Good morning, ladies and gentlemen, and welcome to the Centene Corporation Third Quarter 2018 Earnings Conference Call. All participants will be in listen-only mode. Should you need assistance, please signal a conference specialist by pressing the star key followed by zero. After today's presentation, there will be an opportunity to ask questions. To ask a question, you may press star then one on your telephone keypad. To withdraw your question, please press star then two. Please note, this event is being recorded. At this time, I would like to turn the conference over to Mr. Edmund Kroll, Senior Vice President of Finance and Investor Relations. Please go ahead, sir.
Thank you, Denise, and good morning, everyone. Thank you for joining us on our 2018 third quarter earnings results conference call. Michael Neidorff, Chairman and Chief Executive Officer of Centene, and Jeffrey Schwaneke, Executive Vice President and Chief Financial Officer of Centene, will host this morning's call, which can also be accessed through our website at centene.com. A replay will be available shortly after the call's completion, also at centene.com, or by dialing 877-344-7529 in the U.S. and Canada, or in other countries by dialing 412-317-0088. The playback code number for both dial-ins is 10123967. Any remarks that Centene may make about future expectations, plans, and prospects constitute forward-looking statements for purposes of the safe harbor provision under the Private Securities Litigation Reform Act of 1995.
Actual results may differ materially from those indicated by these forward-looking statements as a result of various important factors, including those discussed in Centene's most recently filed Form 10-Q, dated today, October 23rd, 2018, and our Form 10-K, dated February 20th, 2018, and other public SEC filings. Centene anticipates that subsequent events and developments will cause its estimates to change. While the company may elect to update these forward-looking statements at some point in the future, we specifically disclaim any obligation to do so. The call will also refer to certain non-GAAP measures. A reconciliation of these measures with the most directly comparable GAAP measures can be found in our third quarter 2018 press release, which is also available on our website at centene.com under the Investors section. Finally, a reminder that our next Investor Day will be held on Friday, December 14th in New York City.
With that, I'd like to turn the call over to our Chairman and CEO, Michael Neidorff. Michael?
Thank you, Ed. Good morning, everyone, and thank you for joining Centene's third quarter 2018 earnings call. During the course of this call, we will discuss third quarter financial results and provide update on Centene's markets and products. We will also bring you up to date on the integration of Fidelis. Let me begin with Fidelis. The third quarter was our first full quarter with Fidelis operating as our New York State health plan. The integration is going very well, progressing as expected. We will further enhance the quality of care and current capabilities of Fidelis as we add case management and clinical programs and incorporate our data analytics tools. We are on track to achieve the synergy and increasing targets. On a run rate basis, we expect Fidelis to add approximately $11.5 billion in revenue and over $500 million in adjusted EBITDA, including net synergies.
Now on to the third quarter financial results. We are pleased to report another solid quarter marked by significant top and adjusted bottom line growth. It is important to clarify that the operating metrics in the quarter were strong, as this may have been obscured by three offsetting adjustments booked in the quarter. Two of the adjustments relate to contracts that have expired. These were $140 million benefit related to California IHSS program reconciliation, and $110 million charge related to the expiration of our Veterans Affairs contract. The third adjustment related to a $30 million contribution to our charitable foundation. Membership at quarter end was 14.4 million recipients. This represents an increase of approximately 2.1 million beneficiaries over the third quarter of 2017. This growth is in part the result of the acquisition of Fidelis, which closed effective July 1.
Third quarter revenues increased 36% year-over-year to $16.2 billion. The HBR decreased 170 basis points year-over-year to 86.3%. This was primarily attributable to the benefit of the IHSS program reconciliation and membership growth in the exchange business. The adjusted SG&A expense ratio increased 110 basis points year-over-year to 10%. This was the result of the growth in the exchange business, which operates at a higher SG&A expense ratio and one-time costs associated with the expiration of our VA contract. We reported adjusted third quarter diluted earnings per share of $1.79 compared to $1.35 in the same period last year. This represents growth of 33%. Consistent with our expectations, adjusted net earnings have developed in a quarterly pattern similar to last year. Please note, we reiterate our comments regarding visibility into $69 billion-plus in total revenue for 2019.
As is our practice, we will provide full details and updates of 2019 guidance at our December 14th Investor Day. We are still finalizing our annual planning process, but based on reviews to date, the current adjusted earnings per share consensus for 2019 would be within our guidance range. Jeff will provide further financial details, including updated 2018 guidance in his prepared remarks. A quick comment on medical cost trends. We continue to see, as well as anticipate, overall stable medical cost trends. This is consistent with our expectation in the low single digits. I would also like to make a comment on pharmaceutical costs and the evolution of the PBM model. There have been some recent media articles regarding this topic and our Ohio Medicaid health plan, Buckeye Community Health Plan. To clarify, Buckeye is not charging the state more than any other MCO per script.
Health plans are paid a flat per member rate and cannot charge the state a penny more, even if that member has more prescriptions. As you know, CVS has rescinded their original comment on this matter, and there are no duplicative services by CVS and Envolve. In fact, Buckeye's per member spend on pharmacy services of $83.79 per month is below the all plan average in Ohio of $87.96, according to the NAIC filings for 2017. We support a shift towards a more transparent PBM model that is sustainable with higher quality and lower costs for consumers. Our recent investment in RxAdvance is the latest evidence of our approach. As a matter of fact, our first state will go live with RxAdvance before year-end, and we have a national rollout for RxAdvance throughout 2017. 2019, excuse me.
We look forward to working with the state of Ohio and others to enhance and evolve the PBM model. Moving on to market and product updates. First, we'll discuss Medicaid activity. Mississippi. In October of 2018, as part of a successful reprocurement, we entered into a new agreement to continue to provide services to Medicaid recipients enrolled in the Mississippi Medicaid program. Note that the state added a third vendor as part of the reprocurement process. Arizona. In October of 2018, our Arizona subsidiary, Health Net Access, began a new contract that integrates physical and behavioral health services through the state's Medicaid program in the central and south regions. We now have over 180,000 integrated lives in this program, representing an increase of 120,000. North Carolina.
In early August of 2018, North Carolina released an RFP for the state's first-time transition of Medicaid members out of fee-for-service in the managed care. We have been planning for this RFP for several years. In January of 2017, we established a joint venture with the North Carolina State Medical Society to collaborate on a statewide member-focused approach to Medicaid managed care. The joint venture, Carolina Complete Health, was established as a physician-led health plan to provide Medicaid managed care services in the state. Carolina Complete Health submitted its RFP response this past Friday. We feel we are well positioned due to our joint venture, which is consistent with our local approach. Furthermore, our participation in North Carolina Marketplace will be recognized in the Medicaid RFP score. The state expects to announce winners in early February of 2019. Next, Centurion.
In August, Centurion announced that the Volusia County, Florida, Council voted to award Centurion a contract. Centurion will provide comprehensive healthcare services to an average of 1,425 detainees of the county's detention facilities located near Daytona, Florida. The contract is expected to commence January 1 of 2019. Additionally, Centurion was awarded a contract to provide comprehensive healthcare services to detainees of the Metropolitan Detention Center in Albuquerque, New Mexico. The average detainee population for this service area is 1,550. This contract is expected to commence in February of 2019. Note, these two recent correctional contract wins offer further evidence that we have gained traction in growing this relatively new product line. Now on to Medicare. We remain focused on building a successful Medicare business. At quarter end, we served over 417,000 Medicare and MMP beneficiaries. This represents a year-over-year increase of more than 86,000 recipients or 26%.
Consistent with our Medicare growth strategy, we have expanded our geographic footprint and expect to be in 21 states in 2019. The annual enrollment for the 2019 plan year began on October 15. We continue to take a targeted approach to growing our Medicare Advantage business. In markets that we are focused on, we are pleased with the competitive position of the Allwell products. Further, we are encouraged by CMS' recently released data suggesting we will return to a four-star MA parent rating for the 2020 plan year. We expect this will have a positive impact on multiple new plans, including the joint venture recently established with Ascension Healthcare. Please note, we expect to have 68% of our MA members, excluding Fidelis, in four-star plans in 2020. With Fidelis, it will be 53%. Next, health insurance marketplaces. At September 30, we served 1,530,000 exchange beneficiaries.
This represents a sequential increase of over 26,000 individuals. The addition of Fidelis offsets the sequential loss of members from normal attrition. On a year-over-year basis, membership grew 49%. Our exchange businesses continue to perform well in the third quarter. We expect 2019 to be another strong year for Ambetter. In addition to expanding our footprint in six existing markets next year, Florida, Georgia, Indiana, Kansas, Missouri, and Texas, we are entering four new states, Pennsylvania, North Carolina, South Carolina, and Tennessee. In 2019, we will be offering exchange products in 20 states. Our strategy remains consistent, focusing on low-income subsidized populations. We do not see a significant change in the competitive dynamics of our markets, and pricing appears to be appropriate. I would like to speak to the elimination of the individual mandate in 2019.
We do not expect this to have a meaningful impact on the overall performance of our marketplace product. Open enrollment starts November 1. Our guidance includes incremental marketing and other outreach efforts to offset the federal government's continued reduced efforts. Shifting gears to our rate outlook. We continue to expect a composite Medicaid adjustment of an increase of approximately 1% for 2018. Excuse me. In conclusion, third quarter results offer further evidence of Centene's financial strength and operating capabilities. Centene's pipeline of further growth opportunities remains robust. We continue to explore new growth and diversification prospects while maintaining our focus on margins. We are optimistic about our future and the leading role Centene will continue to play in the evolving healthcare industry. As a reminder, our next Investor Day is on December 14th in New York City. We look forward to seeing you there.
We thank you for your continued interest in Centene. Jeff will now provide you with further details on our third quarter financial results. Jeff?
Thank you, Michael, and good morning. This morning, we reported strong third quarter results with total revenues of $16.2 billion, an increase of 36% over 2017, and adjusted diluted earnings per share of $1.79, an increase of 33% over last year. Earnings for the quarter were driven by the completion of the Fidelis acquisition and the continued strong performance of the marketplace business. Additionally, the third quarter results include the following items, which in aggregate had no effect on diluted earnings per share. First, during the third quarter, we received cost reconciliation information from the state of California associated with the IHSS program, which ended last year. The information allowed us to estimate the effect of the reconciliation, and we recorded a pre-tax benefit of $140 million during the quarter. Second, the Veterans Affairs contract expired this quarter.
In connection with the conclusion of the contract, we recorded a pre-tax charge of $110 million for negotiated settlements and severance costs. Lastly, as an offset to the first two items, we recorded a pre-tax charge of $30 million associated with the contribution commitment to the company's charitable foundation to continue to support the communities that we serve. Let me provide some more details for the quarter. Total revenues grew by approximately $4.3 billion year-over-year, primarily as a result of the acquisition of Fidelis Care, growth in the health insurance marketplace business, expansion in new programs in many of our states, including the Illinois contract expansion and the Pennsylvania LTSS program. Other acquisitions, including MHN, CMG, and Foundation Care, and the return of the Health Insurer Fee in 2018.
This growth was partially offset by lower revenues in California associated with the removal of the IHSS program from managed care, which took effect January 2018, and lower membership and revenue in the Medicaid business due to eligibility redeterminations in many of our states as a result of the strengthening economy and lower unemployment. Additionally, the IHSS adjustment this quarter lowered premium revenues by a little over $100 million. Moving on to HBR. Our Health Benefits Ratio was 86.3% in the third quarter of this year, compared to 88% in last year's third quarter and 85.7% in the second quarter of 2018. The decrease year-over-year is primarily driven by the benefit of the recognition of the IHSS program reconciliation, which reduced the HBR by approximately 100 basis points.
Additionally, the year-over-year membership growth in the health insurance marketplace business and the reinstatement of the Health Insurer Fee in 2018 also decreased the HBR. These decreases were partially offset by the acquisition of Fidelis, which operates at a higher HBR. Sequentially, the 60 basis point increase in HBR from the second quarter of 2018 is primarily attributable to normal seasonality in the commercial business and the acquisition of Fidelis Care. These increases were partially offset by the IHSS program reconciliation I previously mentioned. Now on to SG&A. Our adjusted selling, general, and administrative expense ratio was 10% in the third quarter of this year, compared to 8.9% last year and 9.6% in the second quarter of 2018. The year-over-year increase was primarily due to growth in the health insurance marketplace business, which operates at a higher SG&A expense ratio.
The SG&A expense ratio was also negatively impacted by approximately 70 basis points related to the costs associated with the conclusion of our contract with the U.S. Department of Veterans Affairs and the contribution commitment to our charitable foundation. These increases were partially offset by the acquisition of Fidelis Care. The sequential increase is primarily due to costs associated with the VA contract expiration and the charitable contribution previously mentioned. These increases were partially offset by the acquisition of Fidelis Care, which operates at a lower SG&A expense ratio. Additionally, we spent $0.06 per diluted share on business expansion costs during the third quarter, compared to $0.12 per diluted share last year. Investment income was $80 million during the third quarter, compared to $51 million last year and $65 million last quarter.
The increase year-over-year is due to higher investment balances, mainly associated with the Fidelis acquisition, as well as higher interest rates on short-term investments. Sequentially, investment income increased due to the acquisition of Fidelis. We expect interest income to be lower in the fourth quarter due to lower investable balances associated with the payment of the Health Insurer Fee, Risk Adjustment, and the California rate overpayments mentioned in the second quarter. Interest expense was $97 million for the third quarter 2018, compared to $65 million last year and $80 million for the second quarter of 2018. The increase year-over-year was driven by the additional debt to fund the Fidelis acquisition and higher interest rates on our debt associated with our interest rate swaps. The increase sequentially is driven by a full quarter of the senior notes issued to fund the Fidelis acquisition.
Our effective tax rate for the third quarter was 33.3%, compared to 38.3% in the third quarter of 2017. The lower tax rate was driven by the effective income tax reform in 2018, partially offset by the return of the Health Insurer Fee. Now on to the balance sheet. Cash investments and restricted deposits totaled $14.3 billion at quarter end, including approximately $500 million held by unregulated subsidiaries. Our risk-based capital percentage for NAIC filers continues to be in excess of 350% of the authorized control levels. Debt at quarter end was $6.4 billion, which includes $100 million of borrowings on a revolving credit facility. Our debt-to-capital ratio was 36.9%, excluding our non-recourse debt, compared to 41.2% at the third quarter last year and 36.7% at the second quarter of 2018. We continue to target a debt-to-capital ratio in the mid to upper 30% range.
Our medical claims liability totaled $7 billion at quarter end and represents 51 days in claims payable, compared to 44 days for the second quarter of 2018. The increase in DCP is a result of the addition of the Fidelis business, which accounts for four days, timing of claims payments and business expansions, which accounts for two days, and the impact of the IHSS program reconciliation for one day. Several of the items influencing the DCP increase this quarter are timing related and are expected to reverse. We expect the DCP to be in the mid-40 range on a run rate basis with the inclusion of Fidelis. Cash flow provided by operations was $548 million in the third quarter.
Cash flow was positively impacted by approximately $350 million due to the timing of Fidelis Care claims payments and $175 million due to increases in experience rebate payables, primarily related to the performance of the Health Insurance Marketplace business and the previously mentioned IHSS program reconciliation. Before we discuss the changes to our 2018 annual guidance, let me spend a few minutes to update you on the Fidelis acquisition and the effect on the third quarter 2018 results. On July 1st, 2018, we acquired substantially all the assets of Fidelis Care for approximately $3.5 billion in cash consideration, net of the preliminary working capital adjustment. The integration is in process, we expect to achieve the previously communicated synergy targets.
In connection with the completion of the acquisition, during the third quarter, we incurred approximately $401 million, or $1.46 per diluted share of transaction cost, including investment banking fees, legal costs, and $324 million representing the present value of the contribution to the state of New York as part of the undertakings associated with regulatory approval. On to our annual guidance. We have increased our 2018 annual adjusted diluted earnings per share guidance by $0.02 at the midpoint to reflect the performance in the third quarter, narrowed the ranges of several other guidance metrics. In summary, our updated full-year 2018 guidance is as follows.
Total revenues of $59.8 billion-$60.3 billion, GAAP diluted earnings per share of $4.34-$4.50, adjusted diluted earnings per share of $6.90-$7.10, an HBR of 85.9%-86.3%, SG&A ratio of 10.5%-10.9%, adjusted SG&A ratio of 9.7%-10.1%, an effective tax rate of 34%-36%, diluted shares outstanding of 198.8 million-199.8 million shares. Additionally, we are increasing our full-year 2018 business expansion costs from $0.28-$0.32 per diluted share to $0.30-$0.34 per diluted share. In summary, we were pleased with the strong performance in the third quarter and the completion of the Fidelis acquisition that we expect to continue to drive long-term growth and margin expansion. That concludes my remarks, operator, you may now open the line for questions.
Thank you, sir. Ladies and gentlemen, we will now begin the question and answer session. To ask a question, you may press star then one on your telephone keypad. If you are using a speakerphone, please pick up your handset before pressing the keys. If your question has been addressed, you may withdraw from the queue by pressing star then two. Your first question will be from Kevin Fischbeck of Bank of America Merrill Lynch. Please go ahead.
Great. Thanks. Wanted to ask about the exchanges and how you thought about 2019. I guess you mentioned that the competitive landscape hasn't really changed that much, but it does seem like that there's a number of counties that last year only had one option and this year at least have two, and you guys often stepped in there to be that one option. I think initially the market was concerned that being the only one there was going to be a bad thing. You guys have really outperformed. Wondering now whether there's potential risk on the other side if a new competitor comes in. Does that potentially change the risk pool for you in that market?
Let me respond to that, Kevin. I don't see a change in the risk pool, but we have had, the last two, three years, 80% re-enrollment of our membership. We expect that to continue. There's a great deal of satisfaction with it. We continue to focus on the subsidized market, and some of the others are coming in at higher levels than that. I don't really see any material changes within the marketplace.
Okay, I guess just a question on the MA side. It looks like you guys expect now to have the parent rating back for 2020. How did you think about the 2019 pricing for stars, particularly on some of the new contracts? You have this issue where you fell off on the star ratings for 2019, but you expected to show improvement going forward. Did you kind of think about it in price to the actual star rating that you had in 2019? Did you kind of take the longer-term view that it's better to grow the business and we may see some margin impact in 2019, but then getting back-
Well, I'm going to ask Kevin to join in, but I, last year, said we are committed to growing the business. I'll let Kevin pick that up.
Yeah. Hi, Kevin. I just would reinstate what Michael had said. Our position has been to take the longer-term view. I think when you look at both our expansion strategies, the states we focused on, the potential Ascension alliance, I think it all reflects that.
Okay, great. Thank you.
The next question will be from Josh Raskin of Nephron Research. Please go ahead.
Hi. Thanks. Good morning, guys.
Morning to you.
Morning, Michael. First question, just on the exchanges and sort of just how you guys think about the bidding process and resetting your plans. We've talked about a margin, I guess, above 5% this year. As you think about 2019, is there a reset to your bid margin, or do you think sort of where you are is sustainable? Again, you've been sort of a sole operator in a lot of counties, so my guess is there's no need to make major revisions there. Just how are you thinking about long-term margins, and is there any reset we should expect for 2019?
Yeah. I'll let Jeff and some others comment, as I said in the previous answer, we see our position in the marketplace not changing. Go up to the-- please, Jeff, something you'd like to-
Yeah. Not to get into too much details about 2019, we are certainly not planning for a margin reset in 2019. That's certainly not our view.
Okay, that's perfect. Just on North Carolina, they released the set of bidders. I was actually a little surprised there were only eight plans that were listed. I don't know how to think about that. Is that, hey, there's a little bit of fear around the ability to earn a reasonable return on that contract, and it's a big contract, so there's risk? Is it, nope, it's just such a large contract that there's only a few plans that can realistically win this? I guess I'm just curious on your perspective from the competitive landscape in North Carolina.
Yeah. Hi, it's Kevin. I think one potential contributing factor to what you've just said is that, as you probably know, it was a complicated bid. When one looks at the requirements on an MCO, the respective care management requirements, network and such, the mix between how provider organizations would be implemented as well as outside MCOs, it is a complicated bid. Again, we're very excited about our bid. We believe we have a strong one. That may be a contributing factor.
Yeah. I'll just add to it. I think when you look at the scale, the size, the expectations, the technology required to do it, a lot of people initially get excited about it, sit back, and say, "I think maybe I may have to sit this one out." We're comfortable with our position, our partnership, and think and expect to do well with it.
Okay. Just to clarify, there was nothing in the bid or the RFP that came out that changed your view on the ability to earn a reasonable return, nothing around rates or continuity of care, anything like that's going to make it onerous in the early periods?
No, I don't think so. I think you always look at how bifurcated it is, how many plans they have in a particular region. I think when you look at it in total, I think it's going to be fine. You always have your first year where you're educating people, and we have planned for that accordingly. We've always said new plans, you want to go through three, four quarters. They're that same matrix applies, and we're planning accordingly.
Perfect. All right. Thanks, guys.
The next question will be from Steven Valiquette of Barclays. Please go ahead.
Thanks. Good morning, everybody.
Good morning.
Just quickly for the California IHSS payment, I think you guys mentioned this at your analyst meeting back in June. It seems like it was included in guidance. Just to clarify, $140 million, is it still subject to any material adjustments depending on minimum MLR calculations in California for those prior periods? Also, are these California risk corridors, are they all finalized now? Just want to get more clarity around all that. Thanks.
Yeah, a couple of things. This was not in guidance. It's never been in guidance. The real issue here is they're reconciling the program from the beginning, its inception, all the way back to 2014. This is really the first quarter that we had costs, and I would say member eligibility information from the state in order to perform the reconciliation. The state has the data, not the MCO. Obviously, this is the first time we had a look at it. It is not done. I think in the press release, you'll find that it says that we expect the 2014 through 2016 information to potentially get reconciled late this year or early next year. Then there's still the 2017 year, which would come later, maybe in 2019.
What I will tell you is that it could get adjusted, and if it does, we would disclose it accordingly.
As far as the breakdown of the $140 million, how much of it relates to 2014 to 2016 versus 2017? Is there any just rough breakdown of it that way, just to help us get a sense of the magnitude for how much it could be adjusted?
I think there were rate changes in the program in the later years. I think a significant piece of that relates to 2014, 2015 time periods, with a little bit less in 2017. I would say it probably starts larger at the beginning and gets smaller as the years go on.
Okay. All right. That's helpful. Thanks.
The next question will be from Ralph Giacobbe of Citi. Please go ahead.
Thanks. Good morning.
Morning.
Obviously, a lot more important in MLR and SG&A. Any reason why you wouldn't exclude some of those sort of one-time items from the adjusted figures?
Well, we've never historically done a, if you will, an adjusted HBR, an adjusted SG&A ratio. I think our preference in general is to disclose, and not have an adjustment section that's very long in the filing. I think that makes it confusing. So I think our view was this was a much more easier way to just disclose the information.
I just want to add to that. I think what's really important as we change lenses to a $60 billion company versus what a lot of people remember us as historically, you're going to have a lot of adjustments that come through in a given quarter. That's just the nature of the business. What we did this time, we wanted to ensure that we had the offsets. To ensure that there was no income taken into it, we took the $30 million and put it in the foundation because we wanted to really even it out. So I agree with Jeff, obviously. We decided to keep the adjustment simple so people understand it. We believe that most people, when we say, "Here's a one-time change, one way or the other," tend to discount it.
I'm used to an environment where they say, "That's to be expected in a business this size." At any given quarter, any given time, there's going to be adjustments that are good and bad, but you have to treat them just as one-time events and not part of the ongoing. What I'm pleased with in this quarter is the ongoing business is performing well and consistent with our expectations.
Okay. All right. Fair enough. Then just to follow up, the administration was out yesterday with sort of more flexibility to states around waivers and the like. Any initial thoughts around that and maybe implications of that, and whether it's even a consideration for 2019 as opposed to maybe 2020? Thanks.
David?
Yeah. It's a good question. I just finished reading the guidance last night. Clearly, I think we support the ability for states to have additional flexibility. I think it plays well into both our business model and also our strategy. With respect to some of the nuances and the guidance, I think we're all still studying that.
Okay. Thank you.
The next question will be from Stephen Tanal of Goldman Sachs. Please go ahead.
Morning, guys. Thanks for the question.
Morning, Steve.
Wanted to just follow up on a couple of the ratios. Specifically, first, the HBR. At 873, just looking at typical, and that's kind of ex the IHSS item. The typical seasonality and thinking through kind of the impact of Fidelis, really trying to understand, I guess the question would be, what was the impact of Fidelis, if you could spike that out? I think this HBR looked pretty decent exit.
I want to comment that as we go forward, we've always had the policy. We look at it on a consolidated basis versus bifurcating it because it gets too confusing. Next quarter, what about this or that? We want to look at it in totality, but you can give him some kind of directional.
I think you're exactly right. Obviously, you have two things. One's been here the whole year, the HIF, right? The Health Insurer Fee, pulls down the HBR. If you're comparing to last year, right? Because last year there was no Health Insurer Fee. Then you have the IHSS adjustment. Those two I would kind of put in a separate category. Then you're correct, you do have an increase for the Fidelis business because it does run a higher HBR, and that was predominantly offset by the marketplace because a lot of the organic growth this year has been in the marketplace business. The increased volume of that business as a percentage of the total company pulls down the HBR.
Not quantifying Fidelis. I guess just on the SG&A side, came in a bit higher than we were thinking, and I guess one thing that I heard on the call so far was just the increased business expansion costs, and that's, I guess, stepped up about $0.02 or so. Was that in the third quarter or is that to come in the fourth quarter? Just a step back on that, should we think about that $0.32 number as kind of a run rate number at this point?
Some of that is in the third quarter, as Michael mentioned in his script, related to the open enrollment period. What you have to remember is, what we do is the business expansion costs are incremental to the prior year when you look at, for example, the marketplace business. I would say it's a pretty good run rate, but it can be lumpy from time to time, depending on Medicaid RFPs, right? Because a lot of times, for example, if we had a 1/1 start date, we would have a lot of startup costs in the fourth quarter for that. I would say it's a pretty good run rate. I think that's where we've been in that range for the last several years, but obviously depending on the timing of awards and how many awards are in a specific year, it could change.
Got it. Okay. Thank you.
Thank you.
The next question will be from Sarah James of Piper Jaffray. Please go ahead.
Thank you. I was hoping that you could walk us through capital deployment priorities. As you think about the business model going forward, are there certain areas that would make sense for Centene to add assets or expand their exposure?
Yeah. I think obviously you've seen a lot of the capital that we continue to deploy and have deployed over a long period of time is really related to growth and adding capabilities, and I think you've seen some of that this year with the addition of Community Medical Group, our investment in RxAdvance, Interpreta. We've continued to add capabilities to the business, as well as grow the business. Every new market requires statutory capital. That's capital deployment, increasing the marketplace growth in that business. I think it's a consistent strategy going forward. We're looking for ways to add capabilities that in the long term will continue to grow the business successfully.
Okay. Can you talk about the rate outlook in a little bit more detail? You mentioned reiterating the 1% for 2018, but we've had a couple of updates recently that were higher than that. I'm just wondering, as you're looking for the rest of 2018, focusing on 4Q or kind of rolling out of the year, are you still thinking that 1% is accurate for 4Q, or could the recent update provide some upside to that?
Yeah. I think we've been, and I may get this a little bit off, but I think we've been close to 1% for the last three years. Just to give you the idea about what we're giving you as far as what the 1% is, it's the annualized effect of rate adjustments in this year. It's not just as they occur. It's the annualized effect of those. The other thing is that it's a net rate adjustment, meaning if the state changes the fee schedule and provides a premium adjustment for that, we've excluded those. We've netted those together because typically those are a one-to-one. We're still comfortable with the 1%. We've been in the 1% range for the last several years, and I think I wouldn't see anything different going forward at this point in time.
I think what is important, Sarah, is to what Jeff said there. It's easy to say we got a 5% increase or something, but if they've raised other fees comparable to that, then that could mislead. I think we want, in the interest of clarity, report the net number.
Great. Thank you.
The next question will be from Matt Borsch of BMO Capital Markets. Please go ahead.
Hi. Good morning. Thank you.
Morning.
Could I just ask about the tax rate? The rate looked quite low in this quarter, and I think you're maintaining your tax rate guidance for the full year. Is that implying something pretty high for the fourth quarter? I'm just wondering if you can talk to what's going on there, and apologies if I missed something you already said.
Yeah. No, Matt, that's a good question. I think what's driving the tax rate, obviously, for the quarter is the significance of the adjustments related to the transaction costs associated with the Fidelis transaction. Those are deductible at a statutory tax rate that's roughly around 24%. We've known about these costs for some time, and our guidance has always included those. Again, that's why you didn't see a revision to the tax rate range. Is for the full year, on a GAAP basis, we're going to get back to in between our guidance ranges that we've provided today.
Okay. Got it.
That's also, Matt, a good example of what I said earlier in terms of, in any given quarter, you can have a particular effect that impacts it.
Yeah. Just to give you a little more detail, Matt, we've always had, I would say, a lower back half tax rate because of the addition of Fidelis, because Fidelis is not subject to the Health Insurer Fee this year.
Right.
Their tax rate's much lower.
Right. Got it.
For the full year, we're comfortable with our guidance range.
Got it. Could I just ask a question on, if you look at the organic growth going into 2019 and above $69 billion, am I correct, that implies a high single-digit range for organic growth if you broad side of the barn adjust out for Fidelis?
No, I think, well, once again, for consistency, when there's a partial year on something, we've always had to adjust for the next year. If you go year-over-year, that's consistent. We look for consistency in how we do this. Any way you look at it's a lot of significant growth for that, and then that reflects what the visibility we had last June. We'll update it in more detail and give you more detail in December.
Okay. Thank you.
The next question will be from Peter Costa of Wells Fargo Securities. Please go ahead. Mr. Costa, your line is open. You may be muted on your side.
Hi. Good morning. Sorry about that.
Morning.
Was any of the guidance change or the metrics changing due to the performance at Fidelis being different than you expected? What things have you seen at Fidelis that's been different from your expectations, either positive or negative?
I think it's been very consistent with our expectations and the reaffirmation of the revenue and the EBITDA. I think it reflects that. It's a well-run company, and we're very pleased with it. You talk about integration. Day one, they were on our general ledger. This is a company that had their act together, and it's everything we could have expected.
Just as a follow-up, why was Fidelis Care's view of the individual mandate going away, which caused them to initially seek much higher rates in the exchange business, so different from your view of the individual mandate going away? Is New York somehow different, and are you seeing what they initially saw now that you're seeing what's going on in New York?
Okay. You're right, New York is different. New York has a basic health plan, which I think you're probably aware of. It's one of two states, that and Minnesota, that have that. Just by definition, they're going to have different underwriting issues and risk management issues and selection issues than states without the BHP.
That's what caused them to seek these much higher rates in New York than you were seeking rate increases for next year?
Yeah. If you're a state with a basic health plan like those two, there are definitely different underwriting issues that one has versus a state without that.
Okay. Thank you.
We, of course, could not get involved in any discussions on their rate adjustments until after closing. That would have been inappropriate.
Understood.
The next question will be from Michael Newshel of Evercore ISI. Please go ahead.
Thanks. Good morning.
Morning.
How are you looking at the RFP pipeline? Is there any update on expected timing of the STAR CHIP and STAR+PLUS contracts in Texas after the cancellation and repost of the RFP a few weeks ago?
I think it's a movable feast. Chris, what's the best?
I'll give you my best shot, Michael. Right now, it looks like the Well, as you know, both of the RFPs have been reissued and are due in mid-November. We expect that the awards are going to come Q2, Q3 of 2019. Right now, the projected start dates for both of these are STAR+PLUS will be 6/1 of 2020, and the CHIP and STAR RFP will be 9/1 of 2020.
Okay, great. Also, what's the latest on Pennsylvania, whether the HealthChoices contract will go through another bidding process after the courts vacated that?
I haven't heard anything. It's been very silent. No, we'll continue to focus on long-term care, doing a great job there, the East, getting ready to bring that up, and that's going well. Some things, I'm just going to wait for them to call and say, "It's time to try a third time." We've done well twice, we'll see what happens this time.
Got it.
I'm looking-
Business will just continue in the meantime?
Oh, yeah. I'm sure. They need the help, they want it, well, there's an election coming up. The new governor will be in place, potentially, we'll see what happens there. I'm not forecasting the election, don't misread it, there's a lot of variables. We have so much going on now that if they want to wait a little bit, that's okay. We have a full plate.
Got it. Thank you.
The next question will be from Lance Wilkes of Sanford Bernstein. Please go ahead.
Yeah, good morning.
Morning.
Just a quick question on the days claims payable and the timing issue, more predominantly on the non-Fidelis. Was that related to any particular products? If you could just give a little more color on that'd be helpful.
Yeah, no, nothing specific. When you look at the days and claims payable, some of this depends on which day of the month the actual quarter ends on, and when our check runs are scheduled. Obviously, we're fairly large, so we're making a lot of payments every single day, so it just depends on that. That's what most of the timing items are related to. I think I was pretty clear in my script that, long term, we think in the mid-forties is a good proxy for where we're going to be with the addition of Fidelis.
Okay. On RxAdvance, you made additional investment in convertible preferred. You talked a little bit about the rollout in 2019. If you could talk a little more about both how you're thinking about rolling out the capability, how it replaces existing capabilities, and what would be the impact to a state's kind of pricing model as a result of this? Do you frequently have separate capitation rates related to pharmacy, and this is going to transfer it to-
Yeah
more transparent pricing, or maybe just some more color around that.
Yeah. What I'm going to do is, Jesse's been leading that. I'm going to ask him to bring us up to speed on it.
Yeah. It's a good combination of questions there related to RxAdvance. I think, as Michael referenced in his comments, I think the important starting point here is that we're really investing in the future, kind of more transparent version of the PBM model. That includes making investments in the technology platform, which is really where RxAdvance is today. We're rolling that out on a market-by-market basis, as we referenced that rollout. Has been in process since the initial investments and will initiate in the end of 2018 and continue to occur market by market through 2019. In conjunction with the new implementation of the platform, we will be moving to a different operating model, which is built around transparency and more focused on cost-sharing for total cost of care. Integration of pharmacy costs with the more comprehensive total medical cost.
We do believe that over time, delivering those services more efficiently will provide both higher quality and lower cost for all of our customers, including states.
Yeah. I think it's going to be a game changer.
Got you. Okay, thanks so much.
The next question will be from Dave Windley of Jefferies. Please go ahead.
Hi. Thanks for taking my question. It looked to us that you added something like 110 counties in Medicare Advantage for 2019. You've got the Ascension JV, the stars that were discussed earlier in the call. Michael, I'm just interested in your kind of longer term view aspiration for Medicare Advantage and the business mix for Centene.
Yeah. I think I've said that, when we talk about our growth, that I view the Medicare Advantage product as continuing to fuel our growth into the next decade. We've been using last year, a little bit of this year as a learning process and gradually expanding. I keep telling people it's not how fast, it's how well. Get the fundamentals right. That's what we're doing, but I see it as a very important part of what we're doing, and you'll continue to see it. We've built systems capability for it, and I think that's also very important, whether it be the RxAdvance, the Interpreta, things that help improve outcomes. We see it as a very important part going forward.
Thank you. At the top of the call, you talked about Fidelis and the adding of case management and clinical programs and things like that I think you've been fairly transparent about targeting their HBR as your synergy targets. How quickly can those things happen? Do you think the benefits of those things are fully captured in the synergy targets that you've laid out, or can those be exceeded over time?
Well, I think, one, we're implementing them as we speak. It's something that we got ready for during the extended period before we could close. Those are the kinds of things we could talk about, and did. I think it will. We're very careful, from the standpoint of GAAP reporting and how we do things that from a conservative standpoint, has to be consistent with appropriate GAAP accounting. I would always hope that we can Under promise and over deliver a little bit. We want to keep the expectations real and the timing real. We're very hopeful on the benefits of all this, as they are. I know they were looking forward to our systems and that capability. There's things we're learning from them. It's really great to put two great companies together like that.
Okay, great. Thank you for that.
The next question will be from Zack Sopcak of Morgan Stanley. Please go ahead.
Hey, good morning.
Morning.
Thanks for the question. I wanted to ask first about just your turnaround in MA STARs. From your perspective, what really drove the improvement, and were there any incremental investments involved to get you up for 2020?
Well, I'll ask Kevin to jump in, but I think that's something that's a priority, and we've been focusing on it, and we're not satisfied with where we are. We're going to keep pushing it to increase it and make it better. That's just what happened when we got involved with it. We made it a priority to make the investments to get there, and then we caught a few breaks along the way as well. Kevin, you want to pick it up?
I think Michael said it. It is clearly a priority. Michael's made it pretty clear to us what his expectations are. We've got a strong team that's focused in on Stars as well as RA and other quality activities. It's about execution.
Great. Thank you. Then just to clarify on your charitable contribution. If I look back at your 2017 and 2016 numbers, you excluded them from adjusted net earnings, but now you are including it in adjusted net earnings. Going forward, should I just consider your charitable contribution to be included into it in adjusted net earnings?
I think this goes back to what Michael had mentioned earlier, was that this is really the offset for the other two items. To the extent that you see one like this, I think it would be disclosed similarly to what we did this quarter.
Okay, great. Thanks, guys.
The next question will be from Justin Lake of Wolfe Research. Please go ahead.
Thanks. Good morning.
Morning.
Just wanted to come back on the tax rate. First of all, you're saying that the one-time cost from Fidelis were deductible in the adjusted number?
Well, no, they're deductible on your tax return. They're deductible on your tax return at effectively their statutory rate, which is around 23 and change, I guess is what I would say. Those are actual costs that we burden that when we file our tax return, we'll take a deduction for them.
Right. I guess what I'm just a little bit confused by, if I'm understanding this correctly, is you one-time the cost of the Fidelis integration, right? Those are not included in the adjusted-
In the adjusted earnings. Right. That's exactly right. We had the costs that were effectively backing those out at the applicable tax rate at which they will be on our federal tax return.
Right. Did you also one-time the tax benefit or the tax shield? Or are you saying you ran that-
Yeah. If you look at the press release, it's actually they're combined. The tax benefit of those deductions is disclosed in the press release, but it's aggregated into one line, right?
Right. That's what I was thought.
Yeah, it's the amortization and the transaction cost. The tax benefit of both of those are aggregated into one line in the press release.
Got it.
I think it was $110 million, I think, for the quarter, right?
Okay, the adjusted tax rate. When we look at adjusted pre-tax income and then adjusted after-tax income and look at the tax rate, that tax rate doesn't see the benefit. It just looked somewhat low. Lower than expected. It kind of implies the fourth quarter's going to be pretty meaningful given you didn't change the guidance.
Well, I think this is.
I'm a little bit confused.
Yeah. It's the magnitude to some extent because GAAP net earnings were so low. We're guiding to a GAAP number. If you look at the GAAP number for the quarter, it's roughly 33%. I know it has a small amount of earnings because of the significance of the adjustment of the transaction costs. We're guiding to a GAAP range, which is why we didn't actually change the range, because we're going to get to that GAAP range. Recalculate your math on the GAAP financial statements, and that'll give you what you're looking for.
Got it. Maybe, if I could just follow up the adjusted tax rate we should be thinking about for the year? Maybe that's another way to think about it.
Well, we don't really give an adjusted tax rate. What I can tell you is those items specifically, on the tax return are deductible at a statutory rate, which by the way, the difference between the statutory rate and the rate that you see on our financials has a large piece of it associated with the Health Insurer Fee, the non-deductibility of the Health Insurer Fee. Yeah. That is playing into the calculation, which is why the math is challenging to understand the way you're trying to do it.
All right. Well, I'll take a harder look. I know there's a lot of moving parts in the quarter. Then just lastly, on the services business.
Yeah.
When I look back at the third quarter last year, obviously it looked like a pretty strong margin in the quarter on the services business in 3Q 2017. Obviously, it looks like it is normalizing more than anything maybe in third quarter 2018. Is there a way to think about this services margin as we go forward? Is this a good kind of run rate, this kind of low 80s cost of services?
I think I'll just give you a couple of pieces here, Justin. I think the services line continues to change, specifically with some of the deals that we've done last year. But the services margin that you see in the financials, it would've been a little bit lower because of the VA adjustments that we took this quarter.
Right.
If you exclude those, it would've been lower and more consistent with last year, and that's because the third quarter has a lower cost of services ratio because that's typically when we get the information on the USMM ACO programs, and we have the reconciliation, and that reconciliation is favorable to us, and it was favorable to us by a similar amount last year, third quarter. It's kind of being masked by a couple things. The wind down of the VA program that was at full speed until September 30th. It wound down throughout the quarter. These VA adjustments that we've mentioned also inflated the cost of service ratio a little bit.
I would say the mix in that line continues to change, but I would say mid to low 80s is probably a good estimate, and that could fluctuate by quarter depending on when we have reconciliations in a lot of these programs.
Thanks. Appreciate it.
The next question will be from Ana Gupte of Leerink Partners. Please go ahead.
Hey, thanks for taking the question. Couple of questions. The first one was, as you think about your margins going forward, do you see any reason you couldn't expand margins? Your mix shifting to exchanges and MA looks like trend is weak. You have a better star rating starting 2020. Investment income could go up with interest rates. What would your normalized margin expectations be?
I think we'll talk more about margins in 2019 in December, but we have clearly stated we're demonstrating our interest in expanding margins. I think that's appropriate, and the scale, the size, the activities we have going, the technology we're applying to improve medical costs over time, all will tend, Ana, to give us the ability to expand margins, and we can get more specific on our December call.
Okay. Great. Thanks. That's what I would've thought. The second was on exchanges for 2019. What are you expecting given the decisions are you all making, and is your growth likely to come from secular growth, or are you thinking of it more from just your geographic expansions, and share shifting within your existing markets, or a bit of both?
Well, I'm going to ask you to kind of stick with us in terms of not getting too granular on 2019 until December. That's a pattern that's well established over a lot of years. I will say that from the standpoint, our focus continues to be on the supplements and that portion that has the premium supplement. We see that continuing going into 2019. It's going to be business as usual for us, and we're comfortable with the attrition we had this year relative to previous years. The re-enrollment we had. Everything says it's very much business as usual, and I think you heard Jeff comment earlier that from a margin standpoint of the business, we see maintaining that. It's a business we understand, and we've developed systems to continue to build it and maintain it.
Okay. Great. Thanks. One final one. Any update at all on the Texas RFP?
Well, I think Chris, you just gave a little detail. You want to repeat that?
Sure. I'd be happy to, Michael. Both of the RFPs that were canceled have been reissued and are due in mid-November. The awards will be announced, we believe, in Q2 and Q3 of 2019. Projected start dates for STAR+PLUS will be 6/1 of 2020. CHIP and STAR RFP, our start date will be 9/1 of 2020.
Very helpful. Thanks for the questions.
Thank you.
The next question will be from Gary Taylor of J.P. Morgan. Please go ahead.
Hi. Good morning. Just a couple questions. Sorry to go back to the tax rate again. I think there's a perception that the quarter did benefit materially from a lower tax rate. I followed your discussion, but the nondeductibility of the HIF actually serves to increase the effective tax rate, right? 8 over 24 on a GAAP basis is 33%, but including nondeductibility of the HIF, 8 over a 202 number is like a 4%. It does look like there was a tax benefit in the quarter different from what you've seen in the first half. Fidelis would just be a few hundred basis points, I think. Do you follow where I'm going, and where am I wrong on looking at that?
Yeah. I can understand where you're coming from. I guess what I would say is this is nothing different than what we've already had in our guidance from when we had these costs associated with the Fidelis transaction. Fidelis lower tax rate, not subject to the Health Insurer Fee. You're pulling one item or two items, putting them down below the line, and you're pulling them out at a statutory rate versus your annual effective rate, which includes the nondeductibility of the Health Insurer Fee. I think it's more complicated than that, but we certainly don't view that there was any tax benefit in the quarter. This has been our guidance for, we're guiding to an adjusted number on a full year basis, and we don't see any tax benefit to the quarter the way we've seen it since these costs associated with the regulatory undertakings were known.
Sure. Maybe another way, just to sort of look at the quarter. If we look at pre-tax earnings, we're up $262 million in the first quarter, $89 million in the second quarter. Adjusted pre-tax earnings up about $110 million this quarter. Fidelis, if it ran a 4% margin, would have been over $100 million of that. It does look like the pre-tax earnings growth from the rest of Centene slowed this quarter. Is that something that you'd acknowledge? Does that make sense?
You're adding back the, which pieces are you adding back? The merger costs and the amortization or just the merger costs or?
Yeah, both. It looks like the adjusted pre-tax would be.
Yeah, I think.
$490, which is up like $110 million versus the prior year, which I think was $380.
Yeah, I think the piece you may be missing is the exchange business and how the profitability of the exchange business works, right? Remember it makes.
Yeah.
Yeah. It makes a lot. The other thing is that, remember, the enrollment dates were accelerated this year, the exchange business profile is actually a lot different, and it's a more meaningful piece of the business.
It is bigger. That makes some sense. Last question. The specialty operating income was a $51 million loss. It was $102 million year-over-year. You called out the VA termination cost as the major factor there, but it still would have been about $40 million of OI versus $102 million, you said other federal contracts and then some carve-in of behavioral. Is there any more color you could tell us on just the specialty operating income and where there might be some margin pressure?
Yeah, actually, I think some of this is related to the integration of the physical and behavioral health. Some of those behavioral health revenues and margin is now embedded with on our health plans because we've moved to an integrated approach.
Okay. Thank you.
The next question will be from A.J. Rice of Credit Suisse. Please go ahead.
Hi, everybody. First of all, maybe a numbers question, then one other broader question. In the MLR, when you X out for the unusual items, you've improved 70 basis points year-to-year. I think in the prepared remarks, you said a lot of that was due to the HIF and the health insurance exchanges. I just wondered, it seems like you have, and maybe I'm wrong, but four major things, your core Medicaid, your Fidelis, your HIX, and then the health impact. Any way to sort of parse out where you're seeing improvement year-to-year in HBR and if there is any place where there's pressure?
I think those were the items that we mentioned. We look at the business, I think the Medicaid business was pretty consistent. We didn't highlight it as a driver of the HBR metrics. We highlighted, obviously, Fidelis coming in would be an increase to the HBR, and the marketplace, the size of the business, is a decrease on a year-over-year basis. We highlighted kind of what I would call the drivers for the quarter.
And your-
Year-over-year, by the way, just making sure.
Right. Yes. Your HIX HBR, was it significantly better this year than last year?
No, I think it was in line with our expectations. I think it's volume, the magnitude of the business, obviously, it's a lot larger.
Right. Okay. It's mainly just the growth as opposed to the actual absolute ratio.
Yeah. It's the growth on the business.
Okay. My bigger picture question is obviously with Fidelis now done, your balance sheet still sort of within the range that you guys historically have targeted, I would say. Acquisitions have been a big part of the growth story for the last couple of years, even bigger acquisitions. What's the appetite of the company to look at additional deals? Do you need some time where you're settling in with Fidelis? Or you've done a couple of big ones in pretty rapid succession. Are you open to other things?
Well, I think for Fidelis, the integration, it's well there. I'll put it in this context. We know that the closing got delayed, which gave us a lot of time to prepare for a very effective integration. It's where it needs to be, and it's appropriate. If an opportunity came along, there is no reason for us not to do it. We have a strong balance sheet. We have a lot of capability, and we're in a position to do it. It has to be the right time, the right place, and be first financially effective and then strategically. I'm not saying we're not.
Would it be reasonable to think that Medicare, given your focus on growing that, is a primary place to look, or are there other areas you'd highlight?
Well, we're looking very broadly. You've seen us with the focus on technology, there's some really effective technology that's going to be providing a lot of significant dividends and already are. Our technology committee meeting yesterday demonstrated that we're moving more and more to a leadership position there. There's a lot of very good opportunities there that Stay tuned.
Okay. Thanks a lot.
Ladies and gentlemen, that will conclude our question and answer session. I would like to hand the conference back over to Mr. Neidorff for his closing remarks.
Well, I want to thank you for all your questions. I hope it clarified some of the outstanding issues because I believe we had a strong quarter, and the metrics were right. What people refer to as noise and puts and takes, that's normal cost of business in a company our size. What's important to us is that the fundamentals are strong, it's headed the right way, and we're looking forward to the fourth quarter, and we're looking forward to the December. We can tell you how strong 2019 is going to be. We thank you very much for your time, attention, and great questions. Have a good day.
Thank you, sir. Ladies and gentlemen, the conference has concluded. Thank you for attending today's presentation. At this time, you may disconnect.