Molina Healthcare Inc (MOH) 2014 Q3 法說會逐字稿

Ladies and gentlemen, thank you for standing by. Welcome to the Molina Healthcare and Third Quarter 2014 Earnings Conference Call. (Operator Instructions) As a reminder, this conference call is being recorded Thursday, October 30, 2014. I will now turn the conference call over to Juan Jose Orellana, Senior Vice President of Investor Relations. Please go ahead, sir.

Thank you, George. Hello, everyone, and thank you for joining us. The purpose of this call is to discuss Molina Healthcare's financial results for the third quarter ended September 30, 2014. The Company's earnings release reporting its results was issued today after the market closed and is now posted for viewing on our Company website.

On the call with me today are Dr. Mario Molina, our CEO; John Molina, our CFO; Terry Bayer, our COO; and Joseph White, our Chief Accounting Officer. After the completion of our prepared remarks we will open the call to take your questions. If you have multiple questions, we ask that you get back in the queue so that others can have an opportunity to ask their questions.

Our comments today will contain forward-looking statements under the Safe Harbor provisions of the Private Securities Litigation Reform Act, including but not limited to forward-looking statements about our Medicaid and MMP duals growth, the reimbursement of the ACA insurer fee, the recognition of quality-based revenue by our Texas health plan, our expected membership and revenues in Puerto Rico, and our medical costs. All of our forward-looking statements are based on our 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 October 30, 2014, and we disclaim any obligation to update such statements except as required by 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 Dr. Mario Molina.

Thank you, Juan Jose, and hello, everyone. Our performance this quarter is consistent with what we discussed at our investor day in September. We continue to operate in a very dynamic environment, one that has brought us a tremendous amount of growth in a short period of time. Our premium revenue, which has been fueled by unprecedented enrollment gains, now stands at $6.4 billion on a year-to-date basis, and $200 million more than we booked in all of 2013.

To put our growth in perspective, it took our Company approximately 23 years to grow to 500,000 members. This year we added nearly 500,000 members in the first three quarters alone, but that's not all; we now expect to add an additional 500,000 members in the next nine months. This makes for an exciting time for our Company, a time filled with exceptional growth opportunities that are already contributing to a dramatic expansion. Two-thirds of our new enrollment this year has come from Medicaid expansion lives led by California, Ohio and Washington. The remaining third has come from initiatives that are even more significant to our long-term growth, the expansion of our geographic footprint, and the addition of new programs for the chronically ill.

We expanded our footprint adding South Carolina and Illinois. Our Florida health plan began rolling out the new Managed Medicaid Assistance, or MMA program, in August. The Florida health plan was involved in two acquisitions -- one in Palm Beach and one in the Jacksonville service area. The Jacksonville transaction is now approved for transition of members starting on December 1, 2014, and we anticipate that approximately 65,000 members will be transitioned to become Molina members. In terms of programs for the elderly and disabled, many of whom are chronically ill, we have also implemented dual-eligible contracts in California, Illinois and Ohio, as well as new long-term care contracts in Florida and New Mexico. Last, we began selling marketplace products in nine of our states, and we have learned a great deal from this experience over the past year. Collectively, the coordination of all these new programs combined with Medicaid expansion represents the largest and fastest integration in the history of our Company.

With this growth environment as a backdrop, it is not surprising that our top line revenue growth has been excellent. Administrative costs are also tracking just as we expected. We continue to reap the benefit of the investments in infrastructure that we made last year. As a matter of fact, our year-to-date admin ratio of 8.2% is 160 basis points lower than last year, and our third quarter admin rate of 7.2% is the lowest in five years. This has contributed to the doubling of pre-tax income when you compare the third quarter of 2014 to the third quarter of 2013.

We are positioned to continue capitalizing on this growth and we are fully aware that short-term issues are the price we pay for long-term success. So, let's talk about some of the factors that are having a greater impact on our short-term profitability. They include the delays in revenue recognition, the programmatic challenges of integrating a new managed care business, and a difficult rate environment across many of our states. I will now expand on each of these factors.

First, the delay in revenue recognition has affected our financial results throughout the year. Specifically, the delay in recognition of the health insurer fee and the quality incentive revenue under our contract with the state of Texas have yet to be fully resolved. With respect to the health insurer fee, as of today the Company has a formal commitment for the reimbursement of about 60% of the 2014 fee, including tax effects. Most of the shortfall relates to our California, New Mexico and Texas health plans. Unreimbursed health insurer fees from California, New Mexico and Texas plus unreimbursed tax effects of the fee from Michigan and Utah amounts to $50 million in total for all of 2014.

To date, we have paid $89 million related to the health insurer fee to the Internal Revenue Service, with $81 million related to Medicaid and $8 million related to Medicare. Even though we received informal acknowledgement from California, New Mexico and Texas that they are responsible for reimbursing the fee, so far they have not made formal commitments. We continue to believe that this represents a timing issue and that all of our states will ultimately fund the fee. However, we are less certain that they will formally commit to doing so before the year end.

Failure to secure formal commitments to reimburse the fee will delay revenue recognition and we can expect that some states will not provide such formal commitments until next year. Let me remind you, as we talked about at our investor day, our 2014 guidance assumed that we would be able to book 100% of the fee during the current year. So, the inability to recognize any portion of the $15 million in reimbursement not yet secured will represent a shortfall from our guidance.

Our other major barrier to revenue recognition is related to quality incentives in Texas. You will recall that we have about $35 million of potential quality revenue in Texas for the full year and that our 2014 guidance includes full recognition of this amount. We have yet to receive clear direction from the State as to how some of these quality measures will be calculated. So far this year we have recorded only $8 million of that revenue. To the extent that we do not receive clear guidance by year end, we will not record the full amount of Texas quality revenue. As with the health insurer fee, the outcome of this matter will have a direct effect on our performance versus guidance in 2014.

The second factor impeding profitability in 2014 has to do with implementing new managed care programs and the challenges involved in caring for those with chronic health conditions that result in higher medical costs. Currently, our medical costs are trending slightly higher than we anticipated, and we expect this trend to continue as we bring on additional enrollment in the near future. You may recall, large scale migrations from fee-for-service to managed care that we implemented for the TANF and ABD populations in Ohio; for ABD in California, or in managed care expansion for Star Plus programs in Texas in 2012. These implementations resulted in short-term margin compression due to medical cost volatility. Over time and with the help of medical management initiatives, these programs stabilized and began contributing to earnings as the medical care ratio declined. The implementation of a new managed care program is further complicated by the complex needs of our new members. The care model for chronically ill requires skill, patience and persistence. Frequently, it requires educating both members and physicians about the most appropriate ways to access healthcare services. It requires hard work in assessing the health condition of new members, developing care plans for patients with complex conditions, ensuring that their home environments are supportive of good health, and constant follow-up to coordinate care among medical, behavioral health and personal care providers. In many cases it is difficult to even locate and establish contact with our new members.

Many of you will recall that Terry spoke at length to these issues when we were in New York City last month. Among her lessons learned was that the chronically ill require more intensive management than even we anticipated. We have spoken many times over the past year about the growth in the number of members receiving long-term services and supports, or LTSS. We have also discussed how on a percentage basis profit margins on LTSS are generally lower than those on the acute medical benefits, providing us with very little wiggle room. Despite these challenges, we remain confident in our ability to improve medical margins over time.

First, as members become acclimated to managed care and enrollment decelerates, we would expect medical costs to come down. Second, we have proven in the past that our medical management and care coordination efforts are successful in reducing medical costs over time. A third factor is per-member per-month premium revenue. Premium rate increases have not kept up with medical inflation. We have had success in addressing inadequate premium rates before. One need only look to the experience of our California health plan to see the dramatic effect that even modest rate increases can have on our financial performance. We remain optimistic that the revenue recognition issues associated with the health insurer fee and the spike in medical costs will improve over time. The adequacy of premium rates is an ongoing challenge in our industry. We will continue to support actuarial soundness, but we need more transparency into the states' rate-setting process.

We continue to seek new market opportunities that are consistent with our mission and strategy. This month Molina was selected by the Puerto Rico Health Insurance Administration to operate the commonwealth's Medicaid-funded government health program in the east and southwest regions. We are pleased to have been selected and we look forward to working closely with local providers in order to satisfy readiness requirements. Under the government health program, the new model of care in Puerto Rico will integrate medical and behavioral healthcare services under a single managed care organization in each region. Molina Healthcare's total expected enrollment opportunity in the two regions is about 350,000 members with expected annualized revenues of approximately $750 million. The program currently covers 1.4 million beneficiaries across Puerto Rico and is expected to begin in April 2015.

Along with continuing to pursue opportunities for the future, we continue to focus on providing high quality, cost-effective care for our members. For our Company, quality is a strategic priority. We therefore consider it a great achievement that for 10 consecutive years our health plans have been nationally ranked by NCQA for providing quality care. This year, 9 of our health plans were ranked by NCQA among the best Medicaid health plans in the United States. Our Medicaid plans in New Mexico, Utah and Washington are the highest ranked plans in their respective states. Providing our members with access to quality care continues to be our top priority today, just as it has been for the last 34 years.

The third quarter of 2014, much like the first and second quarters, faced many of the headwinds we have been talking about all year. Nevertheless, we have more than doubled our pre-tax income when compared to the third quarter of last year. We have not reached all of our goals and we will not reach them overnight, but we are certainly making progress. Now I would like to turn the call over to John.

Thank you, Mario, and hello, everyone. Diluted net income per share doubled to $0.33 during the third quarter of 2014, compared to $0.16 per diluted share during the third quarter of 2013. Adjusted net income and adjusted EPS from continuing operations increased to $0.83 per diluted share this quarter compared to $0.71 during the same quarter a year ago. During the third quarter we maintained the strong enrollment and revenue growth we saw in the first half of the year and improved our administrative cost performance markedly.

In summary, premiums and administrative costs are tracking consistently with our expectations. Our medical care ratio is tracking slightly above our expectations, which is creating some pressure on our bottom line. First I'll talk about revenue.

Total revenue this quarter reached $2.5 billion, fueled by increases in both membership and per-member per-month premium. During the third quarter, enrollment grew across all of our products. Let me provide you with some enrollment highlights.

Medicaid expansion on enrollment was strong and grew over 80,000 members this quarter to 315,000, a 35% increase. Not only does our current Medicaid expansion enrollment significantly exceed the enrollment guidance we provided, but the number of expansion members we have added so far this year exceeds the total membership we added in 2012 and 2013 combined. And we are encouraged by recent studies published by the Kaiser Family Foundation and Modern Healthcare that suggest we may continue to see more Medicaid expansion enrollment growth in 2015.

In addition, other states continue to review expanding their Medicaid programs. For example, last week the state of Utah announced that it has come to terms with CMS on a Medicaid expansion program. Enrollment also grew dramatically in Florida and Illinois. The Florida health plan added 40,000 members during the third quarter. In addition, once the Jacksonville transaction closes in December, we anticipate that approximately 65,000 members will transfer to Molina.

In Illinois, we began participating in the managed care program for TANF and expansion patients in August, and our enrollment in that state grew by 15,000 members in the third quarter. Illinois TANF and expansion enrollment is still growing, and we anticipate our membership will increase by 60,000 members in the fourth quarter.

I want to take a moment to highlight that combined 125,000 members that we are expecting from Florida and Illinois during the fourth quarter is the equivalent of adding another entire state. As a point of comparison, our health plan in South Carolina currently has 118,000 members.

We launched Medicare-Medicaid plans, or MMPs, in California, Illinois and Ohio. At September 30, we served over 14,000 MMP members. These are members for whom we provide both Medicare and Medicaid benefits. At September 30, we also served over 20,000 MMP-eligible members in California and Ohio for whom we provide only Medicaid benefits. Over 80% of MMP-eligible members for whom we provide only Medicaid benefits are in Ohio. MMP-eligible members in Ohio are not yet assigned by default to a managed care provider for Medicare coverage. Only those who actively choose or opt-in to receive an integrated offering are enrolled as fully integrated MMP members. Passive enrollment of members into an integrated program is not slated to begin in Ohio until 2015.

Setting aside the technicalities of enrollment, fully integrated MMP members have contributed almost $95 million to premium revenue in the nine months ended September 2014, while MMP-eligible members receiving only Medicaid benefits from Molina contributed another $95 million.

Despite the rapid ramp-up in revenue, we have had some revenue-related issues this year. The most significant, of course, has been our inability to recognize as revenue the full reimbursement we believe we are owed from state Medicaid agencies for the ACA health insurer fee. To reiterate what Mario said, we have about $50 million of health insured fee revenue for the full year of 2014 that we have not been able to recognize even though all the state Medicaid agencies have informally committed to full reimbursement including tax effects. Without a formal commitment from those states, principally, California, New Mexico and Texas, we will not be able to book any of the remaining $50 million this year.

There is still the uncertainty surrounding the Texas quality revenue. We have about $35 million in potential quality revenue in Texas for all of 2014. Through September 30, we recognized only $8 million of that revenue. Unfortunately, we continue to wait further clarification from the state, and given this late date we are doubtful that we will be able to recognize the full amount of our Texas quality revenue during 2014.

Now let's move on to medical costs. I want to emphasize three points. First, the Company's transition to a chronic care focus makes meaningful comparisons to last year's results difficult. As we said before, premiums for long-term services and support, or LTSS, are much greater than those for acute medical benefits, but the percentage margins for administrative costs and profit built into those rates is much lower than that for traditional medical benefits. Through September 30, 2014, we have recorded premium revenue of about $1.1 billion tied to members who are eligible for LTSS, compared to only $700 million for the first nine months of 2013. This 57% growth in LTSS revenue resulted in an increase to our medical expense ratio of 1.2% in the third quarter of 2014.

To further demonstrate how our financial measurements are changing, despite the fact that our medical care ratio increased by 3% during 2014, our medical margin as measured in dollars increased by 8%. Again, as our business continues to grow and become more complex, we will be exploring new methods of presentation that better capture these characteristics. We find geographic descriptions are less informative than product descriptions.

Second, as Mario pointed out, flat to very low rate increase across the Company's traditional Medicaid business have resulted in higher medical care ratio. Third, lack of coordination in the design of profit caps and medical cost floors in some of our contracts is resulting in counterproductive outcomes. In some instances givebacks due to profitable performance in one product cannot be offset against losses in other products. We believe the resulting asymmetric assignment of risk is unfair to health plans and counterproductive to the goal of Medicaid programs to ensure access to care for all beneficiaries.

For example, at our Washington health plan, adjustments to premium revenue as a result of minimum medical loss ratio requirements for the Medicaid expansion population reduced income before taxes by approximately $17 million for the third quarter of 2014, and $23 million for the nine months ended September 30, 2014. Simultaneously, the Washington health plan incurred a medical care ratio in excess of 100% for its aged, blind and disabled members. However, we are unable to offset profits from our Medicaid expansion contract against our ABD contracts. The Washington health plan is therefore left in a position where it must return profits under its Medicaid expansion contract while it receives no relief from losses incurred under its ABD contract despite very little differences between the two programs.

In a similar manner, our New Mexico health plan received a new contract provision limiting profits on retroactively added members, which reduced income before taxes by approximately $6 million for the nine months ended September 30, 2014. At the same time, the New Mexico health plan's LTSS program operated at a medical care ratio in excess of 100%.

In reviewing our overall medical cost performance, I will remind you of what we have said in the past -- 2014 and 2015 will be years of rapid growth, while 2016 will be a year of stabilization. Stabilization and margin expansion will come as we integrate new members into our care models. Our past experiences in Ohio and California, where we have thrived in difficult situations by both managing care and getting appropriate premiums, gives us confidence as we look to the future.

We continue to achieve greater administrative cost leverage. At our investor day events in 2013, we communicated how we are investing in the infrastructure to support our growth, driving administrative costs as a percentage of revenue up to over 10% last year. Earlier this year we discussed our expectations related to administrative costs for 2014. As expected, our administrative costs as a percentage of revenue have declined significantly during 2014 as our revenue has surged. General and administrative expenses were 7.2% for the third quarter of 2014, a decrease from 8.4% in the second quarter of 2014. We remain confident in the target of about 8% for the whole year of 2014.

During the third quarter of 2014, the Internal Revenue Service issued final regulations related to compensation deduction limitations applicable to certain health insurance insurers. Pursuant to these final regulations, the Company recorded a tax benefit during the third quarter of 2014 of approximately $7 million for periods prior to the third quarter of 2014. Days and claims payable this quarter increased by 4 to 50 days. As of September 30, 2014, the Company had cash and investments of around $2.4 billion including approximately $347 million at the parent. And cash flow from operating activities was very strong through September 30 at $841 million.

We now believe that our earnings per diluted share and our adjusted earnings per diluted share may fall below the low end of the ranges included in our previously issued 2014 guidance. This is because, as we have disclosed in the past, our inability to fully recognize the ACA health insurer fee revenue and the Texas quality revenue in 2014, along with medical care costs that are trending higher than we anticipated as compared with our most recent full year 2014 estimates, and the impact of certain contractual provisions that limit our ability to retain profits.

At our investor day in 2012, we embarked on an ambitious plan to double our revenue, decrease our administrative ratio and increase our margin. We are well on our way to accomplishing the first two of these goals. We have consistently stated that we are focused on this long-term plan and an investor should not be distracted by quarterly fluctuations that are inevitable. We remain just as excited about our prospects today as we were when we announced that plan. This concludes our prepared remarks, we are now ready to take questions.

(Operator Instructions) Our first question comes from Sarah James with Wedbush. Please go ahead.

Thank you. I just want to get a little bit more color on what changed in your expectations. It sounds like the majority of it, which is the two timing issues, so I wanted to understand if it wasn't for the health insurance fee in Texas now looking more like a 2015 than 2014 event, could you have maintained guidance? Or was there really something that changed intraquarter on your understanding of the ability to net contracts in a state against each other when looking at profit caps?

Sarah, I think there are a couple of things there. First of all, as you said, the majority of the disconnect is the timing on both Texas quality revenue and health insurer fee. Those combined are close to $77 million, almost $80 million. Then we had the Washington settlement in the third quarter, which was a drag of $11 million, and I think that the impact of the inability to net the profits is an issue. Did we know about it early on? I think we did theoretically, we just didn't understand the impact, and we certainly did not know about the take-back in New Mexico where the retroactive membership was capped at basically a 95% MCR, leaving very little room for profit there.

Got it. If I kind of try to look at what the clean numbers or run rate if I'm taking out the timing issues with the ACA fee, the Texas and Washington payment that doesn't repeat, and you have mentioned before an SG&A number that wasn't matched timing-wise. I'm kind of getting close to $1.36 or so of nonrepeating headwinds, so when I think about go forward, the outlook looks a lot brighter going forward.

Well, I think as I said, we are excited by our prospects. We have some very good growth momentum. We've got Puerto Rico coming on next year. Admin costs are coming down just like we expected, so now it is a matter of us trying to work with the states on correcting some of these contract issues, getting some premium rate increases, as Mario said. For the base business it's been a struggle in most of the states to get what we think are adequate rates. But, yes, we think that we are in good position right now.

Thank you.

Our next question comes from Christian Rigg with Susquehanna Financial Group. Please go ahead.

Thanks for taking my questions. I just want to make sure I understand sort of the EPS in the quarter. So, GAAP was $0.33, you've got $0.07 from the HIF, $0.05 from Texas quality, $0.14 from Washington penalty payment, and then another sort of $0.15 benefit from the retroactive adjustment on the nondeductible comp tax issue. That gets me to about $0.44. Is that kind of the right way to think about it, maybe a penny or two lower for the in-quarter contribution from the nondeductibility in comp?

Joe is adding up the numbers right now as we speak. You are a little bit faster on you arithmetic than he is.

Yes, Chris, I think that is definitely a good way to look at it.

Okay, and then on the G&A absolute costs, my modeling expect a similar amount of leverage but obviously I was a little higher on the top line, but on an actual dollar amount, the G&A expenses declined fairly meaningfully quarter to quarter. Can you give us a sense for what drove that?

It's Joe speaking again. Chris, you know, it is a variety of things. I wouldn't expect that decline. I would just say I wouldn't expect that decline to repeat in the fourth quarter as we gear up for Puerto Rico and we consider what advertising investments we want to make leading into the 2015 enrollment for marketplace. I guess I would just say that the spending had some cycles and this quarter we were just down a little bit. We are still, I think John mentioned in his remarks, we are still -- we are not changing the overall guidance to 8% for the year, so I would just stick with what we talked about since February in terms of admin spend.

Okay, thanks a lot.

Our next question comes from Josh Raskin with Barclays. Please go ahead.

Thanks. Good afternoon. So, I just want to dig into the medical cost issue, because that seems to be the one that is not timing related. And I feel like I've asked this in the past on certain situations like this. But I guess which medical costs specifically are coming in higher, and maybe you could help us with you diligence process on when you are taking on some of these new contracts, especially some with high acuity. Do you use consultants, actuaries? I am just curious how you guys come up with sort of expectations, especially for these new populations. And, again, maybe help us with which buckets have been the most surprising?

Sure, Josh, this is John. I think the two or three areas that are the most meaningful in terms of the MCR would be the LTSS services in New Mexico. Now, we were given data from the state of New Mexico that was a rate bid within a band. We were either the highest or the second highest in terms of what we bid. So, given everything that we saw from the state, our actuaries and outside actuaries, we felt pretty good about that, and it is still running in excess of 100%. We think the state just made some errors in some of their assumptions when they gave us the rates, most notably, the challenge of getting out and reaching all these members.

I think secondarily you've got the HOBD, or the blind and disabled up in Washington, and what happened there was, again, we bid right in line with all of the other managed care players using our actuaries and I believe some consulting actuaries. And we were fine on that program in 2013, but, again, the state then cut the rates because they assumed greater managed care savings than we told them we could get, and I think all health plans expected to get. And it was a bit similar to the situation in Texas, where the actuaries and the state put in assumptions that are too aggressive. The state also included psychotropic and other high cost drugs but didn't give us the tools to manage that and I think that cost us somewhere in the neighborhood of $1 million through nine months. So, like I say, some of these are programmatic things. I know that Florida looks a little bit out of line. The Mario Molina, new MMA members are coming in, I think for the most part, in line, but you've got pretty significant amount of the real high cost nursing home patients there.

Okay. So, I guess my real question is you've got five states running MLRs over 90% at this point, so what's the response? I mean, growth is obviously important and helpful long term, and we are certainly willing to see growing pains, etc., but when do you make a decision? I don't remember the last time Molina exited a program, so is there a point you are talking about chronic multi-year underpayment, do you have to sort of put your foot down in any of these states and just say enough is enough?

Well, I think that the ones that have the most impact are Washington certainly because of how large it is, and I think we talked a little bit about the issues in Washington and some potential remedies. There is really not much difference in terms of looking at the membership profiles of the ABD population in Washington and the expansion population. They are very close in age, very close in utilization, etc., why not offset one line of business with the other? In Texas, that is over 90%, but a good chunk of that, of course, is the unrecognized revenue. Utah has traditionally grown very well. I think that is more of a Medicare issue. So, that's why we are looking at more programs than geographies in the future.

Okay. Can I just ask one quick on the tax rate? What is your expected tax rate going forward now that you no longer subject that compensation deduction limitation?

This is Joe speaking. I don't want to speak to 2015 yet, because this rate is very -- our effective tax rate is very much a product of what our pre-tax income is. So, speaking just to the fourth quarter, Josh, a lot is just going to play out that is just going to determine on whether we can pick up any of this ACA insurer fee revenue, if we can pick up in this Texas quality revenue. If we don't pick that up, we are going to be left with a quarterly effective rate of probably between 60% and 65%. We had the issue of nondeductible expenses which drives the effective rate up as pre-tax goes down. So, worst case it is somewhere north of 60%; if some of that insurer fee revenue comes in or the Texas quality revenue, it will be a little bit below that.

Okay, all right. Thanks, Joe.

Our next question comes from Kevin Fischbeck with Bank of America. Please go ahead.

I guess I think I agree with the concept that the MLR is high, it's new business and you guys have had a track record of bringing down MLR over time. I guess a lot of times when we see companies do that, there is an investment in G&A to get there. How comfortable are you that the G&A run rate is what you need and you don't have to roll out new medical management programs in certain states to really get the MLR where it needs to be?

It is Joe speaking. I think we are pretty comfortable that there is not going to be a huge amount of spend on additional management. Bear in mind that we capture a lot of the med management costs in our MLR that you see on the books right now, and that is part of what is driving the high MLRs. We have talked before about how we have had to staff up in terms of med management care coordination staff, and that is still the case as we roll out the MMP plans and dive into things like Centennial Care in New Mexico and MMA in Florida. So, I think if anything we are going to see from a percentage basis a little bit of moderation on the admin portion that is built into our MLR.

Actually, if I could just ask one more. I guess I understand the comment about the rebate in the expansion states and not being able to offset the other business, but I do believe that was kind of the point from the beginning. And it seems like other companies that reported Medicaid results so far really had pretty strong results relatively speaking. So, I don't see that as a good explanation for why it was off, because basically that new business is maximizing its earnings, which implies that the core business is the business that is not doing well. And so therefore to break the core business maybe into two buckets and when a competitor does it this way, which I think is interesting, of kind of existing business versus new business. How much of the higher MLR would you say is really new business coming in higher versus existing business and having issues in any of the existing books of business?

This is Mario. We are looking at changing the way we report. I think you sort of hit the nail on the head. We mentioned earlier that we don't think that a geographic approach, which is what we used when we were primarily a TANF company, is the best way to do this going forward. We talked about the areas where we really think we have medical cost issues. John mentioned those a few minutes ago. So, I don't think it's -- the other thing is, on the expansion side, the expansion membership has a much bigger impact with us than I think it does with most of the other companies because we have had such a large expansion enrollment. So, this is a bigger issue for us than maybe for some of them.

And, Kevin, if I could just add one technical -- this is Joe speaking -- one technical point to that. I think John spoke to the fact that for the quarter the MLR is probably about 1.2% higher based on the new LTSS business we have added for the MMPs, Florida -- I'm sorry, Centennial Care in Florida.

I guess the 1.2%, that could be just a mix shift issue rather than -- are you saying 1.2% higher just because it is high MLR business, or are you saying it's 1.2% higher because that business is coming in higher than you thought?

Well, no doubt there is a mix shift there. On the other hand, I think if you look historically, we do tend to run higher MCRs when we first enter programs just a result of margin build and conservatism and everything.

All right. Okay, thanks.

Our next question comes from Chris Carter with Credit Suisse. Please go ahead.

Thanks. Good afternoon. Could you just give us an update on how the opt-out rate for the duals is running versus the kind of 50% you previously talked about?

Yes, this is Terry. We updated you in September at investor day that the opt-out rate is coming in where we expected and we were conservative and estimated it would be about 50%, and that is what we are seeing thus far.

Got it, so no change. And then just on the California settlement agreement, can you just give us an update there in terms of where you stand in terms of that balance?

Sure, it's Joe speaking. Just putting the numbers in sequence, Quarter 1 we had $5 million recorded for that as a receivable; Quarter 2 that went to $9.5 million; third quarter it is down to $3.5 million, which reflects obviously better performance in California. So at 9/30, $3.5 million as booked a receivable of the $40 million available.

Okay. And then just maybe one more. I think you said over the next nine months you are going to add 500,000 members, I think 350,000 is Puerto Rico. Can you maybe just break out for us the delta there?

Well, the rest is Illinois and Florida. We are picking up 65,000 members in Florida in December as a result of that acquisition, and then the continued growth in Illinois.

Got it, okay. Thank you.

Our next question comes from Matthew Borsch with Goldman Sachs. Please go ahead.

Yes, I was wondering if you could maybe characterize what your performance is like now with nine months of visibility on the expansion members and how much specifically for that block, it is varying state-by-state, and where you have trouble or pressures in particular regions.

Matt, this is John. When you compare the populations across states, they are very similar in terms of the demographics. The folks are -- we're seeing a lot of chronic conditions for this population, but we are not seeing -- we didn't see the initial utilization pickup in places like California and Washington that we saw in Michigan and Ohio. We think a lot of that is just an educational and a timing issue that folks haven't used services early on in the year because they didn't know they were available to them and they didn't understand the program. If you look at a study that was just put out by the New England Journal of Medicine --

Yes, this is Mario. There as a paper in the New England Journal of Medicine on October 23, a nice little three-page article about the way that Michigan rolled out their new program for expansion and some of the things they did. They put a lot of money upfront into education. They were able to rapidly process and enroll people, and 36% of the patients that have enrolled have so far scheduled a primary care visit. So, I think if you look at a state that has done it right, it was Michigan. I think states like California, where there have been problems with backlogs, have contributed to the lower utilization. But we think it's going to catch up as people figure out that they've got insurance and they learn how to use it.

Okay. And what about with respect to the adequacy of rates? I realize it is relative to the underlying costs that you are talking about, but now that you have the visibility that you do, do you feel significantly better about the expansion funding that you do -- I mean, sorry, if you could just talk on that.

We believe that the rates are adequate. What we have a problem with is this asymmetric risk that we have with some of our contracts, where we have to return money when we are making a profit and absorb losses in other contract areas when we're not. That is part of the problem. We believe that these things should offset -- the various product lines should all be evaluated together. But in terms of expansion, for the most part we feel that the rate are adequate.

And is there an element at which these -- the asymmetrical nature of the contracts caught you by surprise or has it just been something that you struggled with on an ongoing basis and now it is hurting enough that you are bringing it more to our attention in terms of its prominence? And maybe related to that, if you could just touch on the New Mexico situation, because that one in particular sounded like it was a surprise to you.

This is John. With respect to New Mexico, the surprise was the state implemented that on a retroactive basis. It wasn't part of the contract at the beginning of the year. So, that was a surprise to us. I think that we did realize that there were profit caps and MCR floors, and Joe talked about that the last investor day. It just took a much bigger bite in the third quarter than had been in the first two.

This is Joe speaking. I'll just add, too, I think we are seeing more stark disparities for different populations than we have in the past. It's just been a bit -- it's been surprising how the rates have been off so much between different programs. I don't think we've seen that before.

Right, over in some cases and under in others, yes.

And, Matt, that suggests that over time each side will correct itself.

Right. All right, thank you.

(Operator Instructions) Our next question comes from Andy Schenker with Morgan Stanley. Please go ahead.

Thanks. Drilling down a little bit more in Florida, can you maybe talk about the pressures you saw, I guess you highlighted nursing home services. Is that an MMA or is that related to the long-term care services you are offering there? And one of your competitors talked about the potential rate relief for long-term care going back to September 1, maybe update us on your thoughts around that as well.

Sure, it's Joe speaking, Andy. I'll start off with that question for at least -- to get it started. A couple of observations first. You will remember from an MMA perspective, we have only had these rates since July 1, and we have a very small population in Florida, which is something John alluded to in his remarks about how swings in some of these smaller states could be misleading. With that said, what we think we know now based on, again, all the three months of data, our feeling is that while the MCR is high, it is not inconsistent with what we were expecting. We feel like pharmacy is pretty much within the tracks, within the range we expected it to be. We generally feel like both the nursing home and the home and community-based services are coming in as we expected. We are seeing higher inpatient utilization, curiously enough, than we thought on the TANF side. So, I wouldn't -- I don't think there is a whole lot to read into our Florida performance. We also this quarter picked up about $2 million or $2.5 million of unfavorable prior period development from pretty far back in the calendar, and on $100 million revenue base that can be pretty distorted. So, when Terry and I both spoke to Florida back at investor day in September, we talked about an MCR somewhere in the low 90s overall for that business, and I don't think we are seeing anything that would suggest it would be different.

Okay. And then on the long-term care side, potential updates on rates for September, any --

No, I don't think we have anything on that. I don't have anything on that, sorry.

Okay, that's fine. And then just clarifying on the tax update, the $7 million, is that for all of 2013 and the first half of 2014 there?

Yes, that is correct.

And is it roughly even every quarter or is there a lumpiness within those numbers?

It's a little bit lumpy. About $6 million applies to last year. It has to do with the size of the executive comp we are expensing, which was higher last year. But essentially it's about $6 million in 2013 and then $1 million in the first half of this year.

Okay, great. And then just last one to squeeze in here. Any thoughts as we are heading into open enrollment here for the exchanges obviously not a major driver this year but any thoughts about how that is going to change maybe hanging into next year? Thanks.

Well, we were pretty conservative last year with our rates and in a number of states we brought the rates down to be more competitive, and I think that we are more competitive. Having things like the second lowest silver or the cheapest bronze plan in a number of markets. But remember that this is not going to be a big driver for our business. We've got 2.4 million Medicaid beneficiaries, we are going to add another 500,000 over the next nine months, so while we think it is important from a strategic standpoint to put a toe in the water on the exchanges, the real drivers of our business are going to be Medicaid, Medicare duals and that's not going to -- the exchanges are not going to make a huge contribution.

Our next question comes from Anagha Gupte with Leerink Partners. Please go ahead.

So, first question is on the DCP. You have raised it quite considerably. What are your plans? I mean, is that going to stay where it is and how are you thinking about this? This is not unusual --

Anagha, it is Joe speaking. We get a lot of questions about this over time. The best I can say on that is that DCP is a product of the reserve we set with our actuaries. We have a full process with an FSA employed by the Company with a full team of actuaries who set reserves every quarter. Those are vetted by Ernst & Young. The way those shake out is, the DCP shakes out from those reserve estimates, so I think it is fair to say we've got more liabilities. It's factual we have more liabilities on the balance sheet than we have in the past, but we don't target a DCP specifically. My expectation is once these populations get established and we've addressed any kind of claims payment issues, which show up sometimes at the beginning of programs, we're going to drop back down in the mid-40s. I don't know when that will be, though.

Okay, so for the purposes of 2014, you are staying at the 50. Does that go back to what we were told at your investor day in September and looked at the same factors for what might be bringing your guidance down? It sounds like the biggest one is the MLR, obviously, stating such an obvious thing, and then the offset would be the tax rate. Everything else seems kind of within the noise, if you will. Would you say, I guess, and I'm listening to all of -- or looking at your news release and listening to your commentary, it feels like you are saying structurally your loss ratio is now trending upward, and it's not just about kind of one initial spike or anything. It's just that you are getting lower rates and you have pressures on your, whatever profitability caps and so on. And so is that fair? I somehow kind of come out thinking the Medicaid expansion and potentially even duals, the rate setting was a little more fair and so you might at least be neutral if not better.

Well, Anagha, I would say that a little differently. I think what we tried to emphasize is that the -- we assumed we would get 100% of the Texas pay-per-performance quality revenue and the health insurer fee, and those are things that are largely beyond our control. And we really thought this would be resolved by this time of the year. Now that we are nearly in November and they are still not resolved, we don't have as much confidence, and we tried to convey that to everyone. There is a slight upward trend in the MCR and we tried to explain that. A lot of it has to do with certain contracts in certain states. I don't think that is necessarily a overall widespread trend. I mean, you could really talk about this as three, I think three major states that are a problem -- Washington, Texas and New Mexico, and it has to do with issues around the expansion and the contracts; it has to do with the inability to offset give-backs and losses; and it has to do with the inability to recognize the insurer fee and the quality revenue. I think that a component of it is the medical care ratio, but medical care ratio is a ratio, it's not the medical cost, per se, and that can be affected by a lot of things. So, when we are giving revenue back to states, it affects the MCR but not because medical costs are rising or because we are having medical management difficulties. Certainly, over time I think we can whittle these things down.

You also have to remember, and we haven't talked about this, but when you bring in a lot of these new populations, like the duals and like Centennial Care, there are requirements to do initial health assessments and often to make home visits. And a lot of this is an upfront cost that we are bearing because of the large influx of new members. So, that has been a strain.

We have had lots of problems with eligibility in New Mexico. We are getting members retroactively back to January that are coming on in October, and it's because the enrollment system that ACS built has been problematic. So, any time you have enrollment issues, and we've seen this with other states in the past when they have implemented new systems, it makes things very difficult for us. We need to know who is on the plan, when they are on the plan, and where they live and how to reach them, and in some cases we only know that for a third of the members.

Okay. I don't want to belabor it too much, but just one final point, though. Should we, as we think about past 2014, which as you've said a transition year, as we model 2015, is it an okay thing or am I just being too optimistic to model like an 89%-ish ratio, or should we kind of be thinking about 90.5%, 91%?

Come in February and we'll clarify for you.

All right, thanks.

Our next question comes from Dave Windley with Jefferies. Please go ahead.

Thanks. I want to reframe it a slightly different way. What I hear you saying to several questions is that there are a lot of fairly discrete, large dollar amount items that are subject to a signature, a negotiation, an agreement with the state, things that, Dr. Molina, you just mentioned are kind of out of you control, I guess. They are at least in your control to put shoulder against the yoke and continue to push. If you don't get them this year, I mean, what is the reasonable time frame for us to think about you are ultimately getting some of these things and then, secondly, when you do get them, do you expect that they will be retroactive back to the beginning of the period we've been measuring?

So, let me respond to that. I do think these things will be retroactive. We have had discussion with the state of Texas, they recognized that the health insurer fee is a legitimate cost and they believe there is an obligation to pay it. We know that the state of California is planning to submit a rate amendment for approval by CMS in November that will cover this period. The problem is, even if CMS were to do that, it often takes 60 to 90 days to get that amendment processed at the state. You have to get the contract signed and the checks cut, so I think we will get paid, I'm just not sure that we are going to get paid in this year. The other problem we have is that while we have had communications with them, they haven't put it in writing sufficient that we can accrue the revenue. So, it's not that we believe the revenue is not coming, and there are some big chunks of it out there, but this is mostly going to be a timing issue. Nevertheless, it will affect, from an accounting standpoint, the results for 2014 if we don't secure those written agreements before the end of the year.

And, Dave, this is John, let me just follow-up one thing. We have every confidence that on the HIF stuff we are going to collect it. We don't want the people to run wild if we collect $50 million in the first quarter of next year, for example, and think that's a run rate. So, that is why we are downplaying a lot of these quarter-to-quarter fluctuations and looking out for the long term.

Understood. Just quick follow-up on that. In your press release your HIF fee collection, expectation for the fourth quarter actually drops from what you collected in the third quarter. Could you explain that for me?

Sure, it's Joe speaking, Dave. I think we noted that in this quarter, Utah and Michigan caught up and in effect paid 75%, or nine months' worth of the base fee, not the tax effect but the base fee. So, there is a catchup in the quarter.

Okay, and then my final question -- sorry, go ahead. I was going to say my final --

(Inaudible) -- is that $50 million is still out there.

Okay, thanks. Final question coming back to kind of confidence on negotiations. Dr. Molina, how would you describe your confidence on negotiating with the states around these potential offsets relative to the confidence on collecting the HIF fee?

Well, I think that we enjoy good relationships with our state partners, and I think that there are unintended consequences of their actions. So, I think there are strong policy arguments as to why these things should be changed. Any time you come in with new contracts and new programs, or you expand populations, there are always unforeseen results. So, I think there is a good chance that we can get some relief on these things. It just makes sense.

Okay, thank you.

Our next question comes from Peter Costa with Wells Fargo Securities. Please go ahead.

I think we understand the HIF and the Texas quality payments and the Washington settlement well enough, but I'd like to get at what is causing the loss ratio to be higher and how much higher is it? If I adjust for those three things in this quarter I still come up with a loss ratio that is over 90%. So, can you tell us what you were expecting in this quarter relative to sort of that 90%, 90.1% or so?

So, yes, Pete. I think that one of the big drivers is the double whammy in the state of Washington with the ABD population having a higher MCR. Now, remember, while it was a net $11 million drag, it was really a $19 million unfavorable hit, and most of that, if not all of that, hit the ABD line. And so you had this ABD problem, and then we had the revenue reduction due to the give-back of -- $17 million?

Correct. It's the adjustment for the MLR Florida and Washington, Pete. That is $23 million year-to-date, but $17 million of that was in the third quarter. So, if I were modeling I might take that $23 million and spread it over three quarters rather than cramming it all into the third quarter.

The other thing to note is that Washington does their calculations slightly differently for the expansion than the rest of the states in which we have contracts, and that does have some impact. We haven't quantified it yet, but we just know that the arithmetic is different. And then you've got New Mexico with both a higher LTSS. We thought that that was going to come in in the high 90s, not over 100%, and that is then exacerbated by the retroactive issues related to, as Mario said, the retroactive membership.

Okay, I'll try it a slightly different way. The stuff that can be resolved from a rate change that is not one of those, the three things that we have already talked about a lot, when do you expect those rate actions to potentially happen for you next year as opposed to just normal regular way improving the cost trend of the business and getting the new members to have lower loss ratios over time? What do you expect from rate actions to help you out and when?

We are having more rates come up January 1 than we did before. A lot of states have shifted it, so I think New Mexico has shifted, Washington. We are having those discussions right now and whether or not we get rate increases or policy changes that have a similar effect, it's a little too early to tell right now.

This is Mario. I think if you look at what happened with California when they brought the ABDs in for a long time, a year, year and a half, there was a lot of turmoil, but California eventually got it right. If you look at the performance of the California health plan, there has been a dramatic change, and so you see what getting the rates right can do. But we need to work with the states actuaries and some of their policy people to make them understand this.

For Puerto Rico, what are you expecting for loss ratio in that business when it first starts up with you?

We're not talking about Puerto Rico other than just a membership and the revenue, because that was put out by the Medicaid agency. We'll talk about other expectations probably in February.

Okay. And what were your hep-C costs in the quarter?

The hep-C costs are built into the pharmacy numbers that we reported. It hasn't been extraordinary. However, having said that, with this new drug being approved, I think a lot of doctors have been warehousing their patients waiting for an all-oral option and I expect hep-C costs to rise. There was a letter that came from the National Association of Medicaid Directors that went to the Senate Finance Committee asking for some sort of action to be taken. There is also a lot of concern being raised by people in corrections, where the states are completely on the hook for the care of the patients there, and we are seeing a lot of people who are voicing a lot of concerns about how these drugs have been priced. So, I think in the next year you are going to see some action there. We also have some carve-out arrangements in Florida and Washington, which I think will be helpful. So, all the states are looking at this. Everybody is scratching their head trying to figure out what to do, but I don't think it is going to go along status quo in 2015.

Okay, thank you.

Our next question comes from Carl McDonald with Citigroup. Please go ahead.

Great, thanks. So, one follow-up on the Puerto Rico contract. You have had some prior experience there where you were awarded the contract, didn't like the rates and ended up not participating. Is this contract finalized and you are comfortable with the planned reimbursement?

First of all, I don't think the contract is finalized yet and, secondly, the previous procurement was withdrawn, so it wasn't a matter of we didn't like the rates we didn't sign. We never got that far because the whole procurement was withdrawn.

Got it. Actually, as you responded I realized I think I'm confusing you with Centene may have won a couple of RFPs ago and pulled out, so I'll just withdraw that question.

Thank you.

The other question I had was on the compensation deduction. Since there is no explicit piece of that that excludes Medicaid plans or government plans generally, just be interested in why you think the Medicaid business would be exempt from that and whether there has been any conversation with either Treasury or IRS, or if it's just the opinion of the tax and legal advisors?

It's Joe speaking. To your last question, no, there hasn't been any specific discussion with the IRS about this. We feel like, though, the preamble to the final regs is pretty clear about how the de minimis test is going to be calculated. And what that de minimis test really comes down to, obviously, is a numerator and a denominator, and we are very confident the way we read the final regs that that numerator would exclude Medicaid premiums. Now, let me just say, though, that the test for recognition of income tax expense is more likely than not. So, Carl, this is not like a revenue recognition issue where the standard of recognition is near certainty. This is a more likely than not test, but we've spoken to our tax advisors, we've read the preamble of the final regs, we've written the final regs, we've been through the de minimis test and we're confident we pass it.

And, Carl, the auditors have bought off on this and I think just our tradition of pretty conservative accounting should give you some comfort.

Great. Thank you.

That was our last question. I'll turn the call back to you, Mr. Orellana.

Well, thank you very much for listening to our quarterly call. We look forward to talking with you next time. Thank you.

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