Cano Health, Inc.

Good afternoon and welcome to Cano Health's second quarter 2023 earnings call. Currently, all participants are in listen-only mode. After the speaker's presentation, there will be a question and answer session. Please be advised that today's conference is being recorded. Joining us on today's call will be Mark Kent, Interim Chief Executive Officer, and Brian Coppe, Chief Financial Officer. The Cano Health press release, webcast link, and other related materials are available on the Investor Relations section of Kennel Health's website. As a reminder, this call contains forward-looking statements regarding future events and financial performance. Investors are cautioned not to unduly rely on forward-looking statements, and such statements should not be read or understood as a guarantee of future performance or results. We intend these forward-looking statements to be covered by the Safe Harbor provisions for forward-looking statements. contained in Section 27A of the Securities Act and Section 21E of the Securities Exchange Act. We caution you that the forward-looking statements reflect our best judgment as of today, based on factors that are currently known to us, and such statements are subject to risks, uncertainties, and assumptions that could cause actual future events or results to differ materially from those discussed as a result of various factors, including but not limited to risks and uncertainties discussed in our SEC filings. We do not undertake or intend to update any forward-looking statements after this call or as a result of new information, except as may be required by law. During the call, we will also discuss certain financial measures that are not prepared in accordance with GAAP. A reconciliation of the GAAP and non-GAAP results is provided in today's press release and on the Investor Relations section of our website. With that, I'll turn the call over to Mark Kent, Interim CEO of Kennell Health. Please go ahead.

Thank you and good evening everyone. I appreciate you joining us to hear how Kano Health is turning the page to create a sustainable business for all our stakeholders. We are accelerating our strategy to enhance operational efficiency and executing our plan to improve the management of our medical costs to realize the embedded value within our business. Since becoming interim CEO in June, I have worked with the team to conduct a thorough review of all aspects of our business. While our mission and vision remain the same, the strategy and tactics needed to realize the profitability embedded in our business requires a refreshed approach built upon a stronger operational foundation. By now, you may have seen our press release and know that today we announce Kano Health is pursuing a comprehensive process to identify and evaluate interest in a sale of the company or all or substantially all of our assets. We have already been working with advisors and are encouraged with the progress made so far. And while there is no timetable for a conclusion of this process, we expect to share more information at a later date and time when necessary. As a note, we will not be commenting further on this process during our Q&A session after our finished remarks. This step is important for Kano Health's success. Joining with the right strategic partner is an opportunity to accelerate the value generated from producing favorable health outcomes for our patients and reducing medical costs within our community. In the rest of my prepared remarks today, I plan to walk through the progress we have made in just a few short weeks to refocus our strategy on Medicare Advantage and ACO Reach and to accelerate decisions and actions designed to support the organization's long-term success. I'll discuss key dynamics impacting our business and how we will address some of these headwinds. First and foremost, Our core operating strategy is now focused on providing primary care services for Medicare Advantage and ACO REACH members in our core Florida market through both our medical centers and our affiliated networks. Our evolving management team has a long and proven track record of operating successful primary care facilities and affiliate networks in Florida that improve health outcomes for Medicare Advantage and Medicare ACO REACH populations. The team has a longstanding, solid relationships with our payer partners. We are leveraging their experience, technical knowledge, and relationships to streamline and improve our performance across the enterprise. We are now implementing a new plan to flatten our operational structure, rigorously prioritize projects in our Florida operations to improve the speed and quality of the care we deliver, and create a smaller brick-and-mortar footprint to optimize our core Medicare Advantage assets. This new smaller footprint and more focused business required us to realign and reduce the size of our workforce, which we did just last week. While it is difficult to see team members go, the reduction was necessary to allow us to align with this new strategy. We thank those employees who are leaving us for their dedication and service. In order to focus on Medicare Advantage and ACO REACH operations in Florida, we launched processes to divest certain non-core assets. While we cannot assure investors that a transaction will be consummated, we have received second round bids to divest the majority of our Florida Medicaid operations. While valuable, the Medicaid business diverted critical physician capacity and care management resources within our existing medical centers away from our core Medicare Advantage business. We found it was inefficient for our care management teams to serve both Medicare Advantage and Medicaid members who have very different needs. We also made important strategic decisions for our markets outside of Florida. By the fall of 2023, We expect to fully exit our operations in California, New Mexico, and Illinois by selling or closing in those markets. We began notifying members, physicians, employees, and our payer partners about our decisions over a month ago. This decision impacts approximately 5000 total members across 17 medical centers. We also expect to fully exit operations in Puerto Rico by January 1, 2024, which currently has approximately 8,000 members cared for by our affiliates. Conal Health remains committed to supporting our members as they transition to new providers to ensure they receive the highest possible quality of care. In addition to exiting operations in those states, we are consolidating medical centers in Texas and Nevada while simultaneously evaluating offers allowing us to divest these assets. The consolidation plan is intended to improve the economics of these markets, whether they remain part of Kano Health or are divested. We plan to reduce our footprint in Texas and Nevada by closing about half of our centers in those markets to improve their profitability and cash flow. With such actions, our Texas and Nevada medical centers will be highly attractive with the capacity to efficiently and effectively serve the growing Medicare Advantage population. Further, we review taking actions on other non-Medicare lines of business in Kano Health, such as Medicaid, behavioral health, pharmacy operations, and occupational health. Each of these lines of business is attractive on a standalone basis. We have received interest from multiple parties for these assets, are engaging in active discussions, and of course, we cannot assure investors that any particular transaction will be consummated. Our exits from California, New Mexico, Illinois, and Puerto Rico coupled with the consolidations in Texas and Nevada and the potential divestiture of Medicaid will allow the organization to be laser focused on delivering high quality, high access, and high member engagement for our Medicare Advantage and ACO REACH members. Now moving on to the current business environment and the trends we are seeing. First and foremost, we are in the care management business. The quality of care that we deliver remains market leading and a source of pride for all of us. Unfortunately, we have had several emerging process issues that have affected our ability to project our performance. However, these issues can and are being remedied. In our core Medicare Advantage business, capitated revenue in the second quarter of 2023 was well below our expectations. This was primarily due to a shortfall in the Medicare Risk Adjustment Revenue, or MRA, collected versus what was expected and accrued for in prior periods. As the second quarter of 2023 closed, we received the quarterly service funds from our health plan partners, which reflected their reconciliations of the actual and estimated MRA revenue from CMS for our members. These reconciliations resulted in a reduction to our final 2022 and mid-year 2023 estimates during the second quarter. Upon stepping into the Chief Strategy Officer role in April of 2023, I asked our team to perform a cross-functional review and audit of our clinical documentation, billing and coding, and estimation methodologies. and to suggest ways to enhance our practices. Our review found that while our clinical documentation, billing, and coding followed nearly all internal policies, we have clear opportunities to implement simpler, scalable, and more effective protocols designed to enhance our performance. The largest gap we found was attributable to backend processes and the ways that data from those processes inform our MRA estimates. The prior processes were overly manual, and our back-testing analysis demonstrated that they provided limited predictive power. During my time at Humanum and during my time operating independent value-based care primary facilities and a hospital, I learned that the value-based care model succeeds best when physicians have every tool necessary to make informed decisions. And so, to enhance our data capture, this quarter we quickly began revising our approach to limit data variability and to ensure we close gaps in real-time data reporting. I believe our estimates going forward will reflect a more accurate view of these MRA projections that will result in a higher realized and appropriate MRA revenue. We were also impacted by higher utilization than expected in the quarter. This was primarily due to the utilization of health plan supplemental benefits, such as OTC flex cards, and higher utilization across outpatient and pharmacy services. As you recall from our first quarter earnings call, We received information from payers about higher utilization of OTC flex cards very late in the quarter. Prior to receiving actual card utilization data, we assumed that the trend would be in line with historical patterns. The new payer information made it clear that in the second quarter, utilization of the cards was significantly higher than in prior years. And in several cases, we realized that service fund OTC FlexCard impacts in 2023, which were not present in 2022. Moreover, health plan data received in the second quarter of 2023 included retroactive adjustments for OTC FlexCard claims dating back to January 1 of 2023. As a result, not only do we experience higher OTC flex card utilization in the second quarter of 2023, but we also received unfavorable prior period development from the first quarter of 2023. These OTC flex cards became more prevalent in the 2023 annual enrollment period among health plans, particularly in Florida. While they provide an enhanced benefit for our members, at-risk value-based providers like Kano Health are unable to influence or manage these costs, which we recognize in our third-party medical costs. Given these unsustainable burdens OTC Flex Cards place on our third-party medical costs, We are intensely negotiating with several payers to mitigate these costs in 2023 and making reduced OTC flex card costs a top priority in our negotiations for 2024. In the second quarter of 2023, we also saw higher than expected utilization, partially attributable pent-up demand for outpatient procedures. Pharmacy utilization was also higher than expected in the quarter and remained elevated due to higher branded drug costs, primarily related to certain diabetes medications. We expect this to continue in the second half of 2023 and are closely monitoring the claims data we receive. To mitigate these costs, we have a number of action items that are underway, and I will discuss these momentarily. Clearly, these headwinds mean it's imperative that we position ourselves to better facilitate, manage, and influence care delivery in our medical centers and affiliate networks. Focusing on Medicare Advantage and ACO Reach provides Cono Health with the opportunity to rebuild its foundation in a market we understand very well. It also allows us to implement and scale critical operational changes across our footprint, giving us greater leverage over time. Now, let me highlight a few actions we've already taken to simplify our operations and refocus our core capabilities. First, we have successfully right-sized our payer agreements to reflect the size, scale, and impact of our organization to position ConoHealth as a true partner with our payers. Actions taken include developing broader master agreements with payers to replace multiple complex agreements with the same payer. This is intended to allow us to manage our payer relationships more effectively and to yield the best economic impact for our enterprise, not just in a particular region or for a single plan. We are using our scale to negotiate with specialists and hospital systems, which should enable us to reduce our third-party medical costs and support our ability to focus on improving the overall health outcomes of our patients. Third, as part of our restructuring, our Kano at Home program relaunched with a renewed focus on increasing engagement with high-risk patients. The goal is to improve our delivery of primary care in the home setting to avoid costly ER visits and hospital admissions. We previously mentioned that this program can generate a five to ten percent reduction in preventable ER visits and increase our ability to treat high risk patients outside of the hospital. Simultaneously, our member engagement teams have increased contact with high-risk patients to control adverse medical outcomes. For example, in the first half of 2022, we engaged with approximately 800 high-cost members. In the first half of 2023, as part of the action plans that have been implemented, we have engaged with nearly 49,000 high-cost members. Clearly, this level of engagement will have multiple benefits for the organization, including the recognition of higher MRA scores and lower medical costs as we engage and manage these members and better member engagement and better increased member satisfaction. Fourth, we are making operating enhancements to improve our insight into and influence over our medical costs moving forward. This includes reorganizing certain functional areas and adding new positions to strengthen core capabilities. To that end, we have added a leader of value-based care optimization who is responsible for evaluating the various patient touchpoints along the patient care continuum to ensure that our physicians, specialists, pharmacy services, Kano at Home, and care management teams are all seamlessly connected. In addition, we are implementing several new predictive services to improve our ability to provide proactive reporting and analysis of value-based care. Utilizing integrated data about our care touchpoints will ensure that we have the means to quickly assess and identify gaps in care while caring for our patients. Fifth, we have thoroughly reviewed and strategically aligned our referral networks to ensure that we have the right referral partnerships with a focus on patient health outcomes and offering the right care in the right setting at the right time. Sixth, we have a number of initiatives to identify and leverage our patient population data to determine where generic alternatives represent the greatest opportunity. This includes identifying whether prescriptions are prescribed by our own Connell Health physicians or originate with outside specialists. This insight will help us make quick and appropriate actions to reduce our pharmacy costs without sacrificing the quality of care or efficacy of medications prescribed. And finally, we remain committed to operating as efficiently as possible and reducing our SG&A expense. As I mentioned, to adapt to new business footprint, we made the difficult decision to realign and modify the size of our workforce to improve our cost structure. It goes without saying that these initiatives are critical for our success. and for our future as a value-based care company. Redirecting KanoHealth's strategy to focus on the highly profitable and scalable Florida Medicare Advantage market and the Capital Light ACR Reach business will put KanoHealth on a path towards improving our profitability and cash flow. There is still a significant amount of operational work to be done in our medical centers and our corporate functions, but we are encouraged by the potential and the great progress we've seen so far. Systems, initiatives, partnerships, and relationships all need to work and communicate in unison to maximize value for each decision we make. In the coming months, our organization will demonstrate its focus on optimizing our operations to generate greater efficiency, build better relationships with our payers, and improve health outcomes for our Medicare Advantage and ACO REACH members to ensure the organization's long-term success. And now, I'll turn the call over to Brian Coffey, our Chief Financial Officer, to take you through the financials.

Thank you, Mark, and thanks everyone for joining us today. It certainly has been a challenging and disappointing quarter for us and our various stakeholders. We are working relentlessly to execute the initiatives Mark has laid out and to accelerate the organization's path to significantly improve financial performance. Starting with the results of the quarter, total membership increased 35% year-over-year to approximately 381,000 members in the second quarter of 2023. This represents an increase of approximately 100,000 members from the second quarter of 2022. Total Medicare Advantage membership grew approximately 14% versus the prior year, but was about flat sequentially as continued membership growth in our medical centers was partly offset by planned terminations of our affiliates. Membership also declined sequentially in ACA and Medicaid, which were impacted by contractual changes and redeterminations, respectively. Total revenue for the second quarter of 2023 was approximately $767 million, up from approximately $689 million a year ago. Total capitated revenue in the quarter was approximately $743 million, an increase from $655 million in the second quarter of 2022. However, in the second quarter of 2023, capitated revenue was lower than expected, primarily driven by Medicare risk adjustment, or MRA revenue, which is approximately $58 million lower than previously estimated in our most recent full-year 2023 guidance. This lower MRA revenue reflects our updated view of the final 2022 and mid-year 2023 MRA revenue estimates. Of the approximate $58 million shortfall versus our expectations, approximately $44 million was out of period or related to services provided in 2022 and the first quarter of 2023. The Medicare Advantage revenue PMPM was $1,027 in the second quarter of 2023, down 13% sequentially from the first quarter of 2023. primarily driven by the lower than expected MRA revenue. The Medicare ACO REACH revenue PMPM was $1,309, down 12% sequentially from the first quarter of 2023, also lower than expected, and was primarily driven by revised benchmark data we received from CMS related to the 2022 and 2023 performance years. Additional information about our membership mix and our PMPM is available in our second quarter earnings release and second quarter financial supplement posted on our website. Our medical cost ratio, or MCR, in the second quarter of 2023 was 103.5% compared to 82.6% in the second quarter of 2022. Excluding ACO REITs, the MCR was approximately 108.6% in the second quarter of 2023 compared to approximately 81.8% in the second quarter of 2022. This increase was primarily driven by an increase in our Medicare Advantage MCR. The year-over-year increase in the MCR was primarily driven by lower capitated revenue due to the reduction in MRA revenue discussed previously and higher third-party medical costs due to higher utilization and higher costs associated with OTC Flex Cards offered by our health plan partners. The higher utilization contributed to unfavorable prior period development of third-party medical costs during the quarter of approximately $44 million, primarily related to medical service utilization of approximately $26 million and OTC Flex Cards of $18 million. The higher utilization of OTC flex cards occurred across nearly all our health plan partners. In the first quarter of 2023, Candle Health recognized approximately $13 million of OTC flex card costs, while the second quarter of 2023 recognized approximately $51 million, of which approximately $18 million was unfavorable prior fair development from the first quarter of 2023. What we see now is the aggregate cost from these OTC Flex Cards was approximately $33 million per quarter in the first half of 2023. This compares to approximately $12 million per quarter in the first half of 2022. As a result, greater use of OTC Flex Cards by our Medicare Advantage members is projected to add $84 million of third-party medical costs in the full year 2023 compared to the full year 2022. Direct patient expense in the second quarter of 2023 was 7.4% of our total revenue, below the 7.6% in the second quarter of 2022. SG&A expense in the second quarter of 2023 was approximately $99 million, down approximately $6 million compared to the second quarter of 2022. The total SG&A expense as a percentage of revenue was approximately 13%, which was above our expectations, primarily due to lower capitated revenue and headwinds to our cost reduction initiatives related to higher professional and legal fees. Net loss in the second quarter of 2023 was approximately $271 million compared to a net loss of approximately $15 million in the prior year, primarily driven by a higher operating loss the change in fair value of warrant liabilities, and higher interest expense. Operating results in the second quarter of 2023 also included a $62 million increase in the reserve within other long-term assets on our balance sheet, resulting from the full write-down of MSP recovery Class A common stock. Adjusted EBITDA in the second quarter of 2023 was negative approximately $150 million, compared to positive approximately $10 million in the prior year. This was primarily driven by higher medical costs and lower MRA revenue, as I previously described. It's important to note that we recognized $88 million from two large out-of-period items that are not expected to recur in the back half of the year. To summarize, the $88 million of out-of-period items, first, MRA revenue was $58 million lower than expected, and included $44 million unfavorable out-of-period adjustment for lower MRA revenue, while approximately $14 million is expected to recur in each the third and fourth quarter of 2023. Second, as I mentioned previously, there was $44 million of unfavorable prior period development related to utilization of third-party medical services and OTC flex cards. We are withdrawing our full-year 2023 guidance provided on May 9th, 2023, as our management team continues to evaluate strategic interests, assess the divestiture of non-core assets, and accelerate changes to Canal Health's operating structure. These factors are dynamic and outcomes vary widely, while we expect to continue to provide you with updates to our outlook as warranted. However, there are some factors to consider as you think about the remainder of the year. First, as I mentioned, we recognize $88 million of out-of-period items and unfavorable prior period development in the second quarter of 2023. As such, this amount is not expected to recur in future periods. Second, we still expect our financial performance to improve in the second half of 2023, despite higher utilization of OTC flex cards and medical services through the end of the year. The improvements in the second half of the year are driven by operational activities, which Mark highlighted, benefits from third-party medical cost recovery, such as stop loss and Part D rebates, and traditional seasonality, which typically benefit results in the second half of the year. Third, we recently made the decision to reduce our workforce by approximately 700 people, or 17% during the quarter. About 20% of these reductions are due to exiting operations in California, New Mexico, and Illinois, with another 20% due to consolidations in Texas and Nevada, and the remainder attributed to other operational functions. These actions are expected to yield approximately $50 million of annualized cost reduction initiatives beginning in the third quarter of 2023 and through the end of 2024. partially offset by an approximate $4 million restructuring charge that we expect to record in the third quarter of 2023. Fourth, we currently expect to reduce our medical center footprint from 169 as of June 30th, 2023 to approximately 136 medical centers by year end after our market exits and consolidations are completed. The remaining centers will include approximately 123 centers in Florida, and 13 centers in Texas and Nevada. It is important to note there are approximately 23 centers in Florida predominantly related to our Medicaid operations. Fifth, the California, New Mexico, and Illinois markets we are exiting have year-to-date adjusted EBITDA losses of approximately $14 million as of June 30, 2023. For these markets, there will be costs remaining for 2024 which are primarily related to certain leases that we have yet to sublease, are fully exit of approximately $7 million. In regard to Puerto Rico, which we are exiting effective January 1, 2024, the year-to-date adjusted EBITDA losses were approximately $9 million. Now let me turn to our cash flow and liquidity. At the end of the second quarter of 2023, Cash used in operating activities was approximately $45 million year-to-date and was primarily due to unfavorable operating results. Cash used in operations was also impacted by the change in working capital, which reflects lower accounts receivables, including lower estimates for MRA revenue compared to prior periods. We ended the second quarter of 2023 with approximately $15 million in unrestricted cash and $110 million of capacity remaining in our revolving credit facility, providing us with approximately $125 million in total liquidity at such time. However, for the test period ended June 30, 2023, the company was not in compliance with its financial maintenance covenant under the sidecar credit agreement, which relates to the 2023 term loan we closed earlier this year and requires our first lien net leverage ratio to be tested quarterly. At such date, the company's first lien net leverage ratio exceeded the maximum limit of 5.8 to 1, primarily due to the lower capitated revenue and higher third-party medical costs. We have successfully negotiated with our creditors, and on August 10, 2023, the company obtained a waiver and amendment of the sidecar agreement through September 30, 2024. The company's current liquidity as of August 9th, 2023 was approximately $101 million, which consists of unrestricted cash and reflects the full draw of the Credit Suisse revolving line of credit. Our expectation that having secured the 2023 sidecar amendment, we will repay a significant portion of the CS revolving line of credit. The full draw was proven in capital management while we negotiated the sidecar agreement. Furthermore, as the company achieves its various divestiture objectives, the immediate use of those proceeds will be to repay the revolving line of credit, and then within 18 months, the intent is to use the net proceeds to reinvest back into the business with the balance being used to repay debt. Given the operational headwinds we're facing in 2023 and the fact that the company's current liquidity is not expected to be sufficient to cover our operating investing, and financing uses for the next 12 months, management has concluded that there is substantial doubt about Canal Health's ability to continue as a going concern within one year. That is why the company is pursuing a comprehensive process to identify and evaluate interest in the sale of the company or substantially all of its assets, while pursuing multiple initiatives to streamline and simplify the organization to improve efficiency and reduce costs. These initiatives accelerate our shift to focus on our core assets in Florida to improve profitability and cash flow. And we expect our focus on Medicare Advantage and ACO REACH to result in more efficient operations and lower medical costs while helping our patients live their healthiest lives. In conclusion, the company is committed to strengthen our financial footing and implementing our operational and strategic initiatives to improve patient health and deliver for stakeholders. Now I'd like to turn it back to Mark for a few closing comments.