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Edited Transcript of MGLN earnings conference call or presentation 28-Feb-20 1:30pm GMT

Q4 2019 Magellan Health Inc Earnings Call

AVON Mar 25, 2020 (Thomson StreetEvents) -- Edited Transcript of Magellan Health Inc earnings conference call or presentation Friday, February 28, 2020 at 1:30:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Joe Bogdan

Magellan Health, Inc. - SVP of Corporate Finance

* Jonathan Neal Rubin

Magellan Health, Inc. - CFO

* Ken Fasola

Magellan Health, Inc. - CEO

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Conference Call Participants

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* David Anthony Styblo

Jefferies LLC, Research Division - Equity Analyst

* Kevin Mark Fischbeck

BofA Merrill Lynch, Research Division - MD in Equity Research

* Scott J. Fidel

Stephens Inc., Research Division - MD & Analyst

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Presentation

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Operator [1]

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Welcome, and thank you for standing by for the Fourth Quarter 2019 Earnings and the 2020 Guidance Call. (Operator Instructions) Todays' conference is being recorded. If you have any objections, you may disconnect at this time.

I would now like to turn today's meeting to Joe Bogdan. Sir, you may begin.

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Joe Bogdan, Magellan Health, Inc. - SVP of Corporate Finance [2]

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Good morning. Thank you for joining Magellan Health's Full Year 2019 Earnings and 2020 Guidance Call. With me today are Magellan's CEO, Ken Fasola; and our CFO, Jon Rubin.

The press release announcing our fourth quarter earnings and 2020 guidance was distributed this morning. A replay of this call will be available shortly after the conclusion of the call through March 31, 2020. The numbers to access the replay can be found in the earnings release. For those who listen to the rebroadcast of this presentation, we remind you that the remarks made herein are as of Friday, February 28, 2020, and have not been updated subsequent to the initial earnings call on that date.

During our call, we will make forward-looking statements, including statements related to our 2020 guidance. Listeners are cautioned that these statements are subject to certain risks and uncertainties, many of which are difficult to predict and generally beyond our control. These risks and uncertainties can cause actual results to differ materially from our current expectations, and we advise listeners to review the risk factors discussed in our press release this morning and documents we filed with or furnished to the SEC.

In addition, please note that Magellan uses certain non-GAAP financial measures when describing our financial results. Specifically, we refer to segment profit, adjusted net income, and adjusted EPS, which are defined in our SEC filings and in today's press release. Segment profit is equal to net revenues less the sum of cost of care, cost of goods sold, direct service costs, and other operating expenses, and includes income from unconsolidated subsidiaries but excludes segment profit from noncontrolling interests held by other parties, stock compensation expense, 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 the certain adjustments made for acquisitions completed after January 1, 2013, to exclude noncash stock compensation expense resulting from restricted stock purchases by sellers, changes in the fair value of contingent consideration, amortization of identified acquisition intangibles, as well as impairment of identified acquisition intangibles. Please refer to the tables included in this morning's press release, which is available on our website, for a reconciliation of GAAP financial measures to the corresponding non-GAAP measures.

I will now turn the call over to our CEO, Ken Fasola. Ken?

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Ken Fasola, Magellan Health, Inc. - CEO [3]

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Thank you, Joe. Good morning, and thank you all for joining us. I'd like to start by saying how truly excited I am to be here. When I first looked at Magellan, its rich history and noble mission, I knew the company had something very special to offer to our customers and members alike. I've not been disappointed. In fact, I'm more optimistic today than I was the day I started, and I'm energized about the opportunities that lie ahead of us.

Before I share financial and operating updates and near-term priorities, I wanted to provide our investors with my high-level assessment of my first 100 days as CEO. First, Magellan, in a word, is complicated. After talking to customers, investors, and Magellan employees, it's clear we have an opportunity to bring improved clarity to our operating model and accelerate the pace of investment in digital capabilities and process improvement. We've demonstrated an ability to drive distinction and differentiation, managing complex conditions, and we've seen the value that can be created as a byproduct.

Specifically, I believe there is real opportunity to revitalize our behavioral and specialty businesses. This is in our DNA. We cannot, however, scale effectively trying to be all things to all people, and thus need to create unique, differentiated offerings and defensible market positions.

To that end, I've initiated a comprehensive portfolio analysis of all of our lines of business designed to enhance our value proposition and Magellan's brand in the marketplace. Magellan was built on a platform of cutting-edge, market-leading products and services. This increased focus on execution will help us maintain, and in some areas regain, the high ground, and lead the market through product ideation, both clinically and economically.

Vibrant cultures attract and retain talent. We have great people at Magellan. I've been in front of nearly 4,000 employees in face-to-face town hall meetings since my appointment on November 8th, and I have been truly impressed. I am committed to investing in leadership development broadly across all disciplines. I'm also committed to strengthening senior leadership, as evidenced by my hiring of Jim Murray, who many of you know from his time at Humana. Jim is an incredible executive, one I've worked closely beside in the past and have the utmost confidence in. Jim and I share a strong belief that actions speak louder than words. The moves we are making will reinforce our commitment to excellence, anchored by an investment in the culture and leadership necessary to execute and honor our commitments.

Before I talk about Magellan's future and my focus, let me take time to acknowledge our accomplishments in 2019. For the full year 2019, we reported net revenue of $7.2 billion, net income of $55.9 million, and earnings per share of $2.28. Our adjusted net income was $91.7 million, or $3.73 per share, and we achieved segment profit of $252.7 million. Jon will provide additional details on 2019 results later in the call.

Within the Healthcare segment, we successfully executed against our Magellan Complete Care cost-of-care initiatives. In Virginia, our medical loss ratio improved to approximately 90%. The result was a modest segment profit contribution in 2019, compared to a $45 million loss the prior year. I'm proud of the team for delivering on their commitment and look forward to continued progress in 2020.

In the third quarter call, our behavioral and specialty health unit reported an unexpected increase in utilization that was largely concentrated in behavioral health inpatient services. While this variance created some pressure on 2019 earnings, we successfully negotiated rate increases for 2020, which we expect to cover the increase in cost of care. I'd also note that we did not experience any additional behavioral cost-of-care pressure during the fourth quarter.

Turning to Magellan Rx, we re-contracted our retail network, as well as our wholesale -- wholesaler and manufacturer agreements to lower our cost of goods, creating savings for our customers while improving our gross margins. I'm also pleased that we were awarded the Medi-Cal pharmacy benefit administration contract with the state of California at the end of 2019. When we began servicing this -- I'm sorry. When we begin servicing this contract in 2021, we'll be managing the pharmacy benefits for more than 13 million Medicaid members in the state of California.

With more than half of the states in the country as pharmacy benefit administration customers, we continue to strengthen our already dominant position in this important and growing market. Finally, we started investing in future operational improvements across the organization. I'll elaborate on the nature of these activities in a moment, but I'd note that we expect savings to begin to materialize in late 2020 and early 2021.

Let me now turn to the focus of our important work for 2020. In my experience, a strong alignment between a company's culture, execution, and strategy leads to a productive work environment with engaged employees, increased business opportunities, and enhanced value for members, customers, and shareholders. The culture at Magellan is as strong as any I've -- as I've witnessed. Since my first day as Magellan's CEO in mid-November, I've been learning about our unique capabilities and distinctive competencies. I've been traveling the country and meeting with our customers and employees. This firsthand feedback about our challenges and opportunities is helping me shape a strategy that focuses on meeting market demands for our customers, improving health outcomes for our members, and creating value for our shareholders.

As we work to finalize our long-term strategy, we're focusing on 4 immediate priorities for Magellan. First and foremost, we will deliver on our existing commitments. The promises we make must be promises that we keep to our customers, members, and shareholders. Over the last few years, we've not consistently performed to our own, or others', expectations. That's already begun to change, and the remaining near-term priorities will accelerate the pace at which we move forward.

Second, in order to be competitive, we must lower our operating costs and reinvest in our business by improving and automating processes, leveraging technology, consolidating platforms, and reducing any friction that our customers, providers, and members experience when doing business with us. To help drive these efforts, we've established a transformation office, solely focused on executing against these important initiatives. The range of workstreams is broad, targeting process improvement in over a dozen different disciplines.

Third, as we transform how we do business, we are launching an innovation lab to strengthen our capabilities in technology solutions, product innovation, and service delivery. Magellan has deep experience in managing some of the most complex, high-cost areas of health care spend. We know that our payer partners are realizing limited success in managing high-cost populations, notably in fully integrating behavioral and physical health. We'll create new capabilities and programs to bring meaningful value to our clients and members.

I'll talk in a moment about how we've begun to revitalize and enhance our behavioral and specialty health portfolio to address the clinic -- I'm sorry, critical needs in this market. But I do think it's worth mentioning that these challenges are negatively affecting our nation. According to the Centers for Disease Control, U.S. life expectancy either fell or stayed flat between 2014 and 2017. This is largely attributed to fatal drug overdoses and suicide deaths, despite advances in care for other conditions. Magellan has the clinical capabilities, best practices, and expertise to help our customers address these issues.

Finally, as I traveled around the country and met with state Medicaid directors and governors, CEOs and clinical leaders and health plans, and providers, I've heard many similar points being made by this diverse group. The impact of behavioral health, the lack of integration in care delivery, and the high cost of drugs are among the most prevalent challenges they're confronting on a daily basis, and these challenges are growing at a rate that is greater than many of the risk bearers can handle. In the past, we've made significant investments in Magellan Complete Care and Magellan Rx, and as a result, we've experienced recent growth within these businesses, including the pharmacy PBA win in California. I believe we have further growth potential across all our businesses, and we'll sharpen our business acumen to fully capitalize on these opportunities.

In particular, I see a large market for a revitalized and expanded suite of payer solutions within our behavioral and specialty health business. Previously, many viewed this business as somewhat of a binary choice. Customers either carved in or carved out these services. In my conversations with current and former customers, it's obvious that there are many ways in which we can provide significant value to our customers. Whether these services are in-sourced or outsourced, we believe a more integrated behavioral health model is possible, and one with a more pronounced positive outcome for members.

Leveraging our deep clinical experience and locally-based employees, combined with predictive analytics and new care management platforms, consumer engagement and proactive segmentation of specific populations, we can be positioned to provide services that are unequaled in the marketplace. To achieve that, we are prepared to make the necessary investments in people, processes, and technologies to capture the current and emerging market opportunities in behavioral and specialty, and continue our progress in MCC and MRx. I look forward to sharing more about this progress in future calls.

So looking ahead to 2020, we announced in our press release today that net income is expected to be in the range of $42 million to $62 million, which translates to earnings per share of $1.69 to $2.49. We expect adjusted net income of $83 million to $103 million and adjusted earnings per share of $3.34 to $4.14. We anticipate 2020 segment profit in the range of $250 million to $280 million and revenue for the year in the range of $7 billion to $7.4 billion. I'm optimistic about the long-term opportunities ahead and confident in our ability to achieve these 2020 guidance.

Now let me turn the call over to Jon to review the 2019 results and our 2020 guidance in more detail.

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Jonathan Neal Rubin, Magellan Health, Inc. - CFO [4]

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Thanks, Ken, and good morning, everyone. I'm pleased with our results for the fourth quarter, which were solid and in line with our most recent full year 2019 guidance. For the year ended December 31, 2019, revenue was $7.2 billion, largely consistent with 2018. Net revenue growth in MCC was largely offset by the loss of a health plan PBM customer due to an acquisition, and the planned reduction in the geographic scope of our Part D pharmacy plan.

Net income for the year ended December 31, 2019, was $55.9 million, and EPS was $2.28. The increase in net income was primarily due to higher segment profit. Adjusted net income for the year ended December 31, 2019, was $91.7 million, and adjusted EPS was $3.73, compared to $61.7 million and $2.46 per share for the year ended December 31, 2018.

Segment profit increased from $228 million to $252.7 million year over year. 2019 segment profit included approximately $23 million of favorable out-of-period items, versus $10 million in 2018. The majority of these out-of-period adjustments related to our Healthcare segment.

For the full year, we reported 2019 Healthcare segment profit of $177.4 million, compared to $149.1 million in 2018. The 2019 increase was primarily driven by MCC cost-of-care improvements in Virginia, partially offset by the contraction in the MCC Florida footprint and the behavioral and specialty utilization pressure that we discussed previously.

We reported pharmacy management segment profit of $110.4 million for the year ended December 31, 2019, which was an increase from the $104.4 million in 2018. This year-over-year increase was primarily due to strong results in our specialty division and improved margins in our PBM business, partially offset by lower discretionary benefits in 2018.

Regarding other financial results, corporate costs, inclusive of eliminations but excluding stock compensation expense, totaled $35.2 million for the year, compared to $25.6 million in 2018. The increase was mainly due to lower discretionary benefits in 2018.

Excluding stock compensation expense and changes in fair value of contingent consideration, total direct service and operating expenses as a percentage of revenue were 14.9% in the current year, as compared to 14.2% for the prior year. This increase is primarily due to business mix changes and lower discretionary benefits in 2018.

Stock compensation expense for the year ended December 31, 2019, was $25.5 million, a decrease of $4 million from the prior year. This change is primarily the result of accelerated vesting of certain equity awards in 2018.

The effective income tax rate for the year ended December 31, 2019, was 30.8%, compared to 44% for the prior year. The decrease was largely driven by suspension of the nondeductible health insurer fee in 2019, partially offset by book-to-tax differences related to stock compensation expense.

Our cash flow from operations for the year ended December 31, 2019, was $115.8 million, compared to $164.8 million for the prior year. The decline was largely due to the timing of receipt of MCC capitation payments.

As of December 31, 2019, the company's unrestricted cash and investments totaled $195.4 million, which represents an increase of $65 million from the balance at December 31, 2018. Approximately $134.8 million of the unrestricted cash and investments at December 31, 2019, is related to excess capital and undistributed earnings held at regulated entities.

Restricted cash and investments at December 31, 2019, of $475 million reflected a decrease of $52.6 million from the balance at December 31, 2018. This decrease was primarily attributable to a delay in health plan capitation payments from the state of New York, partially offset by growth in MCC Virginia.

Now let me walk you through a summary of our 2020 guidance. We're projecting net revenue of between $7 billion and $7.4 billion. Net income for 2020 is expected to be in the range of $42 million to $62 million, which equates to a diluted EPS range of $1.69 to $2.49. We expect adjusted net income in the range of $83 million to $103 million, and an adjusted EPS range of between $3.34 and $4.14. Our 2020 guidance for segment profit is a range of $250 million to $280 million.

Our 2020 guidance range is largely maintain our current level of margins, while simultaneously funding necessary investments to position us to meaningfully accelerate our prospects for future growth and margin expansion in 2021 and beyond. I'll now highlight the key investments included in our 2020 guidance

For pharmacy, we'll invest approximately $10 million to $15 million in operating costs and up to $30 million in capital costs to prepare for implementation of the Medi-Cal PBA contract, starting in January of 2021, at which point the contract will produce approximately $75 million to $80 million of annual revenue at typical fee-for-service pharmacy benefit administration margins.

From an enterprise standpoint, we're investing $15 million for the transformation and innovation initiatives that Ken discussed. These investments will focus on growth, new products, and operating process improvements. We expect the earnings benefit from these investments to begin in the back half of this year and essentially offset the full year 2020 investments. Going forward, we expect the net benefit to increase to $30 million in 2021 and over $75 million in 2022. Now to put this in perspective, were we to have already achieved the projected return on these investments in 2020, our segment profit would be in the range of $350 million to $400 million.

Now I'll discuss the key year-over-year drivers of our 2020 guidance. To begin, our full year 2019 segment profit of approximately $253 million needs to be adjusted by 3 items to normalize the run rate for 2020 comparisons. First, $23 million of favorable out-of-period adjustments; second, $7 million of severance; and third, $12 million of additional segment profit in 2020 related to the provision for nondeductibility of the health insurer fee. After adjusting for these three items, our 2019 normalized segment profit run rate would be approximately $249 million. The 2020 segment profit guidance midpoint of $265 million is $16 million higher than the normalized 2019 actual results, and includes the aforementioned $10 million to $15 million of startup costs for the California Medicaid pharmacy contract.

Now I'll provide commentary on specific drivers of our 2020 guidance for each of the individual segments, beginning with pharmacy. For our pharmacy management segment, we're expecting 2020 revenue to be up slightly from 2019. Solid PBM net business growth is expected to be mainly offset by determination of a Medicaid fee-for-service contract and a reduction in our Part D membership. We expect the 2020 segment profit margin in pharmacy as a percentage of revenue to be modestly lower than in 2019, largely due to the startup expenses related to the new California pharmacy benefit administration contract.

For our Healthcare segment, we're projecting revenue to be up slightly year over year in 2020, as net growth within the existing Magellan Complete Care states is expected to be mostly offset by net behavioral and specialty health contract lawsuits, particularly in the business where we provide staffing solutions to the federal government. Segment profit margins within Healthcare as a percentage of revenue are expected to be modestly higher than for 2019. This year-over-year expected increase in margin is driven by continued execution against our cost-of-care initiatives within Magellan Complete Care, rate increases in excess of cost-of-care trends, as well as segment profit impact of reinstatement of the health insurer fee. 2020 corporate expenses, excluding stock compensation expense, are expected to be approximately $3 million lower than for 2019.

Now turning to other items in our forecasted earnings, 2020's stock compensation expense is expected to be approximately $29 million. We project depreciation and amortization expense to be about $122 million in 2020, and we expect to incur interest expense of approximately $34 million, and to generate interest income of about $14 million in 2020. The effective income tax rate for 2020 is projected to be approximately 44%. The effective rate is higher than the federal statutory rate primarily due to the inclusion of state taxes and the non-deductibility of both the health insurer fee and a portion of executive compensation under the 2017 Tax Act.

Capital investments for 2020 are expected to be approximately $100 million, which is higher than our historical investment levels primarily due to the investment supporting implementation of the Medi-Cal contract for pharmacy. The 2020 EPS and adjusted EPS calculations are based on our estimate of 24.9 million fully diluted shares for the year. This estimate contemplates the impact of share repurchases and option exercises through February 21, 2020, but does not reflect any potential future activity. In 2019, we repurchased approximately 61,000 shares for $3.7 million. We have $186.3 million remaining in the current share repurchase authorization that expires on October 22, 2020. The pace of any future repurchases will vary, based on a variety of market and company considerations.

In closing, we ended 2019 with solid fourth quarter results, and I believe that our 2020 guidance strikes a good balance between current earnings and the necessary investments to establish a strong foundation for growth and margin expansion in 2021 and beyond. I look forward to discussing our progress on these initiatives on our first quarter call.

And with that, I'll now turn the call back over to Ken. Ken?

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Ken Fasola, Magellan Health, Inc. - CEO [5]

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Thanks, Jon. Before we move to questions, I want to take the opportunity to share a few closing comments. I'm excited and honored to have the opportunity to guide Magellan in our mission of leading humanity to healthy and vibrant lives. I see tremendous opportunity for our businesses to grow and thrive well into the future. And, as I said the first time I had the opportunity to address you, I believe great companies, while defined by their leaders, are in fact built by their people. We have a strong leadership team in place that's been bolstered with the recent additions of Jim Murray, Magellan's new President and Chief Operating Officer, and David Haddock, Magellan's new General Counsel.

The 2020 outlook shared today strikes a balance between current margins and the necessary investments for transformation that will build the foundation for future margin expansion, earnings growth, and value to all our stakeholders. Delivering sustainable, industry-competitive margins across our businesses remains a clear strategic priority for Magellan.

With that, we'll now open up the phone lines for questions.

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Questions and Answers

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Operator [1]

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(Operator Instructions) Our first question comes from Dave Styblo with Jefferies.

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David Anthony Styblo, Jefferies LLC, Research Division - Equity Analyst [2]

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Ken, great to hear your thoughts on the near-term priorities, and maybe I'd start with that, if I could. I know you talked a little bit about doing a portfolio review. I'm curious if you had any early learnings of pieces of the pie that maybe just don't fit, in the context of, you can't do all things for all people. And certainly, heard your comments there about revitalizing growth in behavioral and specialty. I guess the challenge that investors have thought of is the behavioral business might be in a secular decline, but maybe that's more on the state government side and not so much on the payer side. So maybe you could flush out what you see as opportunities to help integrate that. And I'd assume this would be for clients that are maybe small or midsize payers as opposed to the larger ones, who likely have some of these services in house already.

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Ken Fasola, Magellan Health, Inc. - CEO [3]

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Great question, thank you. Let me start with the last piece, because we -- as we spend time thinking about, you know, where opportunity is to go forward, there's no question that behavioral and specialty costs continue, not only to plague the system more broadly, but represent a real opportunity for innovation and integration. So you know, I think that if you think about the idea of being the special teams player at the table as part of an integrated delivery solution, where risk bearers are looking at the total human -- I mean thinking about the patient holistically, there is an opportunity for us to regain a seat at that table and leverage years of real experience, local and distinctive capabilities, to augment emerging digital technologies to provide a more fulsome solution set.

And so I think we perhaps self-inflicted, maybe, or kind of steered ourselves away -- steered the boat out of some of that turbulence, but I think there's an amazing opportunity to steer Magellan back into the conversation and become a vastly more integrated player with payers of all size, candidly. Because I don't think this issue has necessarily been slayed yet, and by virtue of that, creates enormous opportunity for organizations with sovereign and distinctive skills, similar to those we have here at Magellan.

So I really think it -- and you know, the underinvestment that's been kind of a byproduct of our pivot towards MCC and Magellan Rx, while those businesses have grown, I think create a great opportunity for upside as we focus forward. Our early work in and around transformation, executing and honoring our commitments has really taken priority. And so to your first question around what may or may not be deemed as nonstrategic, that portfolio analysis I described is well underway, and I think in future calls we can bring more clarity to the specifics that are necessary, as I said, to demystify Magellan and reduce the degree of complexity and add clarity to our business model.

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David Anthony Styblo, Jefferies LLC, Research Division - Equity Analyst [4]

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Okay. And are there other businesses that you're not in right now that you think would be a good fit and logic as you're pursuing the growth strategy ahead?

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Ken Fasola, Magellan Health, Inc. - CEO [5]

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No, I don't see any businesses that we're not in. I think that, look, you know, the integration that's necessary and the reality that the link between behavioral and physical is well documented, I think the real opportunity for us is to demonstrate. You know, if you're in the Medicaid business, oftentimes it's behavioral that drives physical. As we move into the senior market, it's clear that oftentimes it's the physical that drives behavioral, and I think that's where the real opportunity is. And while we have, as I said, amazing, distinctive, and longstanding sovereign skills, I also think there's an opportunity to leverage many of the new and emerging technologies to create a more comprehensive end-to-end solution, and I think you'll see this in terms of how we refresh and grow our product suite.

Now, I talked about businesses. I do think there are high-cost areas. It's hard to say anything's unmanaged, but there are certainly those that are undermanaged. We see great opportunities, as an example, in oncology. So there are, I think, areas where we have great experience in managing complex care that we can leverage that in other emerging high-cost areas.

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David Anthony Styblo, Jefferies LLC, Research Division - Equity Analyst [6]

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Okay, great. And then Ken, when you stepped in, you sort of inherited a team that had set an established net income margin target of 2% plus in 2021. You guys, providing a lot of information today, haven't had a chance to refresh the bridge kind of in my mind real quick, but I'm curious what your assessment of the company's ability to achieve that. Or is that something that maybe gets pushed out because of the investments that are happening and some of the transformation and initiatives you're going through? And perhaps longer term, what do you see as a target -- net income target for the company over the, call it the next 2 to 4 years, 3 to 5 years, something along that horizon?

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Ken Fasola, Magellan Health, Inc. - CEO [7]

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I'll let Jon add to this as well. He's obviously got a little more time here at Magellan than I do. But I can tell you early on, and I think it's evident -- hopefully you picked it up in the script and as you'll see as we move forward through the balance of the first half of this year -- I'm keenly focused on execution and getting the company organized and focused to build momentum. The level and range of things we're contemplating, both in the transformation office -- and again, transformation's not just around process improvement. It's about rebuilding muscle memory around business development and strengthening our ability to move with speed.

So this is about execution and momentum that I think you'll begin to see, you know, the real benefits of as we move through the year, and I think that will inform -- and we'll take that momentum into '21 and '22, and I think you'll see that reflected in the value that's created as a byproduct. Jon?

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Jonathan Neal Rubin, Magellan Health, Inc. - CFO [8]

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And Dave, let me just add to that a bit in terms of the financials. First, we're obviously not ready to give guidance on 2021 at this point. Having said that, I'd mention a couple of things. One, as Ken alluded to earlier, we see substantial growth opportunity in behavioral specialty through the work that we're doing to sort of reinvigorate the portfolio, the distribution capabilities for the business, et cetera, that hadn't been previously contemplated. 2020's an investment year for us, and you know, relative to our past plans, what I'd say is we're investing more for the long term. It may, from a timing standpoint, mean that we're not making as much incremental progress in 2020 on things like some of the efficiencies, but we're gearing up, really, to be able to drive more sustained and larger improvements, longer term.

So the way I'd characterize it, again, is not yet to give specifics for 2021, but believe that with the transformation office, which over the next couple years we think can drive more than $75 million of improvement, I think we can get to the 2% margin and beyond. But we'll, you know, in the subsequent quarters report more specifically on what we believe the pace of that improvement will be.

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David Anthony Styblo, Jefferies LLC, Research Division - Equity Analyst [9]

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Okay, that's helpful. And then lastly, maybe back to Ken. One of the comments that you said for the near-term priorities, again, was just promises that you want to make and execute on. I'm curious, have you had a different approach, perhaps, to how guidance is built up for this year in terms of feeling like the numbers are particularly conservative and that you guys have room to navigate through any challenges or hiccups that come along the way? Is there any change in how you guys go about setting that and perhaps leaving yourselves some opportunities to create some upside over time?

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Ken Fasola, Magellan Health, Inc. - CEO [10]

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I think the -- excuse me, recovering from a long cold. Nothing more than that, for anybody in the room. But the -- as I said earlier, my primary focus coming in -- you know, I said to the management team, actually to the Board, early on that I was going to be focused on culture, strategy, and execution. And when I arrived here day one, I flipped that to execution, strategy, and culture, which is evolving really, really nicely.

I think Magellan has a real opportunity. When I say we're going to honor the promise, you know, we want to make promises that we can keep and we want to honor the commitments we've already made. You know, we have to be able to execute to our commitments each and every day, and we got a bit behind in a couple areas. And I referred to that when I said we maybe underperformed our own expectations and those of others in the script.

And so my real thinking here after 100 days, one, I'm extraordinarily enthused about the opportunity to build momentum as we move through the year. The team is engaged and digging in. You know, the work that Jim has done in just the first 5 weeks, not only to identify workstreams, but to put -- to size and scope them, to name leaders, and to create a path forward, we're already beginning to see acceleration in the pace with which we can execute around these opportunities. And so I think you'll start to see that momentum in future calls, and then you can draw your own conclusions about what that's likely to mean in terms of upside. But you know, I'm again, as I said, it's a focus on action, an orientation around execution, and revitalizing our growth engine in the business development opportunities that will follow, I'm certain will be meaningful.

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Operator [11]

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Our next question comes from Kevin Fishbeck of Bank of America.

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Kevin Mark Fischbeck, BofA Merrill Lynch, Research Division - MD in Equity Research [12]

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I guess a few questions. The first one, you know, in the press release and in the call so far, you've talked a lot about kind of growing the behavioral and specialty business. You kind of specifically signaled that. I wasn't sure if that was just more to kind of address maybe a change in how the company's talked about or the perception of the market, or whether that was in any way a signal of kind of your view about the growth in the Medicaid or the pharmacy businesses. I wasn't sure if you were de-emphasizing that opportunity in some way to the negative, or whether it was really just about -- that [property] is still the way that the company is talked about historically, you were just talking about behavioral as being a third kind of growth driver. So any color there?

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Ken Fasola, Magellan Health, Inc. - CEO [13]

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Thanks, Kevin, and I am thrilled with the great work that's been done in MCC, and the year-over-year momentum is high priority in terms of sustaining that through 2020 and beyond. And so my comments were not intended in any way, shape, or form to suggest that we're pivoting away from our prior strategy with respect to our Rx businesses and/or MCC; quite the contrary. What I think is that the challenges facing risk bearers, and by virtue of those we serve in and around behavioral and specialty health are continuing to grow. I think it's just a big rock, and I think there's a great opportunity to leverage sovereign skills, distinctive competencies, and emerging technologies to rapidly reinvigorate a business that, frankly, we've kind of taken our eye off of a little bit. So again, in no way suggesting that that's at the expense of either of the other businesses. Quite the contrary, in addition to.

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Kevin Mark Fischbeck, BofA Merrill Lynch, Research Division - MD in Equity Research [14]

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Okay. Great. And then wanted to understand, because again, I appreciate the commitment to delivering on promises, and I guess one step towards that would be this 2020 guidance. And in particular, it might help at least certainly the Street be able to gauge your execution against that would be to get a little bit more color, maybe, on the seasonality for this year. Because it sounds to me, if I have this right, you guys are investing, I don't know, I guess $15 million on this transformational dynamic, which is going to I guess be a drag in the first half and then be a tailwind in the second half.

And then I'm trying to understand the pacing of the $15 million in costs around the Medicaid contract. Is that more in the back half? Just trying to understand some of these kind of onetime things and making sure that we understand the progression so that we can kind of judge how you're executing through the year.

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Jonathan Neal Rubin, Magellan Health, Inc. - CFO [15]

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It's Jon. A couple of comments. So first, on just the overall seasonality, I think you have the general sequencing right, meaning that the transformation benefits will be weighted more towards the back half of the year. Therefore, we will see higher than sort of the proportional earnings in the second half of the year. And, again, we've had -- if you look back at our history, you know, a pattern that's very -- but has been generally more back-half weighted. So if you look at, whether it's last year when we have improvements in MCC in the second half of the year or going back a few years, I think you'll see that similar pattern of something in the 40s, percentage-wise, in the first half and a higher percentage of earnings in the second half.

Relative to California and the $10 million to $15 million, it is a massive implementation. I mean it's the largest pharmacy benefit administration contract by a wide margin, anywhere. So we have already started the work and have already started to bring people on board. Having said that, it does ramp up as the year goes on, but I wouldn't, relative to our overall seasonality, view that as overly material in how it weights the total enterprise numbers. But, you know, it will be, again, as I mentioned with the overall seasonality, somewhat higher weighted in the second half of the year, as we continue to build staff to be ready for implementation.

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Kevin Mark Fischbeck, BofA Merrill Lynch, Research Division - MD in Equity Research [16]

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Okay. Great. And I guess when you think about the investments, you're saying this year, net neutral; next year add $30 million, but next year add $75 million is the way to think about that. Are those actual, good numbers? Or it sounds like you're also making a lot of investments. Should we think about any of these savings being reinvested in the business, or those are kind of net numbers that we should expect from a contribution perspective?

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Jonathan Neal Rubin, Magellan Health, Inc. - CFO [17]

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Yes, I mean those are our estimates right now for net numbers, so that already does net out any incremental investment in those years as well.

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Kevin Mark Fischbeck, BofA Merrill Lynch, Research Division - MD in Equity Research [18]

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Okay, so I may have missed it; there might be other nuance in there, but I think you said something along the lines of that if you had pro forma'd the full savings here, we'd be at a $350 million to $400 million number. I think your guidance this year is $250 million to $280 million, so that would be like $325 million to $355 million. Were you putting that on the 2019 numbers, or were you putting that on the 2020 guidance? Is there another component in there?

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Jonathan Neal Rubin, Magellan Health, Inc. - CFO [19]

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No, there's really 2 components. So the 2 components are, for transformation, you know, again, we've got a $15 million investment this year that we think will be net neutral in 2020 with the benefits we get in the second half of the year. So you know, the full run rate when everything's implemented will be positive $75 million, so you look at that as kind of a plus $75 million. And then on Medi-Cal, for Rx we have a net investment of $10 million to $15 million this year, which obviously won't repeat. And then we said, you know, that would produce revenue going forward of $75 million to $80 million at, you know, typical PBA margins.

So it's really the combination of those two. It's the elimination of the onetime investment this year in Rx, you know, the benefits of that revenue and earnings stream going forward, and then the $75 million in net benefits that we ultimately get on transformation.

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Kevin Mark Fischbeck, BofA Merrill Lynch, Research Division - MD in Equity Research [20]

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Okay, so it's adding California. Okay, that makes sense. And then maybe the last question, it sounds like you're bullish about the growth opportunities here in I guess all of your businesses, but you haven't really grown top line in a little while now. So trying to understand how we should think about the pace of that re-acceleration. I mean excluding California, which I guess we already know about, how does the selling season for next year look? Do you guys expect to see PBM top line growth next year, or is this something that these investments are really more about, you know, 2022, at that perspective? And then the same thing, I guess, on the MCC side. You know, should we be expecting growth, or is this more about kind of a multiyear before we should expect real top line growth?

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Jonathan Neal Rubin, Magellan Health, Inc. - CFO [21]

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Let me start, and then Ken can add color, Kevin. So first, in terms of the growth prospects for PBM, they actually continue to be quite good. I mean we're seeing very solid growth in the PBM this year, in sort of the core PBM business that, you know, again, as we mentioned, there were some one-time losses that partially offset that. Going forward, though, we obviously have the California PBA contract coming in -- you know, that will start to both have revenue and earnings next year, and expect to have strong continued PBM growth as well as on the specialty side. So we think, you know, that'll be good.

If you recall on MCC, you know, we consciously, just given sort of the operational initiatives we had in place to drive improved profitability and to fully digest the very rapid growth we've had over the last few years, did not actively pursue any large new implementations over the last year or so. We are now, you know, actively working the pipeline. And, again, while I can't predict what '21 and '22 will look like, we certainly view that there being significant growth opportunities there.

And then on behavioral specialty, you know, as we re-invigorate the portfolio, while 2020 we're not seeing yet the large opportunity that we believe is there from a potential standpoint, we do think beginning in 2021 and beyond, we'll have ample opportunity to capitalize on the investments we're making. And, Ken, I'll give it to you to talk maybe a little bit more about some of those revitalization efforts.

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Ken Fasola, Magellan Health, Inc. - CEO [22]

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Yes, thanks, Jon. You know, when we talk about transformation, I think the natural inclination is to think about process improvement, and clearly, a lot of the workstreams are oriented around accelerating the pace with which we get at platform consolidation and automating processes that are going to drive efficiencies and margin improvement that I think have -- the pace with which we guided a lot of that stuff in the last year sort of slowed. With respect to -- but there's a second side of the transformation agenda, which is tied to growth. So we have, you know, Jim Murray's leading the transformation workstreams tied to process improvement. I'm leading the transformation workstreams tied to growth.

We're close to being -- we're going to name a chief growth officer, which I think is going to help me with accelerating the pace with which we assess and evaluate our capabilities across the business development continuum, you know, from source through sell, retain, upsell, cross-sell. We get a lot of existing revenue from traditional relationships, and that's why honoring current commitments is so important as we think about building revenue in the short term.

Also look, there are environmental issues out there that are affecting our competitors. Many are struggling, and there's a tremendous amount of consolidation, which creates short-term opportunities that will help fill the pipe. And I think that will buy us time as we work aggressively to create the kind of value proposition that we can leverage and build growth towards '21 and '22. So I think, you know, as you'll see, I referred to this somewhat in the script, but you watch our actions with respect to leadership, leadership development, and laying in talent. We've concentrated. We've augmented existing talent with a number of new folks inside Jim's organization, and now we're moving to strengthen and augment talent inside of business development, and I think you'll see the byproduct of that as we move forward.

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Operator [23]

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Our next question comes from Scott Fidel with Stephens.

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Scott J. Fidel, Stephens Inc., Research Division - MD & Analyst [24]

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Good morning, and Ken, nice to catch up with you today. First question for you guys is, just wanted to clarify the update on the behavioral cost trends relative from the 3Q to the 4Q sort of sequential dynamics. So just wanted to get a sense. So you had the cost bump in the third quarter. I know you guys mentioned in the prepared comments that you didn't see any additional cost pressure. So is it basically that rolling forward to 2021 that the 3Q sort of uplift in costs, that's the new baseline from which you were pricing for 2021, but you didn't see any additional incremental increase in cost trend in 4Q?

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Jonathan Neal Rubin, Magellan Health, Inc. - CFO [25]

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Hi, Scott, it's Jon. I think you characterized it accurately. We haven't seen any additional pressure in fourth quarter. The run rate has been similar to third quarter. And again, as we talked about in the previous quarter, we saw this uptick that really started to occur this year. There were some changes in certain populations that we were covering which did establish that new baseline, so that is what we're carrying into 2020, into this year.

Now, as we mentioned, we did achieve customer rate increases that we were targeting, so that essentially did cover the increased demand we're seeing because of the market and specific population drivers we're seeing within our book. Having said that, we're continuing to implement action plans to mitigate cost of care, so it's not like we're accepting the higher baseline. We've got a number of initiatives on concurrent review for inpatient stays, you know, looking at re-contracting so that we're able to best control those costs going forward as well, from a structural standpoint, and other targeted initiatives within the network to fine-tune the network to be able to drive both adequate access and reduce costs. So that's kind of the quick snapshot I'd give.

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Scott J. Fidel, Stephens Inc., Research Division - MD & Analyst [26]

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Got it. And, Jon, can you put any numbers around that, too, to help frame it in terms of where was your view on trend sort of going into 3Q for behavioral and specialty trend? I know that there's different sort of businesses within that, but it sounds, right, behavioral was sort of the key cost driver. So sort of where was behavioral trend going into 3Q? And then where did your estimate of it currently, entering 2021 in terms of what type of trend you're pricing to?

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Jonathan Neal Rubin, Magellan Health, Inc. - CFO [27]

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It's a great question. So I would say historically, Scott, we've seen mid-single-digit trends, really both on the behavioral and specialty side. I mean there's always going to be some on the specialty side, some puts and takes, depending on the specific categories of care. We did see that spike in 2019, so that the behavioral trend crept up higher, call it the high-single-digit type trends versus what we had historically seen.

In our pricing, you know, we're really pricing for the higher levels of trend to largely continue, again, with some offsets that we're driving on the improvement plans around cost-of-care mitigation. To the extent that trends return to historical levels, that does provide some upside, but we're not counting on that in terms of how we price the business.

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Scott J. Fidel, Stephens Inc., Research Division - MD & Analyst [28]

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Got it, and maybe to bring Ken into this as well, just along those lines of having seen this uplift in the behavioral and specialty trend in terms of where you guys are having to price the business for, how does that factor in at all to, you know, the focus on driving growth in that particular end market right now, as you have seen cost trends rise and you needed to sort of increase pricing for the customers as a result?

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Ken Fasola, Magellan Health, Inc. - CEO [29]

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Scott, good to reconnect, and look forward to seeing you along the way. You know, I'd build on where Jon was, but maybe taking a slightly different perspective. You know, as part of the opportunity to revitalize our behavioral and specialty businesses, there's a huge opportunity to leverage data analytics that we can mine for clinical insight to try to get ahead of a lot of this. You know, site of service is just such an important component in timing related to when we intervene, particularly in our Medicaid business. So you know, if we can continue to work to identify high-risk populations and get in front of them sooner, we can mitigate the impact of utilization down the road, when things sort of spiral out of control too late in the process.

So I think we have a great analytics team here, and we've demonstrated, through our cost-of-care improvements in Virginia and our other MCC states, that we've got competency here. And so I think that there is an opportunity to leverage data analytics. And it's also I think a byproduct, we talk about innovation lab, it's where we're starting. So I hope that helps.

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Scott J. Fidel, Stephens Inc., Research Division - MD & Analyst [30]

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Yes, and I just have one other question on the sort of refocus on BH and specialty, and just interested in your thoughts on the competitive environment in that end market right now. I know, Ken, in the prepared comments, you talked about it looks like you see a bunch of targeted opportunities to get into that space more in a differentiated way. At the same time, you know, from our end, we certainly hear all of the larger national MCOs talking about investing more in the specialty markets and driving more incremental margin and more incremental growth in specialty. So interested in how you juxtapose that in terms of what we are hearing from a number of others is an increased focus on the specialty markets as well.

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Ken Fasola, Magellan Health, Inc. - CEO [31]

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Yes, I actually, I think that focus is a positive trend for us. Because, again, it ties directly to legacy, and I said sovereign, but longstanding distinctive competencies in areas that I think we can add real value. I think we've got to change the nature of the way we build contracts, the nature of the way we think about -- you know, now that we've demonstrated an ability and an acumen to bear risk, how we think about changing the nature of the conversations we have with existing, past, and future customers. And, again, it's not carve-out; it's really carve in. It's bringing Magellan to the table as a special teams coach in one of the -- in an important view around value-based care and managing the whole individual. I just, I think when the return that we can provide exceeds what those companies can achieve on their own, independently -- and I think a lot of them, while there's definitely directionally a desire to invest, we want to be a good partner, and we can share in that.

And so I'm getting a good response, Scott, to those conversations in and among my peers, and I think it just changes the nature of the way we think about how we pitch ourselves and how we position ourselves from a product development standpoint. And we let our value proposition slip in some ways over the last year or so and I think invigorating that, and again, coupled on the conversations I've have with my peers who suggested they're not necessarily satisfied with the progress they're seeing, creates a real opportunity for a different kind of relationship.

So you can't think about it in terms of the way this business used to be. It's really about changing the narrative and paradigm as we move forward. And, again, as I said, I'm getting a good response to that and eager to see where that can go.

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Scott J. Fidel, Stephens Inc., Research Division - MD & Analyst [32]

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Got it, and then one last question for me. Ken, wanted to give you just an initial opportunity to talk about your priorities for capital deployment. Sounds like -- obviously, it sounds like reinvesting in the business seems to be that, but I don't want to put words in your mouth. Maybe if you want to talk about sort of priorities between reinvesting in the business, M&A, and then returns to shareholders in terms of buybacks.

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Ken Fasola, Magellan Health, Inc. - CEO [33]

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Yes, we've -- first, one of the early workstreams was to step back and take a long, hard look at what we've done in the past, see if we can mine that for insight to ensure that the decisions we make going forward around how we deploy capital align directly with our strategy. Again, I spoke to the opportunity to demystify. But, you know, the fact is that we're looking -- we're starting with how we add value to our customers, and it goes back to the kind of partnerships I talked about. Jim laughs at me because I say I'm the king of worthless analogies. But, you know, I can get in Dale Earnhardt's race car, but I'm not going to win the Daytona 500, right?

There's a lot of amazing new and emerging technologies out there that frankly don't have the benefit of our experience, the size and scale that Magellan can bring, and only get to a certain point in the care continuum and then have to hand it off. And I think that the ability to think about how to work in an integrated fashion and weave ourselves into that in ways that can be impactful will inform the kind of decisions we make early on about what we invest in, particularly with respect to strengthening our digital capabilities, targeted investments along that care continuum, and that align very closely with our strategy going forward, as we think about strengthening the business around managing complex care at a time, particularly with respect to behavioral and many of these specialties, where costs are increasing at an extremely rapid rate.

So as I said earlier, it's a big rock. I think we have an opportunity to crack it in a way that can be meaningful, and I think you'll see the capital strategy and deployment of -- and investments we make going forward aligning very closely with that strategy across each of our 3 businesses.

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Operator [34]

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Thank you, and I'm showing no other questions from the phone line at this time.

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Ken Fasola, Magellan Health, Inc. - CEO [35]

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Well, great. Well, listen, thank you all very much for joining us today. We'll look forward to our next call and discussing the progress we're making through the next quarter. Thank you.

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Operator [36]

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Thank you for your participation in today's conference. You may now disconnect at this time. Have a wonderful day.