Centene Corporation

Welcome, and thank you for standing by for the third quarter 2019 earnings call. At this time, all participants are in a listen-only mode. During the question and answer session, please press star 1 on your touchtone phone. 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 Joe Bogdan. Thank you. You may begin.

Good morning, and thank you for joining Magellan Health's third quarter 2019 earnings call. Today, our Magellan CEO, Barry Smith, and our CFO, John Rubin. We're also fortunate to have our incoming CEO, Ken Fasola, on the call as well. While he won't be taking any questions today, his first day at Magellan will be November 14th, and he'll be on our 2020 guidance call in December. 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, December 1st. The numbers to access the replay are in the earnings release. For those who listened to the rebroadcast of this presentation, we remind you that the remarks made herein are as of today, Friday, November 1st, 2019, 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 2019 outlook. Listeners are cautioned that these statements are subject 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 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, 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, special charges or benefits, as well as changes in the 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 non-cash stock compensation expense resulting from restricted stock purchases by sellers, changes in the fair value of contingent consideration, amortization of identified acquisitionables, 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 CEO, Barry Smith.

Thank you, Joe. Good morning, and thank you all for joining us today. On our call this morning, I will comment on the financial results for the quarter and a reduction to 2019. I'll also highlight business and operational developments, including progress on our margin improvement initiatives. For the third quarter of 2019, we reported net revenue of $1.8 billion, net income of $21.3 million, and APS of $0.86 per share. Our adjusted net income was $30.2 million, or $1.23 per share, and we achieved a second profit of $72.2 million. Results for the quarter were solid in MCC and pharmacy, but we are lowering our 2019 earnings guidance primarily due to the following two factors. Cost of care pressure in our behavioral and specialty health business, and severance charges related to our operational improvement initiatives. As I'll discuss, these pressures are short-term in nature and should not affect progress towards our margin goal of at least 2% adjusted income by 2021. Later in the call, John will provide additional details on our quarterly financial results, our updated 2019 earnings guidance, and some initial commentary on our outlook for 2020. Now let me highlight some specific developments within our business during the third quarter and the progress we are making towards our margin approval plan. Within our Magellan Complete Care portfolio of managed Medicaid health plans, we continue to execute against our medical plans towards the goal of achieving industry competitive margins. In addition to reducing costs, our team remains focused on improving the quality and associated outcomes from the medical services provided to our members. In Virginia, I am pleased to report that our efforts to improve the cost of care continue to show progress. Our medical loss ratio for the quarter was in the low 90s. The focus of our medical action plans is not changing. We continue to drive value through the appropriate management of inpatient, outpatient, and personal care services, as well as claimed payment integrity reviews. For example, we've been successful in managing outpatient behavioral health services where we approach care coordination on a member-centric basis. The key is understanding what's best for the member and proactively connecting them to the appropriate care while avoiding waste and duplicates. These upfront interventions also prevent increases in inpatient hospitalizations and ER visits. While we still have work to do to reach our target margin in Virginia, we feel good about the continued progress we've made to date in 2019. Regarding our New York plan, we highlighted our second quarter earnings call that we were awaiting updated capitation rate per fiscal year. I'm pleased to report that we've received these new rates and they are largely in line with our expectations, including an update to our risk scores to reflect the increased acuity of our population. Now turning to our behavioral and specialty health business, we have experienced an increase in cost of care. particularly for inpatient admissions within our behavioral health business. We are currently working on action plans to mitigate the impact. I'd also note that our customer contracts allow for annual resetting of capitation rates to reflect emerging experience and anticipate a future trend. So while these cost pressures affect our 2019 earnings outlook, we do not expect a material ongoing impact in 2020. With respect to product development, we have recently deployed an industry-leading automated prior authorization solution called Decision Point. The tool will provide guidelines for determining the medical necessity of certain imaging procedures to inform providers and enable authorization determinations in real time through full integration at the point of care. Because providers are increasingly accountable for the cost of care of their patients, We see this as a new growth channel and are currently piloting the program with a number of provider groups. Now let me provide you with some quarterly operational highlights for Magellan. Throughout 2019, we have been actively working towards our strategic priority of lowering the cost of goods sold through negotiations with our network pharmacies, manufacturers, and wholesalers. I'm pleased to report that to date, We have renegotiated 98% of the supply chain, creating savings for our customers while also improving our gross margin. Our pharmacy team has also been broadening and deepening our Starvout services to retain existing and attract new customers. We continue to evaluate therapeutic classes of drugs where there is an increase in competition which enhances our opportunity to develop management strategies that create savings while maintaining or improving quality of care. The U.S. Food and Drug Administration has recently reported that biologics are the fastest growing class of therapeutics. Earlier this year, in response to the growing biologic spend, we expanded our formulary management program into therapeutic classes such as oncology biosimilars and medical management biologics medical benefit biologics to treat asthma. In preparation for the expanded market entry of oncology biosimilars, we have also expanded our medical pharmacy management program into a comprehensive solution that aims to educate consumers, customers, members, and providers. These expanded products and services are already gaining solid traction with our client base. In our PBM book of business, We continue to see traction with larger employer accounts in our core middle market employer business. We feel good about our prospects for 2020 organic growth and retention rate. We will share more details since our plan is finalized in early December. Any of you are pleased to share that Magellan RX Management was recently accredited by NCQA for Utilization Management. This recognition reflects the high quality of medical management that we provide to our customers and their members. In our Part D business, our bid rates were below the benchmarks in three out of four regions that we bid, and as a result, we estimate to retain 80% to 90% of our current membership in 2020. As we've mentioned in the past, our entry into EP business was primarily designed to gain the necessary experience to serve the managed care PBM market. One of the key elements to our multi-year margin improvement strategy is reducing our administrative costs. We continue to review and execute against opportunities to improve efficiency across all of our businesses through our efforts to consolidate platforms, remove redundancy, and right-size operations. At earlier, we plan to incur severance charges later this year, which reflect the anticipated 2020 implementation of several of these initiatives. Some of these savings will contribute to our future margin expansion target, and others will be used for funding investments for our business. We'll provide more details during our 2020 guidance call in December. Before turning the call over to John, I'd like to emphasize that the headwinds facing the year are short-term in nature and should not affect the pace of our margin improvement plan. We continue to see significant long-term opportunity for both growth and our healthcare and pharmacy businesses. And we remain focused on improving the adjusted mid-income margin for the company to at least 2% by 2021. Now I'll turn this call over to our Chief Financial Officer, John Rubin. John?

Thank you, Barry, and good morning, everyone. On today's call, I'll review the third quarter results, discuss our revised outlook for 2019, and provide some initial commentary on our 2020 business plan. For the quarter, revenue is approximately $1.8 billion, which is relatively consistent with the same period in 2018. Growth in MCC Virginia and new business were essentially offset by MCC Florida and Medicare Part D footprint reduction, as well as the previously discussed PBM health plan contract loss due to an acquisition. Net income was $21.3 million, and EPS was 86 cents. This compares to net income in EPS of $27.1 million and $1.9 million, respectively, for the third quarter of 2018. Adjusted net income was $30.2 million and adjusted EPS $1.23. This compares to adjusted net income of $36.2 million and adjusted EPS of $1.45 for the prior year quarter. Segment profit was $72.2 million for the third quarter compared to $88.3 million in the prior year quarter. Now for our healthcare business, segment profit for the third quarter of 2019 was $44.7 million versus $61.0 million in the third quarter of 2018. Healthcare results for the current quarter include net favorable out-of-period adjustments of approximately $4 million compared to $22 million of net favorable out-of-period adjustments in the prior year quarter. Adjusting for these out-of-period items, segment profit was $1 million higher than in the prior year quarter. This net increase in segment profit is driven by progress on our cost of care niche in Virginia, offset by cost of care pressure in the behavioral and specialty healthcare business, as well as lower discretionary benefit expenses in 2018. As Barry mentioned, we're seeing an increase in demand for behavioral inpatient services this year. We're currently in negotiations with key behavioral customers on our 2020 rate renewals, which will incorporate this recent experience, so we don't expect significant earnings pressure into 2020. In addition, we're continuing to strengthen and execute our care management programs, particularly inpatient concurrent stay reviews and targeted network initiatives. Turning to pharmacy management, We reported segment profit of $35.4 million for the quarter ended September 30, 2019, which was an increase of 5.2% from the third quarter of 2018. This year-over-year increase is primarily driven by growth and improved profitability in our Magellan RX specialty division. Regarding other financial results, corporate costs, inclusive of eliminations but excluding stock compensation expense, totaled $8 million, compared to $7 million in the third quarter of 2018. Total direct service and operating expenses, excluding stock compensation expense and changes in fair value of contingent consideration, were 14% of revenue in the current quarter, compared to 13.8% in the prior year quarter. This increase is primarily due to lower discretionary benefit expenses in the prior year quarter and a change in business mix. Stock compensation expense for the current quarter was $4.8 million, a decrease of $4.5 million from the prior year's quarter. This reduction is primarily due to timing related to vesting of certain equity awards. The effective income tax rate for the nine months ended September 30th, 2019 was 31.2% versus 26.3% in the prior year. The 2019 year-to-date tax rate is higher than the comparable 2018 rate, mainly due to book-to-tax differences related to stock compensation expense, partially offset by the suspension of the health insurer fee in 2019. We anticipate a full-year effective income of approximately 31%. Our cash flow from operations for the nine months ended September 30th, 2019 was $144.4 million. This compares to cash flow from operations of $34 million for the prior year period. This year-over-year improvement is primarily related to favorable working capital changes and lower tax payments. As of September 30, 2019, the company's unrestricted cash investments totaled $220.3 million compared to $130.4 million at December 31, 2018. Approximately $105.4 million of the unrestricted cash and investments of September 30, 2019 is related to excess capital and undistributed earnings held at regulated entities. Restricted cash and investments of September 30, 2019 decreased $500 million from $527.7 million at December 31, 2018. This decrease was primarily due to changes in working capital of our regulated subsidiaries. Now, as Barry mentioned, we're lowering our earnings guidance, and the primary drivers for the reduction are, first, pressure in our behavioral and specialty healthcare business, primarily related to higher than anticipated demand for behavioral inpatient services, and second, an estimate of severance costs that we expect to recognize later in 2019. Specifically, we're revising our 2019 full-year earnings guidance ranges to the following. net income of $47 to $65 million, EPS in the range of $1.92 to $2.65, adjusted net income of $82 to $98 million, adjusted EPS in the range of $3.35 to $4, and segment profit of $245 to $260 million. We're maintaining our current revenue guidance range of $7 to $7.2 billion. As I noted previously, with key rate renewals and progress for our behavioral health customer contracts, we believe we'll mitigate the majority of this earnings pressure in 2020. We're in the process of finalizing our business 2020, and we'll provide detailed guidance in early December. In advance of the 2020 guidance call, I'll now provide some high-level commentary. To start, the midpoint of our revised 2019 guidance range for segment profit needs to be adjusted by two factors to arrive at a run rate. First, approximately $22 million of combined net favorable year-to-date out-of-period adjustments in estimated fourth quarter severance charts. Second, approximately $12 million of additional segment profit in 2020 related to the provision for non-deductibility of the health insurer fee, which we expect to be reinstated. After adjusting for these two items, our 2019 normalized segment profit run rate would be in the range of $235 to $250 million. We expect that 2020 segment profit will be significantly higher than this normal 2019 segment profit range, and key drivers of this segment profit increase in 2020 include our continued execution against cost of care initiatives for MCC Virginia and other health care contracts, rate increases in our health care business in excess of care trend, and net business growth. In closing, our results for the quarter in MCC and pharmacy were solid. Despite the short-term pressure we're seeing in our specialty health care business, we're making good progress on our profitability improvement initiatives and are well positioned to achieve earnings growth in 2020 and beyond. And with that, I'll now turn the call back over to Barry. Barry?

Thanks, John. As we end today's call, I am delighted to introduce Ken Fasola as Magellan's new Chief Executive Officer to Succeed Me, effective November the 14th, 2019. The Board and I are all pleased we're able to attract such a capable individual of Ken's caliber, who has broad healthcare experience and a proven leadership track record. Ken has had a successful leadership career spanning three decades in the healthcare industry. He has held key executive roles at Humana, United Health Group, and the Blues in business operations, marketing, and sales. Most importantly, he has served as President and Chief Executive Officer of Health Markets, one of the largest health insurance agencies in the U.S., which was acquired earlier this year by UnitedHealth Group. I know the Board is looking forward to working closely with Ken and Magellan's executive leadership team to continue the next phase of growth for the company. I've agreed to assist with the transition as needed. On a personal note, I am grateful to the Board and our executive leadership team and Magellan's 10,000 employees for their commitment and dedication to Magellan Health, its members, customers, and investors. Over the past seven years, the company experienced a period of expansion through organic growth and strategic acquisitions. Magellan's portfolio of businesses, Magellan Complete Care, Magellan Behavioral and Specialty Health, and Magellan Rx Management are poised for future success. I'd like to welcome Ken to the call and ask that he share a few comments. Ken?

Thank you, Barry, and good morning. At Barry's and the Board's confidence, and I'm honored to be named Magellan's CEO. I'm looking forward to leading Magellan and would highlight several distinct advantages we'll build from. It's been said that great companies, while defined by their leaders, are in fact built by their people. Magellan has a team of highly skilled, committed, mission-driven employees anchored around a culture that values respect and caring and proven expertise in managing complex population health across our three business lines. These advantages will serve us well in today's rapidly evolving healthcare marketplace. Over the coming months, I plan to dedicate time with key stakeholders, the Board of Directors, and Magellan's executive leadership team to refine our strategy and lead this company into its next phase of growth. I look forward to meeting those of you on the call in the very near future. And with that, Barry, I'll turn it back over to you.

Great. Thank you, Ken. Yes. And with that now, I'll also back over to the operator who will be happy to take your questions. Operator?

Thank you. We will now begin the question and answer session. If you'd like to ask a question or make a comment, press star 1 and record your name. And you may press star 2 to withdraw that request. Our first question or comment comes from Kevin Fishbeck from Bank of America. Your line is open.

Great. Thanks. I just want to go into the behavioral issues in the quarter. Can you talk a little bit about – you said that you don't really expect much of an impact in 2020. How much of that offset is coming in the form of rate increases versus some of the operational costs and network changes that you're making?

Hi, Kevin. It's John. Let me start on that. Really, as we think about the pressures in behavioral, which were driven by, you know, demand for inpatient services and our means of addressing it, there's really two main things that we're doing. One is, as noted on our prepared remarks, working with customers as we're negotiating rates into 2020 and to make sure that those rates reflect both the baseline experience that we've seen as a result of the increased demand and the trends that we're seeing in the business. So that's something, again, that's in progress and we expect to be completed hopefully by the end of the year in first quarter. Second really is the action plans on the care management side, both you know, concurrent review for inpatient stays. You know, contracts are generally per diem, although we have a mix of contracts. You know, we are making progress on that and looking for further improvements, and also targeted network initiatives because we've identified, you know, some facilities that, you know, are outliers, and we've seen, you know, some change in mix of, you of services to some of the higher-cost facilities. So while I say the relative weighting of those things, the rates will likely have a bigger near-term impact, both will be important as we drive progress going forward.

And the only other thing I would add to John's comment is that when we see these underlying shifts in population, we do have agreements with our clients that we can renegotiate our rates based upon that increased demand. because the population is fundamentally different. And in some of our accounts, we've seen it on the MCC side as well as the commercial side as well, when you have unanticipated populations that have different impacts on utilization and demand, you would typically be able to renegotiate in a way that keeps us whole and allows us to have our normalization. So we expect to see that in this case.

And this ability to kind of recontract, is this that – is this in the normal repricing cycle and you caught this in time for that, or are you saying that your contracts kind of allow for even unexpected changes in utilization throughout the year, you have an ability to go back and recontract that?

Yeah, Kevin, right now we are in the normal cycle, so in a way the timing is good for us because we're just heading into those negotiations, and in many cases with some of the – largest, you know, most critical customers, those are already ongoing. So while our contracts do allow, you know, reopeners under certain circumstances, in this case, we're actually in the normal cycle, which actually facilitates this.

Okay. And then the Virginia contract, it sounds like you're doing well there. I think you said low 90. I think the guidance you had said was that You wanted to be at 90% MLR there. Is that still, you know, what you think the ultimate target is, or is there still opportunity to go below that?

Yeah, I'd say there's some opportunity to go below that. I'd say 90% would be, you know, where we think we need to at least get to to get into the normal profit margin range. But our objective would be to do 90% or better. But we think, you know, based on where we are, 90%, you know, over the perceived will be reasonable.

And Kevin, we've had great success this year in managing costs appropriately with both inpatient utilization management, claims integrity, outpatient costs. We've seen the kinds of initiatives have material impact. The other thing is that many of the initiatives that we deployed, even in late 2018, We haven't seen fully yet the positive impact of those. They're still emerging in a positive way. So we expect to see value throughout this year, but also into 2020, which gives us great hope for normalized margins in the near future there.

Great. And then on the Magellan RX side, I guess you said you've gone to 98% of the supply chain. How do we think about this? This is something that you guys do kind of annually, and it felt like maybe you were a little bit later to that process this year than normal. How do we think about the ability to go back next year and get additional savings? Is it going to be kind of the same pace and timing, or should we see it be a little more fun and loaded?

Yeah, I would say, I mean, Kevin, what you said is true. I mean, it is a continuous process and that you're never done. What I would say, though, is that some of the initiatives we undertook this year were beyond just the normal annual recontracting. You know, we actually did a full, you know, RFP for our wholesaler contrample and did change wholesalers to, you know, affect cost improvement and get the, you know, best possible terms So you're right that it is an annual process. And what I'd say is we'll get the full benefit next year of what we implemented this year, much of which wasn't implemented until second quarter this year. So we'll get some annualization of that next year. And then next year, like you said, through the normal process of as we grow the business and as we have opportunities to affect additional savings.

In fact, as kind of building on John's comment there, we've seen greater and greater success with larger and larger clients, both in the MCO world but also on the commercial side as well. And because of that incremental volume, we're able to go back to networks. Particularly, we have density in certain geographic areas and negotiate better pricing with our network. and on the specialty side negotiate better deals for both our clients, which enhance our margins as well. So it works well. We've seen that progress over the last several years, but it really continues. It's kicking into higher gear now than I think I've seen it in the past.

And then maybe the last question on the severance initiatives and operational improvements. So I'm just trying to understand kind of how that impacts this year's numbers versus next year's numbers, because it sounds like you've got extra costs in this year's numbers that you're not really excluding from the core results, which would go away to some degree next year. Plus you'd be generating savings, some of which gets reinvested, but some of which falls through the bottom line. So I'm just trying to understand if there's any way to quantify at the very least kind of the severance costs that you're taking on this year versus kind of the return on those investments as you expect over the next year or two.

Yeah, this is John. So to General Cobb, we'll provide more detail on next year's budget in December. We're still finalizing the plan, so, you know, I don't have precise numbers for you. But in terms of severance, we're currently expecting order of magnitude is about $5 million of severance in fourth quarter. And that number we will refine as we kind of complete our plans and, you know, go through the next month or so. But that's at least ballpark, you know, what we're expecting at this point. In terms of next year and exactly how much of these savings will be reinvested versus, you know, will accrue to our benefit short-term. Those things we're still, you know, working out and we'll, you know, kind of have a, you know, updated view on as we go to guidance call. The only other note I'd make is if you recall, you know, last year when we talked or even earlier this year, we said we'd have about $35 million of incremental expavings opportunities beyond what we – signed up for and achieved in 2019. Now, that won't be necessarily in 2020, but that, you know, if you think about our two- or three-year path to getting to, you know, fully competitive margins, that's, you know, order of magnitude, the amount that we believe, you know, we have left and have the opportunity to achieve, you know, over the next couple years.

Okay. And just to make sure, that 230 for 50 kind of normalized base that you talked about for 2019. Does that exclude the severance cost or does that still include the severance cost?

That excluded it.

So that was one of the things we adjusted out. Okay. So that 235 is a good base. It has the severance out. Okay. Thank you. You bet. Great. Thanks, Kevin.

Thank you. Our next question or comment comes from Dave Stiblo from Jefferies. Your line is open.

Hi there. Good morning. And Ken, welcome on over. Looking forward to working with you. And Barry, I guess maybe this is the last time we'll publicly hear from you on the call. So just want to say thanks for the perspectives and enjoyed working with you over the years. I want to just come back to understand the guidance. So it sounds like, based on the response to Kevin's question, of the $25 to $30 million segment profit, About $5 million of that is related to severance. I know you guys talked about other costs in there. I just want to make sure that I'm thinking about that right, that it's million there and call it $20 million plus related to the healthcare earnings that are dampened. Is that sort of the right split?

Yeah, I'd say ballpark, Dave, that's right. I would say that of the two items I specifically noted, it's around $5 million on severance and around $15 million on the behavioral specialty cost of care side. But you're right. I mean, there's a handful of other things, smaller things that add up. And as well, you know, we did have some pressure in the first half of the year, which while we were still in the guidance range, would have, you know, potentially pulled us a little bit below midpoint. But round numbers, you know, again, I'd use five and 15, and then, you know, the rest, you know, again, either rounding in terms of where we were versus midpoint or, you know, a handful of other smaller things.

Okay. And then on the severance, I guess you guys had announced this, and I'm thinking there's extra savings back in December a year ago at the guidance call. Just curious, what may have changed as you've evaluated the year to include more severance costs? I would have thought that these would have originally been baked into guidance, knowing sort of the plans that you guys have. Is there something that got pulled forward or a change that is now causing the severance costs to land in the fourth quarter of this year?

Yeah, I would say, David, just have specificity now in terms of the plans and timing. And also, you know, as you can imagine, as we go into the planning phase, we're also looking at the volumes that, you know, we have to deal with in the following year. So whether we're able to achieve the expense reductions, you know, with or without, you you know, reductions in, you know, workforce or requiring additional severance would be based on what it looks like in the following year as well. So I wouldn't look at it as materially different. I would just look at it as fine-tuning of kind of our multi-year plan and the timing of it.

Okay, got it. And then on the behavioral specialty issues, can you – John, maybe can you elaborate a little bit more on how widespread the increased utilization is? Is it related to certain pockets of employer groups or into a certain geography or, you know, very broadly spread across the book? And why do you guys think you're all of a sudden seeing this now?

Yeah, I mean, that's a great question, Dave, and one that honestly we're spending a lot of time trying to gain further understanding of. It is relatively widespread, meaning it's not just one account. I mean, obviously there are certain large accounts where it adds up to more, but we are seeing this increased demand for inpatient, and it's really primarily behavioral health. Seeing that across a variety of accounts, So it does seem like it's more of a, you know, sort of broad market phenomenon rather than either anything specific to, you know, things we're doing or in a particular customer. But in terms of really trying to get down and understand, you know, are there any sort of specific causes versus just, you know, general, you know, demand or industry trends, now we're seeing it be more widespread in nature.

Indeed, the only thing I would add to that is that in some accounts, given the fact that you see churn in populations, you're bringing on new populations who may not have been covered in the past, particularly in the Medicaid world, or on the MCC side, again, individuals, new populations that you're bringing on may not have had access. The fact that we're well-known and there's a relationship already in place of Magellan being a provider for behavioral health, We do believe that does have an impact on the populations that we typically attract or receive. And so those are underlying trends that we're trying to understand better, but they do seem to have an impact.

Okay. And I'm sure from a competitive standpoint, negotiation, you probably don't want to say too much, but can you give us a sense of the, I guess, about $15 million cost drag on this? How much revenue is related against that $15 million? and just trying to get a sense of, okay, how much of a rate increase ballpark do you guys need next year as you go through to feel good about getting back to kind of a normalized profit on the business? And is there any sort of restrictions in terms of regulators that may cap you on how much you can increase the rates for next year?

Yeah, I would say, Dave, it's really much more of a negotiation. I mean, these, again, are – primary plan customers, you know, in the behavioral specialty segment and behavioral health we're talking about. And I've looked at it really more sort of the normal course of negotiating. So no regulatory constraints because, again, these are commercial customers and, you know, we're a subcontractor. Really more arm's length negotiations and, you know, from a contract standpoint, you know, we often have – you know, sort of defined rate methodologies which take into account both the underlying, you know, baseline experience over the period and the actual trends. Now, having said that, it is a negotiation. So while there are no hard constraints, you know, it is something that, you know, we're working hard to, you know, educate customers on and, you know, get to the right place on. I'd rather not speak at a customer level about, you know, what rates are required. It does vary by customer level. But we think it is manageable to, you know, make up the majority of the current shortfall. And, again, those discussions are well underway.

All right, good. Last one, I'll let others. For the 2019 guidance now, what does that assume for the Virginia margin? What's embedded in there?

For the full year? Right, yeah. It's still what we talked about earlier in sort of the low 90s. It would be really a continuation of the type of rates we've seen to date. And again, we're feeling pretty good based on where we are right now.

Sorry, to be more specific, pre-tax margin. What is the assumption?

It's pretty close to break even when you're running in the low 90s, if that was a question.

Yep. Okay. Thanks, guys. Great. Thanks, Dave. And it's been wonderful working with you as well. And all I can tell you, you're getting a great big upgrade with Ken coming on board. So, We're all thrilled to have him, and I'm sure you'll enjoy working with him as well. Great. Thank you.

Thank you. And, again, as a reminder, if you have a question or a comment, it is star 1 and record your name. Our next question or comment comes from Scott Fidel from Stevens. Your line is open.

Hi. Thanks. And, first of all, Barry, best wishes on your retirement. Congrats to Ken on coming on board as CEO. Looking forward to catching up with you soon and hearing yours on the future strategy. So first question, just on sort of keeping on the new sort of behavioral cost issues, how would you guys sort of describe the sequencing of how that emerged during the third quarter? Did that start picking up, you know, earlier in the quarter or later? And then just in terms of from the claims experience and reserve development side? You know, what have you seen on sort of a look-back basis in terms of claims coming, you know, in terms of what that's implying for maybe how, when these issues maybe started emerging in the first half of the year or not as well?

Yes, great question. The way I describe it is, you know, we saw some pressure emerging in the first half of the year, but it seemed within the sort of normal range of seasonal volatility. So we had assumed, you know, that this increase in demand we saw in the first half of the year was more, you know, sort of seasonal in nature and we expected, you know, things to return normal in the second half of the year. In third quarter, You know, we saw claims come in high, and we also had about $3 million in this particular segment of unfavorable development, you know, related to the first half of the year. So the first half actually stayed unfavorably, and then, you know, additional pressure in third quarter. And now, you know, we've kind of incorporated the new run rate into the full-year outlook. So in terms of the progression, that's, you know, how I'd best describe it.

Got it. And, John, do you feel at this point just in terms of keeping the reserving, you know, up to date with these emerging trends, you know, maybe talk about on the reserve side, you know, sort of an end set that you are building in, you know, enough conservatism into the reserves if you do see these trends, you know, continue – you know, are you building in that they are essentially leveling out, or are you building in some additional conservatism that some of these trends may potentially continue to accelerate?

Yeah. No, I mean, we have refined our methodology based on what we know and based on the emerging trends. You know, and again, if you look at second quarter restated and you look over there now, you know, they're relatively level. So, yeah. So, in fact, going into fourth quarter, it's not like we're seeing a huge uptick. Now we've got a much better picture of both second quarter and third quarter and feel like we've appropriately reserved and forecast now for the fourth quarter. I mean, I hope it ends up being conservative, but we think we've got a pretty good beat now on the full year.

And then just on the New York side of things, just to level set on that – In terms of the rate increases and the updated risk scores, did that pretty much come in pretty much spot on with what you had built into the guidance for the year, or was there any sort of variance in terms of either a little bit more favorable or negative relative to what you had in the plan?

Actually, it was pretty much what we expected. I mean, we said... We expected the rate changes to be worth sort of 20 to 25 million over the second half of the year. That was what we originally expected. I'd say, you know, ballpark, you know, we came in pretty close to that in terms of New York overall. The base rates were a little bit lower than expected, and the risk adjusters a little bit higher in terms of the components, but overall we came in pretty close. And obviously, you know, some of that was retroactive to second quarter. If you recall, you know, it was a 4-1 situation. So we did have, you know, some out-of-period favorability as well as, you know, obviously the benefit in the third quarter.

Got it. And then just one last one for me, just relative to the updated guide. And so it's still, you know, has a pretty wide implied range in the 4Q. I want to sort of highlight, you know, sort of, key swing factors, you know, in terms of what you're building in at the higher end relative to the lower end. I'd assume that maybe some of that relates to how much rate you start getting, you know, for the behavioral and specialty issues. And then maybe also within that dynamic, sort of what's embedded sequentially around, you know, pharmacy margins. You know, clearly that was a bright spot in the quarter in terms of the pharmacy margins. is continuing to improve and just sort of interested in, you know, sort of what you're thinking in terms of margins for the RX business and 4Q. And that's it for me. Thanks.

Okay. Yeah, in terms of the pharmacy piece of it, you know, we did see good margins in the quarter. What I'd say is, you know, if you look at the If you look at the last couple of quarters in pharmacy, we've run reasonably well and would expect to continue at that general level of margin. So I think that should be pretty stable as we complete this year and as well as we go into next year. I'm sorry, Scott, can you repeat the first part of the question again?

Sure, Don. Just in terms of the wide range still on sort of the implied 4Q guide and sort of the swing factors to the high end and the low end, the assumption was maybe that that sort of reflects how much rate you get on, you know, to reflect some of the cost issues you're seeing in the behavioral specialty, but just interested in sort of what some of those swing factors are that drive a pretty wide range still on the implied 4Q guide.

Okay, got it. Sorry about that. Yeah, so one, no, it's not the behavioral rates. Those are really 2020 negotiations that we're going through now. So really, in fact, I'm 2019. I wouldn't read a whole lot into the range kind of being plus or minus, you know, seven, seven, seven and a half million. I would just look at it as, you know, there are factors that there's always some level of volatility. And obviously, you know, cost of care is one. On the rate side, there's always things we're negotiating. Generally, those are more favorable in nature with states around risk scores and rates for different facets of the population that have some opportunity. We talked about severance charges. Those are things we'll fine-tune as we go through the bounce of the year. I'd say those are really the key items. The further you get in the year, the more confidence we have. We have narrowed the range some, but like I said, I wouldn't attach a whole lot of significance to the width of the range other than we try to make sure we're forecasting that we've got confidence of being within the range.

Yes, got it. Probably, I guess that wide range is more related to EPS actually than the segment profit dynamics. Again, probably just the reality is with smaller share count as well. I appreciate that clarification. Thank you. Got it.

Thank you. And I'm currently showing no further questions or comments at this time. I would now like to turn the call back over to Barry Smith for closing comments.

We thank you all today for attending our third quarter earnings conference call. Take care.

That concludes today's conference call. Thank you for your participation. You may disconnect at this time.