Magellan Health, Inc.
Q3 2018 Earnings Call Transcript

Published: 10 Nov 2018

[Operator:]

Welcome, and thank you for standing by for the third quarter 2018 earnings call. [Operator Instructions] Today's conference is being recorded. If you have any objections, you may disconnect at this time. Now I will turn the meeting over to Mr. Joe Bogdan. Thank you, sir. You may begin.

[Joe Bogdan:]

Good morning, and thank you for joining Magellan Health's Third Quarter 2018 Earnings Call. With me today are Magellan's Chairman and CEO, Barry Smith; and our CFO, Jon Rubin. The press release announcing our third quarter earnings was distributed this morning. A replay of this call will be available shortly after the conclusion of the call through December 7. The numbers to access the replay are in the earnings release. For those who listen to the rebroadcast of this presentation, we remind you that the remarks made herein are as of today, Wednesday, November 7, 2018, and have not been updated subsequent to the initial earnings call. During our call, we'll make forward-looking statements, including statements related to our growth prospects and our 2018 outlook. Listeners are cautioned that these statements are subject to certain risks and uncertainties, many of which are difficult to predict and generally beyond our control. These risks and uncertainties can cause actual results to differ materially from our current expectations, and we advise listeners to review the risk factors discussed in our press release this morning and documents we filed with or furnished to the SEC. In addition, please note that Magellan uses certain non-GAAP financial measures when describing our financial results. Specifically, we refer to segment profit, adjusted net income and adjusted EPS, which are defined in our SEC filings and in today's press release. Segment profit is equal to net revenues less the sum of cost of care, cost of goods sold, direct service costs and other operating expenses and includes income from unconsolidated subsidiaries, but excludes segment profit from non-controlling interests held by other parties, stock compensation expense, special charges or benefits as well as changes in fair value of contingent consideration recorded in relation to acquisitions. Adjusted net income and adjusted EPS reflect certain adjustments made for acquisitions completed after January 1, 2013, to exclude noncash stock compensation expense resulting from restricted stock purchases by sellers, changes in the fair value of contingent consideration, amortization of identified acquisition intangibles, as well as impairment of identified acquisition intangibles. Please refer to the tables included with this morning's press release, which is available on our website for a reconciliation of these non-GAAP financial measures to the corresponding GAAP measures. I will now turn the call over to our Chairman and CEO, Barry Smith. Barry?

[Barry Smith:]

Thank you, Joe. Good morning, and thank you all for joining us today. On our call this morning, I'll discuss the following topics. First, I'm going to comment on the financial results for the quarter and our reduction to 2018 guidance. Second, I'll make some observations about our growth, success in winning new business and integrating acquisitions. I'll also discuss challenges that we faced along the way. Third, I'll provide an update of some of the operational highlights from the third quarter. Finally, I will share our current focus, areas of focus of each business before transitioning to Jon's detailed financial update. For the third quarter of 2018, we reported net revenue of $1.9 billion, net income of $27.1 million and EPS of $1.09 per share. Our adjusted net income was $36.2 million, or $1.45 per share. And we achieved segment profit of $88.3 million. The quarterly results included approximately $22 million in out of period favorability. We are lowering our 2018 earnings guidance due to the following factors

[Jon Rubin:]

Thanks, Barry, and good morning, everyone. Prior to commenting on the financials, I'd like to note that we're revising the Healthcare operating results table in our 10-Q to provide detailed metrics on our MCC business, given its growth and significance to our strategy. For comparative purposes, we've provided a quarterly historical reclassification of this information from first quarter 2017 through third quarter 2018 as an additional exhibit within this morning's earnings release. Now with respect to the financials, on this morning's call, I'll review the third quarter results, discuss our revised outlook for the full year, and provide some initial commentary on our 2019 business plan. For the quarter, revenue was approximately $1.9 billion, which represents an increase of 31% over the same period in 2017. This increase was mainly driven by net business growth and the annualization of revenue from prior year acquisitions. Net income was $27.1 million and EPS was $1.09. This compares to net income and EPS of $32.5 million and $1.32, respectively, for the third quarter of 2017. Adjusted net income was $36.2 million and adjusted EPS was $1.45. This compares to adjusted net income of $40.4 million and adjusted EPS of $1.64 for the prior year quarter. Segment profit was $88.3 million for the third quarter compared to $87.7 million in the prior year quarter. For Healthcare business, segment profit for the third quarter of 2018 was $61.7 million, which represents an increase of 7% compared to the third quarter of 2017. Healthcare results for the quarter include net favorable out of period adjustments of approximately $22 million, largely driven by favorable client settlements. Other material drivers of the quarterly change in segment profit included the incremental operating losses in Virginia and the impact of the October 2017 rate reduction in Florida, partially offset by the incremental earnings contribution from the Senior Whole Health acquisition that closed on October 31, 2017. Now turning to Pharmacy management. We reported segment profit of $33.6 million for the quarter ended September 30, 2018, which was a decrease of 13% from the third quarter of 2017. This year-over-year decrease was primarily driven by a decline in earnings in our specialty carve-out business, resulting from lost formulary management contracts, which we discussed on our second quarter earnings call. Regarding other financial results, corporate costs inclusive of eliminations, but excluding stock compensation expense, totaled $7 million compared to $8.5 million in the third quarter of 2017. This change was due to costs in the prior year quarter related to the Senior Whole Health acquisition. Total direct service and operating expenses excluding stock compensation expense and changes in fair value of contingent consideration were 13.8% of revenue in the current quarter compared to 15.4% in the prior year quarter. This decrease was primarily due to the acquisition of Senior Whole Health, net growth, lower discretionary benefit expenses, and a change in business mix. Stock compensation expense for the current quarter was $9.3 million, a decrease of $1 million from the prior year quarter. The reduction was largely attributable to restricted stock issued on part of the CDMI acquisition that vested in 2017. The effective income tax rate for the 9 months ended September 30, 2018 was 26.3% versus 34.4% in the prior year. The change in tax rates was largely due to the reduction in base rate, as a result of the 2017 Tax Act, partially offset by the impact of the non-deductible Health Insurer Fee reinstituted in 2018. We anticipate a full year effective income tax rate of approximately 30%. Our cash flow from operations for the 9 months ended September 30, 2018 was $34 million. This compares to cash flow from operations of $112.7 million for the prior year period. This year-over-year change is primarily related to the timing of receivable collections from states in our MCC business. As of September 30, 2018, the company's unrestricted cash and investments totaled $232.2 million compared to $261.2 million at December 31, 2017. Approximately $134.2 million of the unrestricted cash and investments at September 30, 2018, is related to excess capital and undistributed earnings held at regulated entities. Restricted cash and investments at September 30, 2018 decreased to $380.8 million from $465.4 million at December 31, 2017. This decrease was primarily due to accounts receivable increases as well as improved capital efficiency achieved through substituting a letter of credit for statutory surplus in one of our MCC markets. Year-to-date through October 31, 2018, we repurchased approximately 680,000 shares for $53.2 million. We have approximately $200 million remaining in our share repurchase authorization program, which runs through October 22, 2020. Now, as Barry mentioned, we're updating our guidance to reflect the following items. First, utilization pressure in our Healthcare business, and we're actively working on executing action plans to mitigate this pressure. Second, in MCC of Virginia, the unfavorable update to our expected risk scores for 2018. Third, modestly lower margins in our Pharmacy business as a result of delayed timing of network rate improvement actions. And finally, as a result of our operating efficiency initiatives, we're including an initial estimate of severance and other costs that we expect to recognize in 2018. As a result of the above, we're revising our 2018 full year earnings guidance ranges to the following. Net income of $68 million to $88 million; EPS in the range of $2.71 to $3.51; segment profit of $290 million to $310 million; adjusted net income of $107 million to $123 million; and adjusted EPS in the range of $4.26 to $4.90. In addition, we're in the process of finalizing our business plan for 2019 and we'll provide detailed guidance in early December. In advance of the 2019 guidance call, I'll now provide some high-level commentary. To start, our 2018 guidance range for segment profit needs to be adjusted by three factors to arrive at a run rate. First, our year-to-date results include approximately $26 million of net favorable out of period adjustments. Second, our full-year 2018 segment profit guidance includes the benefit of approximately $6 million related to the provision for non-deductibility of the Health Insurer Fee, which will be suspended in 2019. And finally, our updated 2018 segment profit guidance includes $10 million to $20 million of expected severance and other related costs. After adjusting for these three items, our 2018 normalized segment profit run rate would be in the range of $270 million to $290 million. We currently expect that 2019 segment profit will be roughly consistent with this normalized range for 2018. Key drivers of the segment profit increases in 2019 are anticipated to be cost of care initiatives for MCC Virginia and other healthcare contracts, the annualization of new business sold during calendar year 2018, the impact of new business effective in 2019 and same-store growth within existing contracts. We expect these increases will be essentially offset in 2019 by the following headwinds. The reduction in our MCC footprint in Florida, which will result in the contract providing an immaterial contribution to earnings in 2019; the impact of lost contracts; and the impact of the lower level of discretionary benefits in 2018, which we expect to normalize in 2019. In summary, while we're not pleased with our results this year, I'm confident that our growth strategy is sound. After transforming our business and achieving strong top line growth over the past few years, we have significant earnings power in our current portfolio, as we work to increase our margins to industry-competitive levels. We're continuing to further develop our multi-year earnings improvement plan to achieve this, and we'll provide more details on this plan and the execution timeline on our call in early December, when we provide 2019 guidance. With that, I'll now turn the call back over to the operator, and we'll be happy to take your questions. Operator?

[Operator:]

Thank you. [Operator Instructions] And we will go to our first response from David Styblo with Jefferies. Your line is open.

[David Styblo:]

Hi. Good morning. Thanks for taking the question. Maybe I just want to start out with the commentary about the severance cuts that you guys are making. Can you help us understand what parts of the business those are coming from, what duties or roles those are related to? Just trying to get my arms around the cuts that you might be making. And does that create some risk or jeopardize your ability to manage costs at a time when they probably need some extra attention and focus on the initiatives across both sides of the business there?

[Barry Smith:]

Well, David, there are -- thanks for the good question, David, and for joining us today. There are several initiatives we've got underway. We have some business, for example, in the State of Florida today, where we have roughly 40% of the covered lives we had from this year and the prior years. So some of the severance is related to contracts that have terminated that we're transitioning. The other thing that we're looking at very closely are both spans and layers within the company, meaning that we have, we want to be, make sure that we're designing our processes to be far more efficient, and so over the next little while, we'll be looking at the opportunities to create a more efficient organization. So we'll get back to you with more detailed information on our update for the guidance call for 2019 on December 7.

[David Styblo:]

Okay. Obviously, this, you guys talked about this being a challenging year, and some of these things, sometimes you win, [indiscernible] contracts or the new contracts in Virginia have had some startup issues. I guess we don't hear some peers talking about some of the same issues in Virginia, maybe it's because they are so much larger and it gets covered up a little bit more. But I'm just curious to hear your perspective on what's maybe happening in Virginia, specifically. Do you guys think that that, as a whole, can get to a profitable margin, say, in the next 2 to 3 years like most contract peers? Is there something structurally different about that award? And then, I know you don't want to get too far into 2019 guidance, but what, do you expect that business to be losing money again in 2019?

[Barry Smith:]

We'll split the question in 2 parts. Let me kind of give you kind of the overhead, overall response there. Virginia is a little bit different for Magellan. In that, we were the only new entrant in the state, both for the ABD population at the first of the year for the CCC as well as for the Medicaid expansion. So for us, we are building the infrastructure, building the management processes within the state, managing cost of care and building those processes and systems. So for us, it's new work, work that we're learning from and work that we're implementing. So it's a bit different than most of the established MCOs. The second thing I would say is that this implementation process of 3 different implementations roughly in 15 to 18 months is very unusual. It's a good new story we believe, because the state likes the work that we've done, we have great credibility with the state, and they've awarded us incremental business. So that's a good new story. But when you implement 3 times in a row in phased-in implementations, it does create a lot of overhead within the operation and a lot of challenge to both manage cost of care, as well as making sure that we hit the targets the state of set, has set in terms of the dates of implementation and the processes. So we feel good about what we've done there. We have a great reputation in the state, and above all else, we're going to make sure that we maintain those proper relationships and service levels for the members that we serve. So that's all worked out really well, but again we're very different than the other providers in the state, because, again, we've done 3 new implementations that were new to the state. Jon?

[Jon Rubin:]

Yes. And couple of other things I'd just mention, David, one being that, on top of that, again, given what Barry said about us being new to the market, we also are, in a sense, having the rates settle as well through the risk adjustment process. So this year, based on the preliminary risk scores that we've received, we think we will see some incremental pressure which is built into the guidance this year. So we had talked about coming into this quarter in a couple of different phases, we were, we had startup losses in Virginia order of magnitude in the $35 million range. The risk scores put an additional $10 million of pressure on top of that this year. That is short-term, and that we've received 2019 draft rates, and actually those are more in line when you take into account both the base rates and the risk scores to what we expected. So we expect the pressure on that side to be short-term. As we think about 2019, again, we're not in the point where we're going to give guidance, but to at least directionally answer your question. We think we still could see some losses in Virginia. Again as Barry said, we have a whole new population coming on with the expansion population, but do think that, and do expect an, as we think about our business plan for next year, significant improvement. Long-term though, we see every opportunity for this contract to be running at normal Medicaid margins. If you think to the earnings power over time, and I would look at that as probably a two-year period, it's pretty significant. So we're still very bullish long term on the contract. Operationally, things have gone well. The relationship with the state is very strong. And we're in a, in the mode now of executing on a number of initiatives to get there over the multi-year period.

[Barry Smith:]

And let me just add on to Jon's comment, and we'll use Virginia as an example. But with MCC, we've actually invested more resources both for MCC enterprise across the board, as well as locally to make sure that we're on top of appropriate medical cost management. We want to do the right thing by our members. We've just recently hired a new MCC CMO, for example; very experienced Medicaid medical loss ratio management. And we've hired a new analytics lead for MCC. So we've been investing pretty heavily within MCC to manage the very issue that you've brought up.

[David Styblo:]

Okay. Thanks. My last one is, you commented earlier about extended resources, just as you guys were implementing new contracts and so forth. I guess, as you go forward right now, is there, does there need to be a shift in strategy in terms of growth? In other words, do you guys maybe need to put the brakes on growth and work on just improving the challenges that you guys had before you? Or do you think you can still pursue other growth opportunities, particularly some of the larger RFPs that are coming out in the market and across Medicaid in the next 6 to 12 months?

[Barry Smith:]

We absolutely do believe that we need to digest what we've already consumed and be very thoughtful about what we bring on to the chassis. We think there are great opportunities coming out, but we've actually already started to moderate our view and been highly selective of those RFPs that we respond to. There are opportunities though in the future that we continue to develop. So I wouldn't say that we're going to stop drilling, we certainly won't, but we will be very, very selective in terms of the RFPs, the state, the programs that we do pursue.

[Jon Rubin:]

The other thing, just to add quickly to that, David, is that, in addition to what Barry said, we'll look selectively at new markets to expand into, maybe it's one a year that we'll be focused on versus trying to do more than that. There is significant growth opportunity within our existing markets. And part of what we need to do, when you think about Florida, Arizona and even our other MCC markets, is not just to make sure we're stabilizing and operating at high levels, but also looking at expansion opportunities and getting to scale in each of those markets. So part of the strategy that Barry was describing is really wanting to solidify and grow in our existing markets while we're selectively looking at other markets, but definitely on a more measured pace.

[David Styblo:]

Understood. Thanks. I'll step back for others.

[Barry Smith:]

Great. Thanks, Dave.

[Operator:]

Thank you. Our final question we have in queue is Michael Baker with Raymond James. Your line is open.

[Michael Baker:]

Yes, I was looking on the Pharmacy side to get some color on the delays in the network rates, what's kind of driving that? And then secondarily, it sounds like some competitors are also adjusting their model, so maybe you can give us a sense for what the future you see might look like on the Pharmacy side.

[Barry Smith:]

Yes. Thanks for the good question, Michael. We look at really 3 areas of opportunity within Pharmacy. One is clearly the pharmacy network. We've already made some strides and locked in some savings for 2018 -- later 2018 going into 2019. We still are continuing to negotiate, as we've built massive volume, as we add new employer business to our book of business, and we've had and will have significant growth in that space as well. So it's an ongoing process. So I wouldn't say that we've been delayed. It's actually we're having more and more success as we grow mass and scale. So again, we're working on those things, we're working with the national providers, and those -- that dialog is ongoing. And we hope to have those things included in the relatively near future. We also focused on formulary management. These are the high-cost specialty drugs, of course. We have some real opportunities to impact even more some of these large target drug classes that represent large cost for our customers. And so we continue to expand our focus on opportunities within the formulary management business. And then also with the drug acquisition cost, we're looking for opportunities to reduce the drug costs for mail order, both specialty and non-specialty. So these are 3 areas that we are working simultaneously. And I would say that the pharmacy network piece of it, particularly, we do have a few larger network opportunities that we hope to close in the near future.

[Jon Rubin:]

Yes, and just one quick detailed point on that. Mike, in terms of some of the comments in the script around the timing of these actions, there were some specific actions that Barry had referenced that, from a timing standpoint, we had expected to be implemented for third quarter that has slipped a little bit to later in the year. So it's very temporary, it has impact on both third quarter and the guidance for the full year. But long term, we expect to achieve the same benefits that are actually well on our way to getting there.

[Michael Baker:]

And then, finally, just wondering if you could give us the sense of the size of the specialty carve-out business within Pharmacy, given the fact that it seems like that's the one that's pressured the most versus other segments which have growth opportunities to it?

[Jon Rubin:]

Yes. So in the specialty pharmacy carve-out business, if you looked at actuals for 2017, we were running roughly in the $90 million range. If you look at the results through 3 quarters, and again, all the information will be in the Q, we'd expect that. And this is -- these are revenue numbers to be run rating at around the mid-70s this year. And given some of the terminations we've had, we expect it to be a little bit lower in 2019. But one thing I would underscore is, although there's a lot of opportunities in PBM, there are still opportunities in the specialty carve-out space as well. Again, we've gone through some temporary challenges as a result of some of the short term aggressive pricing we've seen in this segment. But we still continue to see opportunities, have them in the pipeline and actually are still selling business. So I wouldn't look at that as just a legacy business, but one that we will continue to pursue.

[Michael Baker:]

Thanks a lot.

[Jon Rubin:]

You got it.

[Barry Smith:]

Thanks Michael.

[Operator:]

Thank you. We have no further questions.

[Barry Smith:]

Well, we appreciate you joining us today on our earnings call, and we'll be back to you on December 7 with our guidance for 2019. Thank you for joining us.

[Operator:]

We thank you all for your participation in today's conference. That will conclude the call. You may now disconnect. Thank you.