronts. As the new data became available, we brought all our health plan CEOs, CFOs and Medical Directors together to analyze the information. Each state health plan has identified its key medical cost drivers and established short-term priorities for battling increased health care costs, while at the same time developing market strategies for continued profitability. Each plan has also developed a comprehensive work plan with priorities to focus on hospital costs, utilization management, claims review and revenue.

The implementation of these initiatives is already underway. I'm confident of our ability to execute the implementation of these initiatives because of the experienced management team that we have assembled. These include new additions like Terry Bayer, our Executive Vice President of Health Plan Operations, who worked in the past for Maxicare and FHP; and Sheila Shapiro, who was with Premera Blue Cross of Washington. More recently, Rick Click join the Company as Chief Information Officer. Rick was formerly Global Technology leader at eBay.

We also recently took steps to strengthen our corporate medical management. Because we contract with state governments for government health care programs, we have little ability to raise premiums in response to medical costs. As a result, controlling medical costs must be our highest priority.

In June of this year, the Company hired William Bracciodieta as its new Chief Medical Officer. He is responsible for oversight of medical management of all of the Company's health plan subsidiaries, including oversight of utilization management, quality management, pharmacy and risk management activities. Before joining Molina, Bill served as Chief Medical Officer for Health Net, for Anthem in its Southeast-East region, for Trigon Blue Cross Blue Shield and for Humana in Florida. Bill is a seasoned veteran with proven success as a Chief Medical Officer in publicly traded companies.

I would now like to introduce Dr. Bracciodieta and give Bill a moment to talk about his philosophy of medical management and the steps that we are taking to address medical costs.

Thank you, Dr. Molina. I'm excited to be here at Molina Healthcare. I think there are a number of opportunities to improve the delivery of high-quality, cost-effective care to our members. I believe that the goal of managed care is to ensure that our members receive the right care at the right time in the right place by the right providers with the right outcome at the right cost.

As Dr. Molina has described, our financial performance here at Molina was due to unexpected increases in medical costs. Over the years, I have built my career by managing medical costs, and there are several major levers that we can pull to manage medical costs without compromising the delivery of high-quality health care to our members. The first of these levers is network and contract management. Where unit costs are rising, we have the opportunity to evaluate and choose which providers we want to keep in our network.

The second levers utilization management. Three areas of focus are prior authorization, concurrent review and retrospective review. These key areas will be among my areas of concentration. We believe that primary care physicians should coordinate our members' care. If that is not occurring, action will be taken.

The third lever is case management and disease management. Because of the increase in catastrophic cases, there are significant opportunities for improvement in this area.

The fourth lever is claims payout management. Our goal is to pay provider claims promptly and correctly. Automated and manual review processes are being strengthened to increase the accuracy and fairness of the claims payment process. As you may already know, as a Medicaid HMO, we have almost no ability to do underwriting or to affect benefit design. Therefore, as a steward of public funds, we must ensure that everyone understands the benefits that are covered.

Finally, there must be tight coordination between medical management, our actuaries and our claims payment operation. We must ensure that we pay only for authorized services and that our actuaries are aware of potential high-dollar cases before the claims are received.

I have give you some general comments about how I will approach the challenges we are facing here at Molina. Now let me outline specific actions that we are executing on during the next two quarters. We are partnering with cost-effective providers; particularly, we are working with our physician partners to ensure that members requiring acute care are referred to appropriate and cost-effective hospitals.

In addition, we are reassessing our hospital network needs in specific geographic areas and are attempting to re-contract with hospitals as appropriate. We will continue our efforts to ensure that the appropriate sources of funding are used in providing for our members' needs. In certain circumstances, this may involve the enrollment of our members in other government programs.

We are also making further improvements to our payment process. The Company has undertaken a number of initiatives to strengthen the linkages between medical management and the claims payment process. Among these initiatives are enhanced preauthorization processes, improved claims auditing procedures and the retention of third-party vendors to review claims adjudication, both before and after the release of payments.

We will be evaluating what we preauthorized, and we will use authorization data as well as claims data to better predict and manage our costs. We will be increasing provider quality and developing programs which can identify performance variation among providers. We will complete the implementation of a program which reviews evaluation and management codes for accuracy. We will be increasing electronic data interchange and communication with our providers. And we will be building specialist networks to support efficient primary care physicians.

Finally, the Company has operated an extensive network of primary care facilities in California for over 20 years. And we are currently evaluating operating our own medical facilities where cost-effective providers are not available.

Now I would like to turn things back to Dr. Molina.

Thank you, Bill. In addition to the medical management efforts outlined by Bill, we're also working with state authorities to ensure that premium rates are adequate, that delivery case rates more effectively match the costs of maternity services and that we do not bear a disproportionate share of the cost of serving the seriously ill. We are continuing our efforts to ensure that the appropriate resources of funding are used to provide for our members' needs. In certain cases, this may mean that insurers or other government programs assume the responsibility of a patient's medical cost.

We understand that these are not overnight solutions, and we do anticipate that it will take some time for these initiatives to deliver results. Given the timing and ramp-up requirements of some of these initiatives, our guidance reflects a second half of 2005 that is similar to the first half of the year.

Finally, the Company has taken steps to strengthen its management infrastructure and improve medical informatics. We have recently implemented the MedInsight tool developed by Milliman USA. This will help us to better understand our costs by provider, geographic region, diagnosis and aid category, among others. This will enhance our ability to turn cost and utilization data into actionable information. In the short run, these steps will increase our administrative costs, but we believe that in return, we will be able to better manage our medical costs in the future.

While I'm disappointed in our most recent results, I'm not discouraged. I believe very firmly that this Company has a bright, long-term future. In fact, in the two years since the IPO, I have not sold any of the shares that I own outright. We are in the right place at the right time, providing invaluable service to state governments to help them address their Medicaid budget issues, at the same time improving access to high-quality care for low-income families and individuals. The challenges that we face are intrinsic to meeting the needs of traditionally underserved populations. This Company has a 25-year history of meeting these challenges. We continue to have a high degree of confidence in our industry, our Company, our future and our ability to overcome these challenges.

Now I would like to turn the call over to John.

Thank you, Mario. As Mario discussed, various developments in our business environment, combined with the challenges specific to our business, had an adverse impact on our results this quarter. The Company recorded a net loss for the second quarter ended June 30, 2005, of $4.7 million or $0.17 per fully diluted share, compared with net income of $12 million or $0.43 per fully diluted share for the same period last year. These results are consistent with the preliminary results communicated to investors on July 20, 2005.

Factors contributing our net loss included $13.4 million in adverse out-of-period claims development related to the first quarter of 2005, which affected second-quarter earnings on a fully diluted basis by $0.30 per share. Given the experience in first-quarter claims discovered during our analysis, we have added $12 million to the Company's liabilities for claims uncertainty. This is a $0.27 impact on a fully diluted basis.

A negative $0.07 per share resulted from one-time charges totaling 3.1 million in the quarter. The charges includes anticipate hospital provider settlements, a loss contract charge for a commercial membership transition services agreement in New Mexico, and costs associated with our equity offering in the second quarter of 2005. This loss, however, was offset in part by a benefit of $1.4 million due to lowered employee bonus expense, resulting in a pickup of approximately $0.03 per share.

Premium revenues for the first quarter ended June 30, 2005, were $401 million, up 62% from 248 million in the same quarter a year ago. Revenue growth is primarily the result of higher membership and, to a lesser extent, the result of rate increases. Membership in the second quarter of 2005 increased to 898,000 members, up 246,000 from the second quarter ended June 30, 2004.

For the most part, the gain in membership can be credited to our acquisitions in California, Michigan and New Mexico. However, our startup health plan in Indiana is growing consistently and contributing to organic membership gains. On a consolidated basis, our growth in membership delivered an additional $110 million to our revenue lines. Higher premiums delivered an additional 43 million. Blended premium increases were the most pronounced at the Company's Michigan and Washington HMOs.

As we highlighted in our press release, in the second quarter, the Company experienced significantly higher-than-expected medical care costs. Our medical care ratio for the second quarter of 2005 increased to 91.9% of revenue, as compared to our medical care ratio for the second quarter of 2004 of 84.2%. In absolute terms, medical care costs increased to $370 million in the second quarter of 2005 from 209 million in the second quarter of 2004.

As Mario discussed, the increase in medical costs was a result of various factors, which included increased hospital costs, increase of incidence of catastrophic claims, increased maternity costs and increased utilization as a result of flulike illness. Excluding the $13.4 million of adverse out-of-period claims development, the $12 million addition to our reserves and the $1.75 million in provider settlements, the Company's medical care ratio would have been approximately 85.2% for the second quarter of 2005.

I would like to emphasize that our analysis and review of claims data related to our acquisitions in the past year does not suggest that the acquisitions caused the unexpected rise in our medical care costs. The blocks of membership transition as part of the transactions in Washington and Michigan are incurring medical costs in line with our expectations, while our New Mexico business is experiencing a higher-than-expected medical run rate, primarily as a result of higher unit cost.

Including premium taxes, our general and administrative expenses increased to 9.2% of total revenue, as compared to 7.6% of total revenue for the second quarter of 2004. As I've said before, we consider G&A expenses less premium taxes, or what we call core G&A, to be a better measure of our administrative efficiency. Core G&A expense increased to 6.7% of total revenue in the second quarter of 2005, as compared to 5.9% in the second quarter of 2004.

The primary causes of our increased G&A ratio were startup costs in our Indiana, Texas and Ohio plans, costs associated with our planned entry into the Medicare market and increased state insurance assessments. Core G&A excluding these items was 6.0% of revenue in the second quarter, compared to 5.9% during the same time in 2004.

This remaining increase of approximately 10 basis points to our core G&A has funded the enhancements to the Company's administrative infrastructure, including bringing on board the additional talent Mario has discussed and improving our medical informatics capabilities.

Cash flow from operating activities provided approximately $8 million for the quarter ending June 30, 2005. Over time, we continue to expect cash flow from operations to approximate net income plus depreciation and amortization.

Days in claims payable increased to 50 days at the end of the second quarter of 2005, up from 48 days for the first quarter. Excluding our Utah plan, our days in claims payable would have actually increased by 3, to 51 days.

As a conservative measure, again in light of claims expense experienced in Q1, the Company has increased its estimate of claims liability as of June 30, 2005, by approximately $12 million to mitigate the impact of any future out-of-period claims development.

For the second quarter of 2005, we finished the quarter with cash and investments at the parent company of approximately $49 million. All of our health plans remain solvent and well-capitalized, with $52 million in statutory equity in excess of regulatory capital. Our $180 million credit facility remains, for the most part, undrawn. As of June 30, 2005, approximately $3 million had been drawn on the facility. As of June 30, 2005, the Company was out of compliance on two credit facility covenants, and we are working with our banks to rectify the situation.

On July 20, the Company made a revision to its guidance for the remainder of 2005 to reflect the impact on the business of higher medical cost trends observed during the second quarter of 2005. We are affirming this previously issued guidance.

For the full-year 2005, we are projecting earnings per diluted share of $0.73 to $0.80. Net income will be between 20.6 million and 22.6 million. Premium revenue will be in the range of 1.6 billion to 1.7 billion. Medical care costs as a percentage of premium and other operating revenue will be between 87.6% and 87.8%. Administrative expenses, including premium taxes and nonrecurring charges as a percentage of total revenue, will be between 9.7 and 9.9%.

This guidance assumes an effective tax rate of 38.0% and weighted-average diluted shares outstanding of 28 million. The guidance includes the estimated impact of the quality improvement fee of 9% implemented by the State of California effective July 1, 2005, and the estimated results of operations of the Indiana HMO.

The guidance does not include any estimated revenue or revenue costs for operations for the Ohio or Texas HMOs, nor does it include any expected benefits from the medical cost control efforts previously discussed. It also does not assume that medical costs return to historic seasonal patterns or the benefits of any rate relief we may be able to secure or receive from the states we contract with.

This concludes our prepared remarks. We would now like to open the call to your questions.

(OPERATOR INSTRUCTIONS). Greg Nersessian, Lehman Brothers.

My first question is just on the itemized list of the drivers of the higher medical costs in the quarter. It looks like some of them relate to the issues that resulted in the negative prior-period reserve development and some of the specific case items, Mario, you mention. But your guidance suggests that some of these costs will continue going forward. Can you sort of go through that list and talk about which are the ones that will continue to persist and are factored into your guidance and which ones are sort of related to issues, maybe flu-related or whatnot, that are in the past and won't be recurring going forward, and maybe quantify those?

Well, I would say first of all, Greg, that we are assuming that the run rate for the second half of the year is going to be very similar to the first half of the year. Clearly, some of those things may not recur. For example, the flulike illness probably will not be a continuing problem. And we're hoping that the outpatient utilization trends that we saw will reverse. We continue to see increased maternity costs in Michigan and Washington, and we've talked about what that relates to and what we are doing to mitigate that.

The increasing catastrophic costs -- clearly a concern, and we would hope that those things, likewise, are not going to continue to recur. But, given what we know at this point, we have decided to continue that run rate. Some of the cases, like the hemophiliac patients, could continue to be a problem.

And with respect to higher hospital costs, we can work to move patients to lower-cost facilities by working with the physicians to make sure that they are utilizing the most cost-effective hospitals. But efforts like recontracting with hospitals will take time, and so we are taking a little bit longer timeframe with that.

So, I guess, would you say that, I mean, with all the growth that you've had -- I know, John, you mentioned that the higher medical costs are not related to the acquisitions. But given that you're covering maybe a larger percentage of SSI members in some of these markets and you're covering different types of members than you historically have, and in different geographical areas, I mean, is there a demographic issue here that suggests that some of these cost drivers will continue because they are based on covering a different population, maybe, than you historically have?

Well, Greg, I think that our guidance assumes that the costs are going to stay the way they have been in the first half of the year. In terms of are we covering more SSI, we're covering more absolute numbers of SSI patients, but our percentage has remained unchanged. That's why, as we developed our estimates for costs, we assumed that the high-dollar cases would stay at about the same level as they had in the past. It didn't happen.

As far as some of the other demographic changes, we are still looking at what the impact of having more patients in western Washington, for example, means for the overall business. But that's why we just want to take a very conservative approach and assume that we're going to get no benefit from the recontracting effort that Mario discussed or some of the medical management issues that Dr. Bracciodieta discussed.

One other thing, Greg. I want to emphasize you cannot assume that the changes in medical costs are simply due to changes in the aid categories -- I mean the numbers of patients in those aid categories that we are taking care of. As John points out, some of it really is geographic.

Okay. That's fair. On this hospital recontracting effort, could you give us a sense of where that is geographically and maybe what percentage of your hospitals you need to recontract with, and also a flavor of what types of contracts those are now and how those need to be changed, what the basis of those reimbursement methodologies have to move to?

Greg, this is Bill Bracciodieta. As you know, a hospital recontracting effort is a massive undertaking, and we're looking at all of our contracts throughout the Molina sphere of influence. So we will be looking to change the payment methodologies and to narrow networks so that, once we've identified the providers and hospitals that are the most efficient, we can then bring some membership leverage to bear. But as far as geography, it's the entire Molina sphere of influence, and I would not be able to give you a timeline at this point. It's way too early in the game to talk about that. But, as you know, recontracting is a long-term proposition.

Okay. Great, thanks. I will get back in queue. Thank you.

Tom Carroll, Legg Mason.

Question for you that is related to Greg's, in perhaps a bit more detail. And I asked you this a couple weeks ago, but now that you have had time to review more of the catastrophic claims in more detail, were there any consistent themes that presented themselves as you look at that block of catastrophic claims? For example, were the claims disproportionately incurred by SSI members versus TANF members? Were they chronic in nature? Did they tend to be accidents? Can you chat a bit about that?

Well, I'll sort of take it in reverse order. No, it does not appear that these are chronic problems. They are more acute medical problems. They were high-dollar, catastrophic cases.

And they were all over the board, unfortunately. I think, if you look at the increase in the number of claims over $50,000, that increased by over 67%. So it's not like these are all neonates, Tom. If they were all neonates, I think that's what we would have -- we would expect some sort of a pattern there. But it's also with adults. We don't cover SSI to a great degree in California and Washington, and we did see significant increases in these cases in both of those states as well.

Okay. Interesting. I'll move on from there. The medical facility comment you had -- does this imply that you plan to open your Company-owned facilities in markets other than California? And how would that work? Maybe just walk us through an example.

Well, you are correct in your assumption. We are looking at the possibility of opening up medical clinics in areas outside of California. One of the primary drivers for this is inappropriate ER utilization. So, to the extent that people are having difficulty getting in to see a primary care provider or going to an emergency room after hours, we think that there are opportunities for us, if we can't contract with more cost-effective providers, to open our own medical clinics. We certainly have a lot of experience operating primary care clinics; we have done that successfully for over 20 years.

Matt Perry, Wachovia Securities.

A couple questions on the increase to reserves for maybe some future negative prior-period development. Is that 12 million, is that, do you think, related to further claims to come in for the first quarter or more for the second quarter? And could you maybe quantify how much of that 12 million you think is related to maybe increased hospital costs versus, like, the maternity costs and catastrophic cases?

I think the additional conservatism in our reserving is related to, probably, still the peak in March that we saw with Washington and Michigan flu illnesses that Mario discussed. That's really where it peaked. And maybe some spillover into the second quarter. We really saw our cost increases, I would say, more on the outpatient maternity side than we do on these catastrophics, but, since the costs for the first quarter were so unexpected, we felt that it would be best to be as conservative as possible.

And could you maybe talk about -- it seems like hospital recontracting and maybe changing the behavior of some of your referring physicians is going to be an important part of addressing the higher costs. Can you talk about maybe how much you think -- how much improvement you can maybe see from each of those items? And maybe give a couple examples of how you might be able to change the behavior of the referring physicians?

Well, let me make a comment on that. First of all, we have already implemented some of these measures and made some adjustments to the referral patterns. As Bill mentioned, we have a very large network. In some of the geographic regions, we contract with virtually every hospital, and I'm not really sure that's necessary. So there are some definite opportunities. We have already begun making some inroads there.

In terms of quantitating how many providers we're going to have in the network or how that is going to work in the future, I think it's a little premature for us to say that. But we are definitely working on it. We have already taken some immediate steps to change some of the patterns of utilization.

And are those steps that you think will have at least the opportunity to provide benefits in the shorter term versus longer-term recontracting?

I think changing the utilization patterns will have some immediate impacts, but the bigger issue, as you point out, is negotiating new contracts and looking at who are our most cost-effective and efficient providers. That's going to be more of a long-term solution. So there's a combination of both.

Do you think at this point you have the data to identify appropriately those higher-cost providers?

Well, we mentioned that we have implemented a new program called MedInsight, which was developed by Milliman USA, our actuaries. And it gives us an incredible ability to spec the data down by county, by hospital, by physician, by member. So with the new tool, and it has just recently been implemented, I think we have a lot more ability to take traditional utilization data and convert that into something that we can actually used to better manage costs.

Okay. And just lastly, you've mentioned a few of the regions were you have seen the higher costs. Are you seeing anything in California that would worry you, or do you think the cost trends there are as expected?

Well, first of all, let me just preface my remarks by saying it all worries me. I don't think that there's any particular area that we can ignore, and even in areas where we're doing well, I think we need to turn over every stone and look for ways that we can improve. Each state has its own particular issues. Each one of the management teams from each state has identified what are the cost drivers in that particular state and are taking steps to address it. Certainly, hospital costs are an issue here in California. But likewise, this is probably the area where we have the largest hospital network. So I think in many respects it gives us a great deal of opportunity.

Carl McDonald, CIBC.

I just wanted to follow up on one of the earlier questions. If you allocate the unfavorable development, strip out what you consider to be one-time items, can you give us a sense of how you're thinking about run rate earnings for both the first quarter and the second quarter?

Okay, Carl, for the first and second quarter, if you make those changes, you take the 13.4 that we came up with the analysis and push that back into the first quarter, as well as the additional claims liability and the onetime provider costs, we're looking at a medical care ratio for Q2 of about 85.2%. I don't know what that -- you have got to add those things to the first quarter, you come up with the MLR for first quarter. I don't have that off the top of my hand.

Okay, but those sort of three items plus the $1.4 million benefit would be the major sort of what you would call one-time-ish items in the second quarter?

Correct.

Okay. And will you guys also consider share repurchase, given the stock's current price, the potential return from share repurchase relative to the M&A opportunities that you are seeing out there?

That's a very interesting question, Carl. We are looking at that. It is a balance between what we think is the best use of our capital. And other issue is, frankly, to the extent that we do stock repurchases, we also decrease the float. And we have heard from investors that that's an issue that they would like to have us address. They want to see more float. So we have not made any decision yet as to what we're going to do, but we are considering it.

And lastly, as you look at some of the high-cost catastrophic cases, can you give us a sense of how many of those typically recur from period to period? Or is it a situation where you tend to have a high-cost claim for a certain period of time, it then goes away, on a sort of member-by-member basis?

Well, the most of the catastrophic claims are one-time kind of events. The problem we had is that the number of those increased out of proportion to the membership. So we're going to have to take some time to see if we are in a new state in which we can expect on a traditional going-forward basis to have more of these types of catastrophic claims, or if this is really an anomaly.

But I think when you look at the guidance that we are giving and the medical costs that we are projecting for the second half of the year, it takes into account that uncertainty.

Josh Raskin, Lehman Brothers.

I just had two questions, the first on the flu. I was wondering if you could just walk us through how the accruals for the flu season for '04 and '05 might -- it sounds like you guys, I guess, had accrued, didn't see it, so maybe took down some of those reserves and then now are sort of adding them back. So I was just wondering just if you could walk us through what the procedures are. You can leave the amounts out, unless you feel comfortable giving some of those as well. That's my first question.

Well, I think the flu season typically is a December and January event, and we did not see, either in the pharmacy data or in the paid claims that we got through the first quarter, we really didn't see much in the way of a spike. And so we set the reserves based on that information. During the second quarter, as we were doing the analysis, we did see, although we didn't see an increase much in the pharmacy expense, as Mario mentioned, we did see an awful lot of office visits for respiratory illnesses coming through. So we set a higher reserve, really related to the March time period, during the analysis of the claims that came through and paid for during the second quarter. And that's really caused us to increase those reserves. And it was both inpatient- and outpatient-related respiratory illnesses.

Got you. So those reserves weren't made, though -- obviously, you didn't see that until March, so you didn't make those until the second quarter?

That's correct. It wasn't until we were doing the analysis on the claims trends in the second quarter that we realized that we had underestimated the costs during the first quarter and so had to go back and increase those triangles.

Got you. And then just on the catastrophic claims, I understand that you guys are sort of staying away from giving actual amounts are. But could you help us understand magnitude of deviation, if we think about the actuarial range that you guys probably typically set around those events, were we one standard deviation, two standard deviations away from the high end? Just to give us a sense of where these came in.

Well, first of all, Josh, actuaries don't look at things in terms of standard deviations. But I'll let John take the rest of the questions.

We saw an increase, Josh, over $10 million year-over-year in terms of the catastrophic cases. And we define catastrophic as things over 50,000.

Off a base of--?

Off a base of less than 20, so it was about a 50% increase.

So in your sort of -- you guys have been around for 20 years. Is there anything ever -- is this as bad as you've ever seen it in terms of that 50% increase, or has there ever been a similar period?

Not that I can recall.

No, we can't recall ever having a quarter like this. This is unusual. I think we have time for one more question.

Ed Kroll from SG Cowen.

My question, first, is on the provider settlement. Is that fully cleaned up now? And maybe you can just briefly tell us what that related to. I mean, is there a chance that there could be some more of this coming in the coming quarters? And then same sort of question on the 900,000 transition service cost in New Mexico. Is that done, or could there be some recurrence of that as well?

I thought I'd mention that we kind of stumbled over the word good. There wasn't a whole lot of good about this call, but in terms of the provider settlement issues, there are some provider disputes we have basically around interpretation of provider contract language, and we have reserved some money basically to settle those things. I don't think this is going to be a big, recurring item, but it's not fully completed yet.

And as far as the lost contract, that is a cleanup item. It is done now; it's behind us.

Okay, great. And if I could just shift gears to Indiana, wondering, A., was your membership, which seemed pretty sizable to me -- were you profitable in the quarter, or were development costs, did that overwhelm any underwriting profit? And then, can you give us a sense what the PMPMs are there in Indiana and what kind of growth you would be looking for for the rest of year, just ballpark, if you could?

Okay, well, first of all, Ed, we typically don't discuss the profitability on a state-by-state basis, but the Indiana plan has been growing nicely. Nevertheless, it really is not an important factor right now in our financials, either positive or negative. It's just too small to have much of an impact.

And just a sense -- I mean, do you anticipate growth in the second half in membership in Indiana?

We think we will see some as they continue to convert that state to mandatory managed care throughout the state, but I think it would be premature to come up with any kind of enrollment projections.

All right, well, thank you, everyone. We appreciate your participation.

Ladies and gentlemen, that does conclude the conference call for today. We thank you for your participation and ask that you please disconnect your lines.