Centene Corp (CNC) — Q4 2016 Earnings Call Transcript

Thank you, Carey, and good morning everyone. Thank you for joining us on our 2016 fourth quarter and full-year 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. The call should last approximately 45 minutes and also may 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 877-344-7529 in the U.S. and Canada, or in other countries by dialing 412-317-0088. The playback code for both dial-ins is 10098783. 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-K dated February 22, 2016, the Form 10-Q dated October 25, 2016, and other public 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. Please mark your calendars, our next Investor Day will be on Friday, June 16 in New York City. And 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 fourth quarter and full-year 2016 earnings call. During the course of this morning's call, we will discuss our fourth quarter and full-year 2016 financial results and provide updates on Centene's markets and products. Additionally, we will bring you up to date on the Health Net integration and discuss the changing healthcare regulatory landscape. Let me begin with fourth quarter and full-year 2016 financials. We were pleased to conclude the year with a strong fourth quarter, marked by solid top and bottom line growth. Membership at quarter end was 11.4 million recipients, representing an increase of 6.3 million beneficiaries over the fourth quarter of 2015. Fourth quarter results increased 89% year-over-year at the revenue level to $11.9 billion. 2016 revenues grew 78% year-over-year to $40.6 billion, ahead of our guided range. The revenue increases were primarily attributable to the Health Net acquisition. The fourth quarter HBR improved 320 basis points year-over-year and 220 basis points sequentially to 84.8%. The 2016 HBR improved 240 basis points year-over-year to 86.5%. These improvements were primarily related to the product mix shift from the addition of Health Net and a California minimum MLR change. We reported adjusted fourth quarter diluted earnings per share of $1.19 compared to $0.97 in the same prior period of last year, representing growth of 23%. Adjusted 2016 diluted earnings per share were $4.43 compared to $3.14 reported in 2015, representing an increase of 41%. Lastly, 2016 operating cash flows came in very strong at $1.9 billion or 3.3 times net earnings. Please note, there are several moving parts related to the adjusted numbers, including the California minimum MLR change I just mentioned. Jeff will provide further details on these during his prepared remarks. A quick comment on medical costs including flu. The latest data indicate the flu season is peaking higher and earlier than last year's season. Please note last year's flu season was more moderate than usual. Importantly, we continue to see as well as anticipate overall stable medical cost trends consistent with our expectations in the low single digits. Next, the Health Net integration. 2016 was a transitional year for Centene as we began integrating Health Net into our enterprise. Health Net, which is now our California plan, is fully integrated from a cultural, leadership, human resource, and financial systems standpoint. The operational systems are on track to be fully converted within our anticipated timeframe, and we continue to expect to reach or exceed our synergy targets. We are confident all of the components of the PDR booked in the second quarter of 2016 have been successfully resolved and did not record any PDRs in the fourth quarter of 2016 for 2017. We are already seeing improvements in the operating performances of the markets and products in 2017, the most significant being the California PPO product, which was the largest component of the PDR. We are monitoring changes to the PPO membership and are finding the benefit design changes, price increases, and network enhancements, which became effective in 2017, have created a more balanced book of business. In addition, we have made equally significant progress in addressing the substance abuse issues related to this product in 2017. We anticipate the California PPO product will be at least breakeven in 2017, in line with our expectations. I would now like to make a few comments on the changing healthcare regulatory landscape. In the healthcare industry, especially the government services sector, change is nothing new. What remains constant though is the need for high quality, affordable healthcare. This is regardless of what party is in office or the status of the economy. Centene has over three decades of experience spanning five presidents from both sides of the aisle. During this time, we have proven our ability to provide high quality, cost-effective healthcare to state beneficiaries while saving states money and delivering strong returns to our shareholders. In addition, we have demonstrated our agility as well as our capacity and capability to successfully navigate industry changes. This is evidenced by our success with the ACA while others have struggled. You will recall, we maintained a business as usual approach when it came to exchanges. Early indications suggest, if the ACA is completely repealed and replaced, the process may take several years and include a transition plan designed to minimize, if any disruption to states or subsidized populations. As an example of this, the new administration recently submitted a proposed rule to the OMB aimed at stabilizing the exchanges. Currently, there are no specific agenda regarding the administration's approach to Medicaid. We believe it is likely they will give additional flexibility to states for managing this population, which aligns nicely with Centene's local approach to healthcare. In addition, the administration has to determine its plan for dealing with those states that have expanded Medicaid versus those that have not. In the meantime, we are taking our business as usual approach from an execution standpoint. We believe we can work on any basis, whether it is block grants or per capita caps. I will note that per capita caps is a fair approach for states that have a growing Medicaid population. Centene provides healthcare services to the largest number of Medicaid recipients. We have an experienced team on hand and are confident our scale, systems, and expertise will allow us to be ready as the new healthcare agenda unfolds. Moving on to markets and product updates. First, we will discuss recent Medicaid activity, Nebraska. In January 2017, we commenced operations under Nebraska's new Heritage Health program covering TANF, CHIP, ABD, Foster Care, and Long Term Care beneficiaries. Results are currently trending in line with expectations and we anticipate serving between 75,000 and 80,000 members under this contract. Indiana, also in January 2017, we began a new contract serving beneficiaries enrolled in Indiana's Hoosier Healthwise and Healthy Indiana Plans. These contracts represent a re-procurement in a state Centene has been successfully operating in for over 20 years. North Carolina. In September 2015, North Carolina's General Assembly passed reform legislation to privatize the state's Medicaid program. As a proactive approach, Centene signed an agreement last month with the North Carolina Medical Society to collaborate on a statewide member-focused approach to Medicaid managed care. As part of this agreement, a joint venture known as Carolina Complete Health was formed. This JV was established to organize and operate a physician-led health plan to provide Medicaid managed care services in the state. A key feature of the JV will be the active participation of physicians in the ownership and governance of the health plan. Centene will manage the financial and daily operations. Carolina Complete Health will seek to participate in the privatization process as a bidder for a likely North Carolina Medicaid RFP in the near future. This joint venture serves as another example of Centene's ability to provide innovative solutions to meet local market needs. Pennsylvania, last month Centene was selected to serve Medicaid recipients enrolled in the state's HealthChoices program in three zones. I would like to remind you this award was in response to a reissue of the state's initial RFP and we're pleased to have retained the three zones first awarded to Centene in April of 2016. Implementation is well underway and we will be ready to hit the ground running on the anticipated start date of June 1, 2017. Georgia, in November of 2016, Centene was awarded a statewide contract to continue serving Medicaid members. Under the new contract, Centene will be one of four plans providing medical, behavioral, dental, and vision health benefits to the state's Medicaid beneficiaries. Centene has been providing healthcare services to Georgia's Medicaid recipients for over a decade, and we look forward to continuing our partnership with the state. The new contract is expected to begin on July 1, 2017. Nevada, also in November of 2016, Centene was selected to serve Medicaid recipients in two counties in Nevada. This contract is expected to begin on July 1, 2017, and we anticipate membership of 35,000 to 50,000. In addition, we expect to offer a Health Insurance Marketplace product in these two counties beginning in 2018. Nevada marks Centene's 29th state of operation. Next, Medicare. At year-end, we served over 334,000 Medicare beneficiaries. On January 1, we began offering Medicare Advantage plans in four new states, Texas, Georgia, Mississippi, and Florida under our four-star parent rating. We are applying a test-and-learn approach to our first year of MA operations, similar to Centene's initial launch of our exchange product in 2014. Also, similar to our exchange approach, we will be focused on providing high-quality, affordable MA products to low-income beneficiaries. We do not anticipate meaningful MA membership in these four new markets in 2017. We will be applying the insights we gained this year with respect to network, plan design, and benefits to Centene's 2018 MA plans. Overall, we expect our Medicare Advantage business to be profitable in 2017. Now, health insurance marketplace. 2016 marked another year of Centene's successful operating on the exchanges. At December 31, we served roughly 540,000 exchange members, in line with our expectations. Over 90% of these members were subsidy eligible. In 2017, the open enrollment period included last week and we have just over 1 million paid members. The key demographics of these members, including age, gender, financial assistance, and metal tier are consistent with our experience over the past three years. Over 90% are subsidy eligible and almost 90% enrolled in silver tier plans. This includes those members enrolled in Maricopa County, Arizona, which Centene is a sole exchange provider. In addition, over 90% of our total paid enrollees are a combination of members renewing their Ambetter plans and shoppers who are new to the exchanges. This is important for two reasons. We have historical data on our renewing members, including medical history and utilization patterns, and the new shoppers are actively selecting our Ambetter exchange products based on price network and benefit design. This is the same purchase criteria reflected in our risk pool since we began offering exchange products in 2014. We are closely monitoring emerging claims experience specifically membership profile and claims utilization pattern. Thus far in 2017, we have seen no evidence of unanticipated utilization levels. As it is early in the year, we feel it is prudent to include the extra level of conservatism in our 2017 guidance related to this business to allow for uncertainty regarding membership behavior post-election. We continue to expect our marketplace offering to be profitable this year. Lastly, Federal Services. The 2017 TRICARE contract appeal process was completed in November, and we were pleased to have sustained our West Region award. This represents a return to Health Net's region when the TRICARE program was initially launched in 1988 and aligns nicely with Centene's growing business in the western U.S. This new contract is expected to commence on October 1, 2017. Separately, our current VA Choice contract runs through the summer of 2017. We are actively reviewing the Community Choice Network RFP that was released in late 2016, and we remain committed to providing high-quality services to our nation's veterans. Shifting gears to our rate outlook. For 2016, our composite Medicaid rate adjustment was an increase of approximately 1%. We continue to expect the 2017 composite Medicaid rate adjustment of 0% to 1%, consistent with the past few years. Separately, CMS issued the 2018 advanced notice last week and preliminary Medicare Advantage rates appear to be in line with our expectations. In summary, 2016 was another successful year for Centene. We are now realizing the full benefits of the Health Net acquisition, particularly those products due to Centene, which will drive further growth and greater scale in 2017 and beyond. Over time, we believe the critical mass achieved with the addition of Health Net will prove to be invaluable. We remain committed to long-term margin expansion and continue to make the necessary investments in systems and infrastructure to successfully execute our strategy. We are optimistic about our ability to extend Centene's leadership position in government-sponsored healthcare. Thank you for your interest in Centene. Jeff will now provide further details on our fourth quarter and full-year 2016 financial results.

Thank you, Michael, and good morning. Earlier today, we've reported our fourth quarter and full-year 2016 results. For the full year, total revenues were $40.6 billion and adjusted diluted earnings per share were $4.43. The increase in the top and bottom lines compared to 2015 was the result of the acquisition of Health Net, growth in the Health Insurance Marketplace business, and the full year effect of product and market expansions in 2015 and 2016. Membership grew to 11.4 million members, an increase of 124% between years. For the fourth quarter, total revenues were $11.9 billion, an increase of 89% over Q4 of 2015, and diluted earnings per share were $1.45, compared to $0.91 last year and adjusted diluted earnings per share was $1.19, compared to $0.97 last year. As highlighted in our press release issued this morning, adjusted diluted EPS for the fourth quarter and full year excludes the following items: the acquisition costs associated with the Health Net transaction, amortization of acquired intangible assets, the favorable pre-tax effect of $195 million of additional revenue associated with the retroactive contract amendment received in the fourth quarter that changed the minimum MLR calculation under California's Medicaid expansion program. This amount relates to periods prior to the acquisition date for legacy Health Net business, and periods prior to 2016 for the legacy Centene business. A charitable contribution to the company's foundation of $50 million in connection with the additional revenue from a change in the California minimum MLR previously noted, and debt extinguishment costs of $11 million, associated with the early redemption of the Centene and Health Net senior notes that were scheduled to mature in the first half of 2017. Additionally, the fourth quarter and full year results also include a net benefit of $0.03 and $0.05 per diluted share, respectively, due to the early adoption of the stock-based compensation accounting standard and the incorporation of retirement provisions in our stock-based compensation agreements. In more detail, total revenues grew by $5.6 billion in the fourth quarter year-over-year, primarily as a result of the Health Net acquisition, which closed on March 24, 2016, the start-up of the Texas STAR Kids program in November 2016, the July start-up of the Louisiana Medicaid expansion business, and growth in the Health Insurance Marketplace business. Sequentially, total revenues grew by $1.1 billion from the third quarter of 2016, driven by the $195 million of additional revenue associated with the change in California minimum MLR definition, and $500 million of additional revenue received in the fourth quarter associated with pass-through payments from the State of California that were recorded in premium tax revenue and premium tax expense. Moving on to the HBR. Our health benefits ratio was 84.8% in the fourth quarter this year, compared to 88% in last year's fourth quarter and 87% in the third quarter. The 320 basis point decrease in the fourth quarter year-over-year is a result of the higher mix of commercial business associated with the Health Net acquisition and the effect of the retroactive revenue recorded in California associated with the change in the minimum MLR definition. Sequentially, the variance is driven by the California minimum MLR change, which decreased the fourth quarter HBR by 170 basis points. Our selling, general and administrative expense ratio was 9.9% in Q4 this year, excluding the Health Net merger costs compared to 8.6% last year and 9.1% in the third quarter, also excluding Health Net merger costs. The increase in the ratio as compared to the prior year is primarily due to several items. First, the acquisition of Health Net, which operates at a higher SG&A ratio due to the higher mix of commercial and Medicare business. Second, the fourth quarter of 2016 includes a higher level of seasonal costs related to the open enrollment period for the Health Insurance Marketplace business due to the expected growth in 2017. And third, the fourth quarter of 2016 includes the $50 million charitable contribution to our foundation as a result of the additional revenue recorded related to the California minimum MLR change, which increased our SG&A ratio in the fourth quarter by approximately 50 basis points. The increase sequentially is a result of the higher enrollment costs on the Health Insurance Marketplace and the charitable contribution previously mentioned. Excluding Health Net merger costs, business expansion costs of $0.11 were incurred in the fourth quarter and $0.25 for all of 2016. Investment and other income was $34 million in the fourth quarter compared to $8 million last year and $33 million in the third quarter. Interest expense was $217 million this year compared to $43 million last year. Sequentially, interest expense increased from $57 million in the third quarter to $75 million in the fourth quarter. The increase year-over-year is primarily due to the financing associated with the Health Net transaction. Sequentially, the increase is due to the early redemption of the Centene and legacy Health Net senior notes that were scheduled to mature in the middle of 2017. This increased interest expense by $11 million pre-tax for the fourth quarter and full year. Our effective income tax rate was 47.3% in the fourth quarter of 2016. The lower than projected tax rate in the fourth quarter is due to the additional earnings associated with the revised minimum MLR definition in California and the stock-based compensation adoption. The increased earnings and lower tax rate associated with the California minimum MLR definition lowered our effective tax. For the full year 2016, our effective tax rate was 51.8% compared to 48.6% in the prior year. The increase in our effective tax rate year-over-year is due to the acquisition of Health Net, partially offset by the California minimum MLR change and the adoption of the new stock-based compensation standard previously discussed. The California minimum MLR change and the stock-based compensation adoption decreased our effective tax rate for the full year by over 400 basis points. Before I get into details regarding the balance sheet, first, let me provide an update on the fair valuation exercise associated with the Health Net acquisition. During the fourth quarter, we finalized the fair valuation associated with the transaction including our fair valuation estimates of intangible assets and substance abuse treatment center costs. Total intangible assets have been revised to $1.530 billion amortized over a weighted useful life of 12 years. In addition, we finalized the liability associated with the substance abuse treatment center cost and increased our estimated liability by approximately $30 million during the fourth quarter. This adjustment primarily relates to periods prior to the acquisition date and did not go through earnings. As of December 31, 2016, we maintained approximately $125 million in medical claims liability associated with the substance abuse treatment center costs primarily related to periods prior to the acquisition date. Now on to the balance sheet. Cash and investments totaled almost $9.1 billion at year-end, including $264 million held by unregulated subsidiaries. Our risk-based capital percentage for NAIC filers continues to be in excess of 350% of the authorized control level. Debt on December 31 was $4.7 billion, including $100 million of borrowings on our revolving credit facility. Our debt to capital ratio was 43.7% excluding our non-recourse mortgage note, compared to 34.7% at last year-end. We have reduced our debt to capital ratio by approximately 60 basis points since the Health Net acquisition. Our medical claims liability totaled $3.9 billion at December 31, and represents 42 days in claims payable compared to 41 days last quarter. Cash flow from operations was $1.6 billion in the fourth quarter and $1.9 billion for the full year. Operating cash flows for the fourth quarter and full year were impacted by the finalization of the opening balance sheet associated with the Health Net transaction. As a result, operating cash flows benefited by approximately $445 million in the fourth quarter. Now, for 2017 guidance. Our total revenue and adjusted diluted earnings per share guidance remains unchanged from our December Investor Day. We have adjusted our GAAP diluted earnings per share guidance to reflect the finalization of the purchase price allocation with respect to intangible assets. This increased our GAAP diluted earnings per share by $0.04 on the bottom and top end of the ranges. The updated amounts are reflected in the revised guidance included in our press release today. Additionally, as previously stated at our December Investor Day, we took numerous actions in 2016 to resolve the issues associated with the products that were included in the PDR. As a result, we did not record any premium deficiency reserves in the fourth quarter of 2016 related to 2017. Overall, 2016 was a transformative year and we are pleased with the operating momentum heading into 2017. That concludes my remarks, and operator, you may now open the line for questions.

Thank you. I wanted to follow up on some comments you made for 2017 guidance. So initially, you had talked about flu peaking earlier and maybe a little higher, so how does that compare to what you have in guidance? And then, it sounded like you said that you built in some conservatism on health insurance exchange expectations to 2017. So, if you could help us understand what that means.

Sure. I'd be happy to. Yeah. I'll start off, and Jeff and others can add to it. There's been reports out on the flu, so I wanted to ensure that you all understood we've been tracking it. Last year was a very low base, so it's higher than last year. It is peaking earlier. It's all contained within the guidance that we've given you. And so, it's not a surprise. I was only really trying to clarify it to avoid any confusion later, Sarah. As it relates to the second part of your question, we took an approach of being conservative in looking at the exchanges and the costs. Why? Because everybody was doing it anyway and we said, let's just build it in to people who are comfortable that we've done, it's that the, we could still achieve our range that we originally talked about the high end. And it's just being extremely conservative. It's still a great year with a lot of upside and we said everybody is so concerned about this now. As I said, early indications and it's one month, so it's – but it's importantly – you look at the demographics of the population that is very consistent with what we've had success within the past. So, it was just the case of saying, let's be conservative. It's much better to meet and beat than later on saying that it didn't quite come out as we expected. So it's just the comfort zone, I think for investors and ourselves.

Got it. And other aspects of your health insurance product, maybe either in the benefit design or in the provider contracts such as risk sharing, that give you comfort around markets like Arizona on the health insurance exchange and being able to control costs in advance where you're just the only one or one of two?

Right. So I think, first of all, in Arizona, there were two issues going back. We had the Health Net PPO product which went away December 31. We then went back in and we entered with our design product that we have used everywhere and contrary to what people think, I mean, in the insurance business an ideal world is where you do a carry or replace. It ensures you get the full balanced book of business and that's something we've learned a long time ago. So as it relates to Arizona and going in by example in any of the new markets, we've used our same design – product design, we've used our same network approach to it and we've been very consistent. And when we took that any experience we had in Arizona through the old business and looked at it through our lens, it said, it should perform consistent with our expectations of any of our businesses. And 90% plus of it is in the silver tiers we said, which is the area we have the most success with the subsidized members. So it's very consistent.

Thanks. Good morning. Can you quantify any benefit from the California minimum MLR adjustment that was related to the first three quarters of 2016 that may have been included in the fourth quarter?

Yes. So, just a quick thing on that. If you recall the minimum MLR in California actually ended on July 1, actually June 30. So, the minimum MLR rebate provisions, I think, they began in January 2014 and then went all the way up through June 30 of 2016. And in the third quarter, we had mentioned that we had roughly $0.09, I think in the guidance for the full year which really represented the current year effect for our California Health & Wellness plan, and then subsequent to the acquisition date for the Health Net plan. So, in total, it was around 200 – a little over $220 million of benefit for us for the full year, so that's little over $25 million of its effectively in the adjusted diluted earnings per share number, pre-tax.

Right. And just one more clarification on the revenue guidance given that it was unchanged. Can you just clarify whether that includes the Pennsylvania HealthChoices contract win?

Yeah. Yeah. Obviously, we have – it does and obviously we have an $800 million range on that, so it's early in the year contracts start dates, et cetera, et cetera. We just thought it prudent to just keep the same guidance range with the $800 million spread we have on the range.

Thanks. Good morning, guys.

Good morning.

Michael, just wanted to follow-up on the North Carolina JV that you guys created. I certainly understand with the potential RFP coming out, why you guys would be so active early here. But could you just walk us through the economics? Is that kind of look any different than your typical awards? I know you said that the physicians have some ownership stake in it as well. So, is there some sort of non-controlling interest that you guys have to disburse distribute, how does that work?

So, it's going to be – it's an 80/20 joint venture with us having the 80. It's certainly – typically we've done in other markets very successfully. We work with the physicians on the medical policies and practices. The financial side of things we manage. And it will – in the end, ensure their involvement on how medicine is practiced, which is something we've always subscribed to in all markets. So there's no change there. But, yes, we think it's particularly important with the state that as large as that and as new as it is to really I've called it out and we want to doctors understanding that they will have every opportunity to view the medical policies and practices. And then – but from a financial standpoint, we will be managing that.

Thanks. Hi, everybody.

Hi.

First of all, let me ask you about the Health Net synergies. I know you guys said you're generally tracking your expectations and presumably a lot of what you'll realize in 2017 is the result of actions already taken into 2016. I wonder when you think about 2017 and actions still to be done to capture more synergies. What's still left to be done with respect to Health Net integration and so forth?

Well, we're still working through the operational systems, the claims payment, some of the medical management things being put in place. And Mark Brooks is doing an outstanding job for us in that area and working through very methodically. Some of them will be bringing back from offshore, some of the claims payment. That something is nothing to do with the current political environment. We announced that we will be doing that with the acquisition almost two years ago now. So that's consistent with our approach. So, those kinds of things and actually when we look at it, we're more efficient in our automated claims payment here in the U.S. and when it is offshore. So, we see all those things still to come to bear. But I keep encouraging and I think the senior management encourage everybody that's involved with the execution, it's not how fast, it's how well, it's on target. I think what was important to us and what I highlighted before, the things that have been integrated, the cultural thing, the HR, the general ledger where we're moving the IBNR system to ours running parallel in the first quarter, and then we'll be putting in our system, those kinds of things. It's really worked the way one would expect it to and then some, and I'll gratuitously take advantage of your questions rolling one other thing. It gives us a great deal of confidence in our ability to take on a fairly large acquisition, one that was not simple and had some issues and integrated effectively, and so it's all worked on schedule.

Great. Thanks. Just wanted to ask on the individual business. I think previously you talked about having about $300 million of kind of making a net payable position on the risk adjusters, risk corridor, minimum MLR.

Right.

Is that where you kind of ended the year or did anything change around that?

Yeah. Total around the year-end is going to be around $425 million of risk adjustment payable. You'll see that in our 10-K.

I want to thank you all for participating and I will tell you, I look forward to you having more of these kinds of calls with the kind of results we delivered this past quarters. So, off to 2017 we go. Have a great year, everybody.