Centene Corp (CNC) — Q2 2016 Earnings Call Transcript

Thank you, Denise, and good morning, everyone. Thank you for joining us on our 2016 second quarter earnings results conference call. Michael Neidorff, Chairman and Chief Executive Officer, and Jeff Schwaneke, Executive Vice President and Chief Financial Officer of Centene, will host this morning's call. Today's call may also be accessed through our website at centene.com. A replay will be available shortly after the call's completion also at centene.com or by dialing in the U.S. and Canada 877-344-7529, or in other countries by dialing 412-317-0088. The playback number for both dial-ins is 10088567. Any remarks that Centene may make about future expectations, plans and prospects constitute forward-looking statements for purposes of the Safe Harbor provision under the Private Securities Litigation Reform Act of 1995. Actual results may differ materially from those indicated by these forward-looking statements as a result of various important factors, including those discussed in Centene's most recently filed Form 10-Q dated today July 26, 2016, and our most recent Form 10-K dated February 22, 2016, and other publicly available SEC filings. Centene anticipates that subsequent events and developments will cause its estimates to change. While the company may elect to update these forward-looking statements at some point in the future, we specifically disclaim any obligation to do so. With that, I'd like to turn the call over to our Chairman and CEO, Michael Neidorff. Michael?

Thank you, Ed. Good morning, everyone, and thank you for joining Centene's second quarter 2016 earnings call. During the course of this morning's call, we will discuss our second quarter results and provide updates on Centene's markets and products. Additionally, we will bring you up-to-date on the Health Net integration and the fair value analysis of legacy Health Net's balance sheet. Let me begin with a few comments on second quarter results. The second quarter marks Centene's first full quarter with Health Net. Overall, we are pleased with our operating performance which is marked by strong top and bottom line growth. We recognize there have been questions regarding the Health Net balance sheet and underlying operations. Consistent with our previous comments, we continue to make progress on the fair valuation of the Health Net balance sheet. Importantly, there has been no unfavorable development on the medical claims liability established at March 24th. We did increase reserves for medical claims associated with disputed substance abuse treatment center costs. Additionally, we recorded premium deficiency reserves primarily associated with Arizona and California individual PPO business. We believe we have effectively addressed these concerns with the purchase accounting adjustments. We also believe the opening balance sheet is appropriately estimated at fair value and the PDRs offset losses for certain contracts in 2016. While there are some moving parts, it is important to note these issues are not unusual in a large acquisition, and we believe they are manageable. We are addressing them in a manner consistent with Centene's approach and have taken significant actions to improve these operating results in 2017 and beyond. These include price increases, plan design changes, and a significant reduction in our Arizona commercial book. Jeff will provide further details on this topic in his prepared remarks. Turning to second quarter financials. Total revenues increased 98% year-over-year to $10.9 billion. Membership at quarter end was 11.4 million, representing an increase of 6.8 million beneficiaries over the second quarter of 2015. The HBR improved 250 basis points year-over-year to 86.6%. This was mainly attributable to the product mix shift from Health Net. Importantly, we continue to see as well as anticipate stable medical costs trend. Lastly, we reported adjusted diluted earnings per share of $1.29, which includes a $0.19 benefit related to 2015 risk adjustment and reinsurance reconciliation under the ACA. This compares to $0.76 reported in the second quarter of 2015. Jeff will provide further financial details including updated 2016 guidance. Now on to the Health Net integration. As we discussed at our June Investor Day, the integration is on track or ahead of schedule in many areas. Our integration team continues to closely monitor financial and operational metrics. We have now completed the actions needed to capture over 90% of the $75 million first year synergy target. As a reminder, this target is for the first 12 months following the March 24 close of the deal.

Thank you, Michael, and good morning. This morning, I will begin with highlighting the results for the second quarter of 2016 and provide an update on our acquisition accounting and 2016 full-year guidance. We had a strong second quarter of 2016. Membership was 11.4 million members, an increase of 148% between years, driven by the Health Net acquisition. Total revenues were $10.9 billion, an increase of 98% over Q2 of 2015. Diluted earnings per share for the second quarter of 2016 was $0.98, adjusted diluted earnings per share of $1.29 when excluding Health Net acquisition costs and intangible amortization, compared to $0.76 on an adjusted basis last year. Diluted earnings per share and adjusted diluted earnings per share includes $0.19 per share benefit related to the reconciliation of the 2015 reinsurance and risk adjustment provisions of the Marketplace business. In more detail, total revenues grew by $5.4 billion in the second quarter, primarily as a result of a full quarter of revenue from the Health Net acquisition, expansions or new programs in many of our states in 2015, and growth in the Health Insurance Marketplace business in 2016. Our health benefits ratio was 86.6% in the second quarter this year, compared to 89.1% in last year's second quarter and 88.7% in the first quarter of 2016. The 250 basis point decrease year-over-year results from including a full quarter of the Health Net acquisition and growth in the Health Insurance Marketplace business, both of which operate at a lower HBR. Sequentially, the 210 basis point decrease from the first quarter reflects the effect of the Health Net acquisition, the reconciliation of the 2015 reinsurance and risk adjustment provisions of the Health Insurance Marketplace business and lower flu costs, which were more prevalent in the first quarter of 2016. The Health Insurance Marketplace business continues to perform well in 2016, with over 618,000 members at June 30. During the second quarter, CMS released additional information related to the reinsurance and risk adjustment provisions of the business. The reconciliation of both of these provisions for 2015 improved our pre-tax operating results for the second quarter by approximately $70 million, or $0.19 per diluted share. This is after considering the risk-sharing contracts, primarily in California, the risk corridor, and the minimum MLR.

Hi. Thanks, good morning. Michael, you guys just ran through a whole bunch of stuff on the PDR and I guess I just really want to understand what exactly is going on with those losses. So I mean the $300 million seems like a pretty big number, that's 50% or so of Health Net's pre-tax. So I guess I'm trying to understand, were their earnings just overstated historically or in these PDRs it sounds like that's really just from March 24 through the end of the year. So it sounds like it's a run rate of more like $400 million, and I'm just curious how does that not impact operations going forward?

Yes, Josh, this is Jeff. You're correct. I would bifurcate that. The PDR also does include the substance abuse facility issue that I just mentioned and I will tell you that the largest component of the PDR is in Arizona. So I think that the math that you did is pretty close as far as the annual run rate. And what I'll tell you is that it was based on information as of the 24th of March and using that information and fair valuing those liabilities effectively as of the acquisition date. And that all those things that I enumerated as far as the actions we have taken, we believe will improve those margins heading into 2017.

I think, Josh, that's kind of the key as you – if we run through all the various issues, all the actions are being taken with effect January of 2017, which is plan design which we've been working on for the past several months, the premium increases, the removal from business in Arizona. So there's a whole list of issues that have been dealt with very aggressively so that we will not be discussing this kind of issue next year.

So that makes sense. I just want to make sure I understand. So the substance abuse is included in the $300 million, that's the $90 million or is it more pervasive than that?

No, there's actually two components, Josh. So, there's a piece that's really from March 24 and prior and then there's the March 24 and into the future, right. And so the $90 million is what we added to the medical claims liability as of March 24, that really is for the prior issues. And then we have a component which is also in the $300 million for, I would say, March 24 through the end of this year.

So there are some changes been made to the certificate of benefits and the timing on that is being worked on with the state. And there's some fraud and abuse that's under full investigation by ourselves and the state, which will impact both of those issues. And so the best way to deal with it was this way, knowing that going forward it's been dealt with very effectively.

That makes sense. But I guess I still question how does Health Net get away with not – like what exactly was the dispute, they just weren't paying these claims and it turns out they had to? I'm just curious how...

Well, I'll give you as much as I can, but it is in litigation. Some of it's in litigation at this point, so I want to be careful. But in the interest of as much transparency as we can. There were some changes to the certificate of coverage, which we believe we're entitled to. And which the state's evaluating as well as through other legal recourse. There's that. That's being contested by the providers. There's also a whole series of claims where we believe there's been significant fraud and abuse that we have contested and are being investigated very thoroughly and we expect to prevail on a lot of those. So what we've effectively done is we've changed some things that created this issue this year but will not be an issue next year. And so the best way to handle it going forward and it doesn't hit income, it goes on the balance sheet with purchase accounting. We had that and so what Jeff and the finance team has done is that once we closed, we had the benefit of being able to pore through everything, make those adjustments and ensure that its not hitting the income statement. And so that's as much with the legal issues and the fact that it is going to be in the courts, I want to be careful how much more I say, Josh.

No, that's fair, Michael. I get it, I just want to make sure I got the number right. So $90 million is prior plus another chunk of the PDR going forward. So I don't know, let's just call it half of the PDR for rough math, is substance abuse related. And are you guys assuming that you owe all of the claims now. I mean, I understand it's under litigation.

Well, you know, I know I can't comment on that. I've got to be really careful on that one, Josh.

Okay.

No, no. I'm glad you're asking this because it's really important to us that everyone understand that the way Centene does these things, is we look at it, we address it. You know, I've had several meetings personally with Commissioner Jones. We've talked about it and his deputy. We've talked about the action we're taking. What some people thought we had to wait till 2018 we're effecting January 1 of 2017. So we're being very aggressive in fixing it. The other side of it, I don't want anybody to lose sight of this, there's a lot of business, Medicaid and other, that's doing very well and you saw some of the benefit of the HBR. So we knew some of this was where. We knew it could be dealt with in purchase accounting and we continue to move through it aggressively.

Okay. And are you guys exiting – so Arizona is the largest component, whatever, I don't know what that means, half or so but are you guys. So is this like, you know, how much of the business that's suffering or how much of that you just flat out getting out of next year?

There is a considerable amount of it that we are exiting and the exact amount we'll be able to discuss in future calls. But if it's unprofitable and we do not see a road to normalizing margins in it, we're going to exit it, and it's not a overwhelming amount of the business.

And Josh, this is Jeff. I mean, just another thing that compounds the issue is the risk corridor, so a substantial piece of the risk corridor – the theoretical benefit that Health Net had assumed was in Arizona. So that's obviously compounding the issue and increasing the size of the PDR there.

And I can't emphasize enough, I'm really glad that this came out so fast because it's things that have been there that we're dealing with very effectively, we believe, correcting, and will be behind us as we move forward. So I'm really glad it came out quickly.

Me too. And then, I guess, just last one, again I apologize for another question here. Just the $0.19 benefit on the 3R accruals, obviously that means that the Exchanges ran a little bit better then you guys had accrued for last year. Is there a similar expectation now for 2016, did you make any adjustments? I'm assuming you're accruing three 3Rs and payables based on the same math you've...

I'm going to – I'll start and then Jeff can add anything if he likes what I say or don't say. We, obviously, accrue at what we believe to be the most realistic number that reflects where it's going to end up. But we also apply an abundance of conservatism. I would much rather sit here and say there is a benefit than a loss or something less than that. So I think – I would hope next year there's a benefit. I'm not going to project it to be as large, but I will say that we treat it as a one-time thing. We call it out separate from the $1.10 earnings in the quarter. Because we're not looking to say we had a wild and wonderful quarter from operations. We did have a very strong, positive quarter for operations. But that extra amount we call out as separate from that that which came from continuing operations.

Hi. Thanks, good morning.

Good morning.

Good morning, Michael. You guys just ran through a whole bunch of stuff on the PDR and I guess I just really want to understand what exactly is going on with those losses. So I mean the $300 million seems like a pretty big number, that's 50% or so of Health Net's pre-tax. So I guess I'm trying to understand, were their earnings just overstated historically or in these PDRs it sounds like that's really just from March 24 through the end of the year. So it sounds like it's a run rate of more like $400 million, and I'm just curious how does that not impact operations going forward?

Yes, Josh, this is Jeff. You're correct. I would bifurcate that. The PDR also does include the substance abuse facility issue that I just mentioned and I will tell you that the largest component of the PDR is in Arizona. So I think that the math that you did is pretty close as far as the annual run rate. And what I'll tell you is that it was based on information as of the 24th of March and using that information and fair valuing those liabilities effectively as of the acquisition date. And that all those things that I enumerated as far as the actions we have taken, we believe will improve those margins heading into 2017.

I think, Josh, that's kind of the key as you – if we run through all the various issues, all the actions are being taken with effect January of 2017, which is plan design which we've been working on for the past several months, the premium increases, the removal from business in Arizona. So there's a whole list of issues that have been dealt with very aggressively so that we will not be discussing this kind of issue next year.

So that makes sense. I just want to make sure I understand. So the substance abuse is included in the $300 million, that's the $90 million or is it more pervasive than that?

No, there's actually two components, Josh. So, there's a piece that's really from March 24 and prior and then there's the March 24 and into the future, right. And so the $90 million is what we added to the medical claims liability as of March 24, that really is for the prior issues. And then we have a component which is also in the $300 million for, I would say, March 24 through the end of this year.

That makes sense. But I guess I still question how does Health Net get away with not – like what exactly was the dispute, they just weren't paying these claims and it turns out they had to? I'm just curious how...

Well, I'll give you as much as I can, but it is in litigation. Some of it's in litigation at this point, so I want to be careful. But in the interest of as much transparency as we can. There were some changes to the certificate of coverage, which we believe we're entitled to. And which the state's evaluating as well as through other legal recourse. There's that. That's being contested by the providers. There's also a whole series of claims where we believe there's been significant fraud and abuse that we have contested and are being investigated very thoroughly and we expect to prevail on a lot of those. So what we've effectively done is we've changed some things that created this issue this year but will not be an issue next year. And so the best way to handle it going forward and it doesn't hit income, it goes on the balance sheet with purchase accounting. We had that and so what Jeff and the finance team has done is that once we closed, we had the benefit of being able to pore through everything, make those adjustments and ensure that its not hitting the income statement. And so that's as much with the legal issues and the fact that it is going to be in the courts, I want to be careful how much more I say, Josh.

No, that's fair, Michael. I get it, I just want to make sure I got the number right. So $90 million is prior plus another chunk of the PDR going forward. So I don't know, let's just call it half of the PDR for rough math, is substance abuse related. And are you guys assuming that you owe all of the claims now. I mean, I understand it's under litigation.

Well, you know, I know I can't comment on that. I've got to be really careful on that one, Josh.

Okay.

No, no. I'm glad you're asking this because it's really important to us that everyone understand that the way Centene does these things, is we look at it, we address it. You know, I've had several meetings personally with Commissioner Jones. We've talked about it and his deputy. We've talked about the action we're taking. What some people thought we had to wait till 2018 we're effecting January 1 of 2017. So we're being very aggressive in fixing it. The other side of it, I don't want anybody to lose sight of this, there's a lot of business, Medicaid and other, that's doing very well and you saw some of the benefit of the HBR. So we knew some of this was where. We knew it could be dealt with in purchase accounting and we continue to move through it aggressively.

Okay. And are you guys exiting – so Arizona is the largest component, whatever, I don't know what that means, half or so but are you guys. So is this like, you know, how much of the business that's suffering or how much of that you just flat out getting out of next year?

There is a considerable amount of it that we are exiting and the exact amount we'll be able to discuss in future calls. But if it's unprofitable and we do not see a road to normalizing margins in it, we're going to exit it, and it's not a overwhelming amount of the business.

And Josh, this is Jeff. I mean, just another thing that compounds the issue is the risk corridor, so a substantial piece of the risk corridor – the theoretical benefit that Health Net had assumed was in Arizona. So that's obviously compounding the issue and increasing the size of the PDR there.

And I can't emphasize enough, I'm really glad that this came out so fast because it's things that have been there that we're dealing with very effectively, we believe, correcting, and will be behind us as we move forward. So I'm really glad it came out quickly.