UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

Form 10-Q

(Mark One)

þ		QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2008

o		TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from      to

Molina Healthcare, Inc.

Delaware		13-4204626
(State or other jurisdiction of		(I.R.S. Employer
incorporation or organization)		Identification No.)
200 Oceangate, Suite 100
Long Beach, California		90802
(Address of principal executive offices)		(Zip Code)

(562) 435-3666
(Registrant’s telephone number, including area code)

     Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes þ No o

     Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer o		Accelerated filer þ	Non-accelerated filer o (Do not check if a smaller reporting company)			Smaller reporting company o

     Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No þ

     The number of shares of the issuer’s Common Stock, par value $0.001 per share, outstanding as of October 24, 2008, was approximately 26,926,000.

 

 

MOLINA HEALTHCARE, INC.

Index

Part I — Financial Information
Item 1. Financial Statements
Condensed Consolidated Balance Sheets as of September 30, 2008 (unaudited) and December 31, 2007			3
Consolidated Statements of Income for the three month and nine month periods ended September 30, 2008 and 2007 (unaudited)			4
Consolidated Statements of Comprehensive Income for the three month and nine month periods ended September 30, 2008 and 2007 (unaudited)			5
Consolidated Statements of Cash Flows for the nine months ended September 30, 2008 and 2007 (unaudited)			6
Notes to Condensed Consolidated Financial Statements (unaudited)			7
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations			17
Item 3. Quantitative and Qualitative Disclosures About Market Risk			37
Item 4. Controls and Procedures			37
Part II — Other Information
Item 1. Legal Proceedings			38
Item 1A. Risk Factors			39
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds			41
Item 5. Other Information			41
Item 6. Exhibits			41
Signatures			42
EX-31.1
EX-31.2
EX-32.1
EX-32.2

PART I — FINANCIAL INFORMATION

Item 1: Financial Statements.

MOLINA HEALTHCARE, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

		September 30,				December 31,
		2008				2007
		(Unaudited)
		(Amounts in thousands, except per-share data)
ASSETS
Current assets:
Cash and cash equivalents		$	382,436			$	459,064
Investments			163,676				242,855
Receivables			169,760				111,537
Deferred income taxes			14,172				8,616
Prepaid expenses and other current assets			14,402				12,521
Total current assets			744,446				834,593
Property and equipment, net			64,633				49,555
Goodwill and intangible assets, net			200,783				207,223
Investments			63,827				—
Restricted investments			36,510				29,019
Receivable for ceded life and annuity contracts			27,828				29,240
Other assets			19,846				21,675
Total assets		$	1,157,873			$	1,171,305
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Medical claims and benefits payable		$	298,787			$	311,606
Accounts payable and accrued liabilities			70,918				69,266
Deferred revenue			19,153				40,104
Income taxes payable			7,755				5,946
Total current liabilities			396,613				426,922
Long-term debt			200,000				200,000
Deferred income taxes			6,598				10,136
Liability for ceded life and annuity contracts			27,828				29,240
Other long-term liabilities			18,740				14,529
Total liabilities			649,779				680,827
Stockholders’ equity:
Common stock, $0.001 par value; 80,000 shares authorized, outstanding 27,393 shares at September 30, 2008 and 28,444 shares at December 31, 2007			27				28
Preferred stock, $0.001 par value; 20,000 shares authorized, no shares outstanding			—				—
Additional paid-in capital			163,648				185,808
Accumulated other comprehensive (loss) income			(4,537	)			272
Retained earnings			371,617				324,760
Treasury stock, at cost; 1,292 shares at September 30, 2008 and 1,201 shares at December 31, 2007			(22,661	)			(20,390	)
Total stockholders’ equity			508,094				490,478
Total liabilities and stockholders’ equity		$	1,157,873			$	1,171,305

CONSOLIDATED STATEMENTS OF INCOME

		Three Months Ended								Nine Months Ended
		September 30,								September 30,
		2008				2007				2008				2007
		(Amounts in thousands, except
						net income per share)
						(Unaudited)
Revenue:
Premium revenue		$	791,554			$	628,402			$	2,282,345			$	1,791,764
Investment income			4,775				7,632				17,517				21,061
Total revenue			796,329				636,034				2,299,862				1,812,825
Expenses:
Medical care costs			669,355				525,902				1,936,531				1,519,244
General and administrative expenses			88,030				74,235				253,196				204,831
Depreciation and amortization			8,515				7,082				24,997				20,274
Impairment charge on purchased software			—				—				—				782
Total expenses			765,900				607,219				2,214,724				1,745,131
Operating income			30,429				28,815				85,138				67,694
Interest expense			(1,980	)			(530	)			(6,559	)			(2,380	)
Income before income taxes			28,449				28,285				78,579				65,314
Provision for income taxes			11,263				10,772				31,722				24,895
Net income		$	17,186			$	17,513			$	46,857			$	40,419
Net income per share:
Basic		$	0.63			$	0.62			$	1.68			$	1.43
Diluted		$	0.62			$	0.62			$	1.67			$	1.43
Weighted average shares outstanding:
Basic			27,449				28,306				27,971				28,229
Diluted			27,582				28,441				28,087				28,356

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

		Three Months Ended								Nine Months Ended
		September 30,								September 30,
		2008				2007				2008				2007
		(Amounts in thousands)
		(Unaudited)
Net income		$	17,186			$	17,513			$	46,857			$	40,419
Other comprehensive (loss) income, net of tax:
Unrealized (loss) gain on investments			(1,562	)			252				(4,809	)			448
Other comprehensive (loss) income			(1,562	)			252				(4,809	)			448
Comprehensive income		$	15,624			$	17,765			$	42,048			$	40,867

CONSOLIDATED STATEMENTS OF CASH FLOWS

		Nine Months Ended
		September 30,
		2008				2007
		(Amounts in thousands)
		(Unaudited)
Operating activities
Net income		$	46,857			$	40,419
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization			24,997				20,274
Amortization of deferred financing costs			1,219				646
Deferred income taxes			(6,135	)			(4,139	)
Stock-based compensation			5,769				5,238
Tax provision from employee stock compensation recorded as additional paid-in capital			(247	)			—
Changes in operating assets and liabilities:
Receivables			(58,223	)			(13,310	)
Prepaid expenses and other current assets			(1,881	)			(2,161	)
Medical claims and benefits payable			(12,819	)			18,674
Accounts payable and accrued liabilities			(666	)			14,283
Deferred revenue			(20,951	)			23,923
Income taxes			1,809				8,989
Net cash (used in) provided by operating activities			(20,271	)			112,836
Investing activities
Purchases of equipment			(28,314	)			(16,514	)
Purchases of investments			(181,377	)			(85,252	)
Sales and maturities of investments			188,896				59,292
Increase in restricted cash			(7,491	)			(7,608	)
Cash paid in business purchase transaction			(1,000	)			—
Increase in other assets			(578	)			(2,921	)
Increase in other long-term liabilities			4,211				6,569
Net cash used in investing activities			(25,653	)			(46,434	)
Financing activities
Treasury stock purchases			(32,237	)			—
Repayment of amounts borrowed under credit facility			—				(25,000	)
Payment of credit facility fees			—				(551	)
Excess tax benefits from employee stock compensation			43				554
Proceeds from exercise of stock options and employee stock purchases			1,490				2,539
Net cash used in financing activities			(30,704	)			(22,458	)
Net (decrease) increase in cash and cash equivalents			(76,628	)			43,944
Cash and cash equivalents at beginning of period			459,064				403,650
Cash and cash equivalents at end of period		$	382,436			$	447,594
Supplemental cash flow information
Cash paid during the period for:
Income taxes		$	36,127			$	15,003
Interest		$	3,945			$	2,695
Schedule of non-cash investing and financing activities:
Unrealized (loss) gain on investments		$	(7,833	)		$	720
Deferred taxes			3,024				(272	)
Net unrealized (loss) gain on investments		$	(4,809	)		$	448
Retirement of common stock used for stock-based compensation		$	512			$	480
Accrued purchases of equipment		$	541			$	290
Retirement of treasury stock		$	29,966			$	—
Cumulative effect of adoption of Financial Interpretation No. 48, Accounting for Uncertainty in Income Taxes		$	—			$	445
Details of business purchase transaction:
Fair value of assets acquired		$	(2,262	)		$	—
Common stock issued to seller			1,262				—
Net cash paid in business purchase transaction		$	(1,000	)		$	—
Business purchase transactions adjustments:
Accounts payable and accrued liabilities		$	1,265			$	—
Deferred taxes			65				2,041
Goodwill and intangible assets, net		$	1,330			$	2,041

MOLINA HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

1. Basis of Presentation

Organization and Operations

     Molina Healthcare, Inc. (the “Company”) is a multi-state managed care organization participating exclusively in government-sponsored health care programs for low-income persons, such as the Medicaid program and the State Children’s Health Insurance Program, or SCHIP. We also serve a small number of members who are dually eligible under both the Medicaid and the Medicare programs, and commencing in January 2007 we began to serve a small number of low-income Medicare members. We conduct our business primarily through nine licensed health plans in the states of California, Michigan, Missouri, Nevada, New Mexico, Ohio, Texas, Utah, and Washington. The health plans are locally operated by our respective wholly owned subsidiaries in those nine states, each of which is licensed as a health maintenance organization, or HMO. See Note 10, “Subsequent Events,” regarding our Florida health plan.

     Our results of operations include the results of the November 1, 2007 acquisition of Mercy CarePlus, a Medicaid managed care organization based in St. Louis, Missouri.

Consolidated and Interim Financial Information

     The condensed consolidated financial statements include the accounts of the Company and all majority owned subsidiaries. In the opinion of management, all adjustments considered necessary for a fair presentation of the results as of the date and for the interim periods presented, which consist solely of normal recurring adjustments, have been included. All significant intercompany balances and transactions have been eliminated in consolidation. The condensed consolidated results of income for the current interim period are not necessarily indicative of the results for the entire year ending December 31, 2008. Financial information related to subsidiaries acquired during any year is included only for the period subsequent to their acquisition.

     The unaudited condensed consolidated interim financial statements have been prepared under the assumption that users of the interim financial data have either read or have access to our audited consolidated financial statements for the fiscal year ended December 31, 2007. Accordingly, certain disclosures that would substantially duplicate the disclosures contained in the December 31, 2007 audited consolidated financial statements have been omitted. These unaudited condensed consolidated interim financial statements should be read in conjunction with our December 31, 2007 audited financial statements. Certain 2007 amounts in the condensed consolidated statement of cash flows regarding stock-based compensation have been reclassified to conform to the 2008 presentation.

2. Significant Accounting Policies

Earnings Per Share

     The denominators for the computation of basic and diluted earnings per share are calculated as follows:

		Three Months Ended September 30,								Nine Months Ended September 30,
		2008				2007				2008				2007
		(in thousands)
Shares outstanding at the beginning of the period			27,453				28,284				28,444				28,119
Weighted average number of treasury shares purchased			(20	)			—				(549	)			—
Weighted average number of shares issued under employee stock plans			16				22				76				110
Denominator for basic earnings per share			27,449				28,306				27,971				28,229
Dilutive effect of employee stock options and restricted stock			133				135				116				127
Denominator for diluted earnings per share			27,582				28,441				28,087				28,356

Stock-Based Compensation

     At September 30, 2008, we had employee equity incentives outstanding under two plans: (1) the 2002 Equity Incentive Plan; and (2) the 2000 Omnibus Stock and Incentive Plan (from which equity incentives are no longer awarded). We account for stock-based compensation in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 123(R), Share-Based Payment. Restricted stock awards are valued based on the closing market price of our common stock on the grant date. The Black-Scholes valuation model is used to estimate the fair value of stock options as of the grant date. For both restricted stock and stock option awards, the expense is recognized over the vesting period, generally straight-line over four years.

     Charged to general and administrative expenses, total stock-based compensation expense (net of tax at the combined federal and state statutory tax rate) for the three and nine months ended September 30, 2008 and 2007 was as follows:

		Three Months Ended								Nine Months
		September 30,								Ended September 30,
		2008				2007				2008				2007
		(in thousands)
Stock options (including shares issued under our employee stock purchase plan)		$	436			$	312			$	1,291			$	1,398
Restricted stock awards			918				677				2,286				1,850
Total stock-based compensation expense, net of tax		$	1,354			$	989			$	3,577			$	3,248

     As of September 30, 2008, unrecognized compensation expense related to stock options totaled $2.1 million, which we expect to recognize over a weighted-average period of 1.9 years. Also as of September 30, 2008, unrecognized compensation expense related to restricted stock awards totaled $15.5 million, which we expect to recognize over a weighted-average period of 3.0 years.

     We used the following assumptions in the Black-Scholes valuation model for options:

		Three Months Ended								Nine Months Ended
		September 30,								September 30,
		2008(1)				2007				2008				2007
Risk-free interest rate			—				4.6	%			2.5	%			4.5	%
Expected volatility			—				38.0	%			45.3	%			48.2	%
Expected option term (in years)			—				6				4				6
Expected dividend yield			—			None				None				None
Grant date weighted-average fair value per share			—			$	12.05			$	12.80			$	16.30

     Stock option activity for the nine months ended September 30, 2008 was as follows:

														Weighted-
						Weighted-								Average
						Average				Aggregate				Remaining
						Exercise				Intrinsic				Contractual
		Options				Price				Value				Term
										(in thousands)				(in years)
Outstanding as of December 31, 2007			733,713			$	30.45
Granted			12,000			$	33.57
Exercised			(16,921	)		$	27.75			$	66
Forfeited			(46,653	)		$	34.47
Outstanding as of September 30, 2008			682,139			$	30.30			$	1,748				7.0
Exercisable and expected to vest as of September 30, 2008			638,584			$	30.19			$	1,736				6.9
Exercisable as of September 30, 2008			430,454			$	29.77			$	1,568				6.3

     Restricted stock activity for the nine months ended September 30, 2008 was as follows:

						Weighted-
						Average				Aggregate
						Grant Date				Market
		Shares				Fair Value				Value
										(in thousands)
Unvested balance as of December 31, 2007			235,413			$	34.14
Granted			383,500				30.96			$	11,872
Vested			(76,571	)			32.25			$	2,237
Forfeited			(53,662	)			33.66
Unvested balance as of September 30, 2008			488,680			$	31.99

Impairment Charge

     During the nine months ended September 30, 2007, an impairment charge of $782,000 was recorded related to commercial software no longer used for operations. No such charge occurred during the nine months ended September 30, 2008.

New Accounting Pronouncements

     In May 2008, the Financial Accounting Standards Board (“FASB”) issued FASB Staff Position APB 14-1, Accounting for Convertible Debt Instruments That May Be Settled in Cash upon Conversion (Including Partial Cash Settlement) (the “FSP”). The FSP requires the proceeds from the issuance of such convertible debt instruments to be allocated between a liability component and an equity component. The resulting debt discount is amortized over the period the convertible debt is expected to be outstanding, as additional non-cash interest expense. The change in accounting treatment is effective for fiscal years beginning after December 15, 2008, and shall be applied retrospectively to prior periods. The FSP changes the accounting treatment for our $200.0 million 3.75% Convertible Senior Notes due 2014, which were issued in October 2007 (see Note 6, “Long-Term Debt”). The impact of this new accounting treatment will result in an increase to non-cash interest expense beginning in fiscal year 2009 for financial statements covering past and future periods. Assuming a 7.9% interest rate, we have estimated the incremental impact of the FSP to our results of operations in 2009 to be $3.4 million, or $0.13 per diluted share, net of tax. This estimate assumes a 38% combined federal and state statutory tax rate and 27 million diluted shares outstanding. We estimate the retroactive adjustment for prior periods will be approximately $0.8 million, or $0.02 per diluted share, net of tax, for 2007, and $2.9 million, or $0.10 per diluted share, net of tax, for 2008.

     In December 2007, the FASB issued SFAS 141(R), Business Combinations and SFAS 160, Noncontrolling Interests in Consolidated Financial Statements. The standards are intended to improve, simplify, and converge internationally the accounting for business combinations and the reporting of noncontrolling (minority) interests in consolidated financial statements. SFAS 141(R) requires the acquiring entity in a business combination to recognize all (and only) the assets acquired and liabilities assumed in the transaction; establishes the acquisition-date fair value as the measurement objective for all assets acquired and liabilities assumed; and requires the acquirer to disclose to investors and other users all of the information they need to evaluate and understand the nature and financial effect of the business combination. SFAS 141(R) is effective for fiscal years, and interim periods within those fiscal years, beginning on or after December 15, 2008. SFAS 141(R) applies prospectively to business combinations for which the acquisition date is on or after the beginning of the first annual reporting period beginning on or after December 15, 2008. Earlier adoption is prohibited.

     SFAS 160 is designed to improve the relevance, comparability, and transparency of financial information provided to investors by requiring all entities to report minority interests in subsidiaries in the same way—as equity in the consolidated financial statements. Moreover, SFAS 160 eliminates the diversity that currently exists in accounting for transactions between an entity and minority interests by requiring they be treated as equity transactions. In addition, SFAS 160 requires that a parent company recognize a gain or loss in net income when a subsidiary is deconsolidated upon a change in control. SFAS 160 is effective for fiscal years, and interim periods within those fiscal years, beginning on or after December 15, 2008. Earlier adoption is prohibited. In addition, SFAS 160 shall be applied prospectively as of the beginning of the fiscal year in which it is initially applied, except for the presentation and disclosure requirements. The presentation and disclosure requirements shall be applied retrospectively for all periods presented. As of September 30, 2008, we did not have material outstanding minority interests.

     Other recent accounting pronouncements issued by the FASB (including its Emerging Issues Task Force), the AICPA, and the SEC did not, or are not believed by management to, have a material impact on our present or future consolidated financial statements.

3. Fair Value Measurements

     As of September 30, 2008, we had cash and cash equivalents of $382.4 million, investments totaling $227.5 million, and restricted investments of $36.5 million. The cash equivalents consist of highly liquid securities with original or purchase date remaining maturities of up to three months that are readily convertible into known amounts of cash. Our investments consisted of investment grade debt securities and are designated as available-for-sale. Of the $227.5 million total, $163.7 million are classified as current assets, and $63.8 million are classified as non-current assets (see further discussion below). Our investment policies require that all of our investments have final maturities of ten years or less (excluding auction rate and variable rate securities where interest rates are periodically reset) and that the average maturity be four years or less. The restricted investments, classified as non-current assets and designated as held-to-maturity, consist of interest-bearing deposits and U.S. treasury securities required by the respective states in which we operate. Investments and restricted investments are subject to interest rate risk and will decrease in value if market rates increase. All non-restricted investments are reported at fair market value on the balance sheet. All restricted investments are carried at amortized cost, which approximates market value. We have the ability to hold these restricted investments until maturity and, as a result, we would not expect the value of these investments to decline significantly due to a sudden change in market interest rates. Declines in interest rates over time will reduce our investment income.

     In September 2006, the FASB issued SFAS 157, Fair Value Measurements. SFAS 157 defines fair value, establishes a framework for measuring fair value in accordance with accounting principles generally accepted in the United States, and expands disclosures about fair value measurements. We adopted the provisions of SFAS 157 as of January 1, 2008 for our financial instruments. Although the adoption of SFAS 157 did not materially impact our financial position, results of operations, or cash flow, we are now required to provide additional disclosures as part of our financial statements.

     SFAS 157 establishes a three-tier fair value hierarchy, which prioritizes the inputs used in measuring fair value. These tiers are: Level 1, defined as observable inputs such as quoted prices in active markets; Level 2, defined as inputs other than quoted prices in active markets that are either directly or indirectly observable; and Level 3, defined as unobservable inputs in which little or no market data exists, therefore requiring an entity to develop its own assumptions.

     As of September 30, 2008, we held investments in auction rate securities, totaling $70.8 million, with a fair value of $63.8 million, which are required to be measured at fair value on a recurring basis. Our auction rate securities are designated as available-for-sale securities and are reflected at fair value. Prior to January 1, 2008, these securities were recorded at fair value based on quoted prices in active markets (i.e., SFAS 157 Level 1 data). Liquidity for these auction rate securities is typically provided by an auction process which allows holders to sell their notes, and which resets the applicable interest rate at pre-determined intervals, usually every 7, 28, or 35 days. However, due to recent events in the credit markets, the auction events for some of these instruments failed during the nine months ended September 30, 2008. An auction failure means that the parties wishing to sell their securities could not be matched with an adequate volume of buyers. Therefore, the fair values of these securities were estimated using a discounted cash flow analysis or other type of valuation model as of September 30, 2008. These analyses considered, among other things, the collateral underlying the securities, the creditworthiness of the counterparty, the timing of expected future cash flows, and the expectation of the next time the security would be expected to have a successful auction. The estimated values of these securities were also compared, when possible, to valuation data with respect to similar securities held by other parties.

     As a result of the decline in fair value for our investments in auction rate securities, which we deem to be temporary and attribute to liquidity issues rather than to credit issues, we recorded unrealized losses, net of tax at the combined federal and state statutory rate, of $1.2 million and $4.3 million for the three and nine months ended September 30, 2008, respectively, to accumulated other comprehensive (loss) income. Substantially all of the $63.8 million in auction rate security instruments held by us at September 30, 2008 were in securities collateralized by student loans, which loans are guaranteed by the U.S. government. Due to our belief that the market for these student loan collateralized instruments may take in excess of twelve months to fully recover, we have classified these investments as non-current, and have included them in investments on the unaudited condensed consolidated balance sheet at September 30, 2008. As of September 30, 2008, we continue to earn interest on our auction rate security instruments. Any future fluctuation in fair value related to these instruments that we deem to be temporary, including any recoveries of previous write-downs, would be recorded to accumulated other comprehensive (loss) income. If we determine that any future valuation adjustment was other than temporary, we would record a charge to earnings as appropriate.

     Our assets measured at fair value on a recurring basis subject to the disclosure requirements of SFAS 157 at September 30, 2008, were as follows:

		Fair Value Measurements at Reporting Date Using
						Quoted
						Prices in
						Active				Significant
						Markets for				Other
						Identical				Observable				Significant
		September 30,				Assets				Inputs				Unobservable Inputs
		2008				(Level 1)				(Level 2)				(Level 3)
		(in thousands)
Auction rate securities		$	63,827			$	—			$	—			$	63,827
Other available-for-sale securities			163,676				163,676				—				—
Total assets measured at fair value		$	227,503			$	163,676			$	—			$	63,827

     Based on market conditions which resulted in the absence of quoted prices in active markets for our auction rate securities, we changed our valuation methodology for auction rate securities to a discounted cash flow analysis during the first quarter of 2008. Accordingly, since our initial adoption of SFAS 157 on January 1, 2008, these securities changed from Level 1 to Level 3 within SFAS 157’s hierarchy. The following table presents our assets measured at fair value on a recurring basis using significant unobservable inputs (Level 3) as defined in SFAS 157 at September 30, 2008:

		Fair Value
		Measurements
		Using Significant
		Unobservable Inputs
		(Level 3)
Auction Rate Securities		(in thousands)
Balance at December 31, 2007		$	—
Transfers to Level 3			82,150
Total losses (realized or unrealized):
Included in earnings			—
Included in other comprehensive income			(6,923	)
Settlements			(11,400	)
Balance at September 30, 2008		$	63,827
The amount of total losses for the period included in other comprehensive income attributable to the change in unrealized losses relating to assets still held at September 30, 2008		$	(6,923	)

4. Receivables

     Receivables consist primarily of amounts due from the various states in which we operate. All receivables are subject to potential retroactive adjustment. As the amounts of all receivables are readily determinable and our creditors are in almost all instances state governments, our allowance for doubtful accounts is immaterial. Any amounts determined to be uncollectible are charged to expense when such determination is made. Accounts receivable by health plan operating subsidiary were as follows:

		September 30,				December 31,
		2008				2007
		(in thousands)
California		$	63,583			$	23,046
Michigan			10,511				6,419
Missouri			22,714				15,986
Ohio			34,196				28,522
Utah			20,205				23,987
Washington			9,679				8,308
Others			8,872				5,269
Total receivables		$	169,760			$	111,537

     California. The significant increase in our California health plan receivable as of September 30, 2008 was due to the delayed passage of the California state budget for 2008-2009. Until the budget was passed on September 23, 2008, the State of California had ceased paying its vendors for the previous two months’ billings. Substantially all receivables due our California and Missouri health plans at September 30, 2008 were collected in October 2008.

     Ohio. As of September 30, 2008, the receivable due our Ohio health plan included two significant components. The first is approximately $10.0 million of accrued birth income, net, due from the State of Ohio. Birth income is a one-time payment for the delivery of a child from the Medicaid program in Ohio.

     The second significant component of the Ohio receivable is approximately $22.0 million due from a capitated provider group. Although we have a capitation arrangement with this provider group, our agreement with them calls for us to pay for certain medical services incurred by the provider group’s members, and then to deduct the amount of such payments from the monthly capitation paid to the provider group. Of the $22.0 million receivable, approximately $14.8 million represents medical services we have paid on behalf of the provider group, which we will deduct from capitation payments in the months of October and November 2008. The other component of the Ohio receivable includes an estimate of our liability for claims incurred by members of this provider group, not covered by capitation, for which we have not yet made payment. This amount totaled $7.2 million as of September 30, 2008. The offsetting liability for the amount of this receivable established for claims incurred but not paid is included in “Medical claims and benefits payable” in our condensed consolidated balance sheets. As part of the agreement with this provider group, our Ohio health plan has withheld approximately $9.0 million from capitation payments due the group, and placed the funds in an escrow account. The Ohio health plan is entitled to the escrow amount if the provider group is unable to repay amounts owed to us. The escrow account is included in “Restricted investments” in our condensed consolidated balance sheets. During the quarter ended September 30, 2008, our average capitation payment to this provider group was approximately $12 million.

     Utah. Our Utah health plan’s agreement with the State of Utah calls for the reimbursement of medical costs incurred in serving our members plus an administrative fee of 9% of that medical cost amount, plus a portion of any cost savings realized as defined in the agreement. Our Utah health plan bills the State of Utah monthly for actual paid health care claims plus administrative fees. Our receivable balance from the State of Utah includes: (1) amounts billed to the state for actual paid health care claims plus administrative fees; and (2) amounts estimated for incurred but not reported claims, which, along with the related administrative fees, are not billable to the State of Utah until such claims are actually paid.

5. Other Assets

     Receivable for ceded life and annuity contracts. We acquired our wholly owned life insurance subsidiary, Molina Healthcare Insurance Company, in 2005. We report this 100% ceded reinsurance arrangement by recording a non-current receivable from the reinsurer with a corresponding non-current liability for ceded life and annuity contracts.

     Other assets. Other assets include primarily deferred financing costs associated with our long-term debt, certain investments held in connection with our deferred employee compensation program, and an investment in a vision services provider (see Note 9, “Related Party Transactions”).

6. Long-Term Debt

Convertible Senior Notes

     In October 2007, we completed our offering of $200.0 million aggregate principal amount of 3.75% Convertible Senior Notes due 2014 (the “Notes”). The sale of the Notes resulted in net proceeds of $193.4 million. The Notes rank equally in right of payment with our existing and future senior indebtedness, and are convertible into cash and, under certain circumstances, shares of our common stock. The initial conversion rate is 21.3067 shares of our common stock per one thousand dollar principal amount of the Notes. This represents an initial conversion price of approximately $46.93 per share of our common stock. In addition, if certain corporate transactions that constitute a change of control occur prior to maturity, we will increase the conversion rate in certain circumstances. Prior to July 2014, holders may convert their Notes only under the following circumstances:

•

During any fiscal quarter after our fiscal quarter ending December 31, 2007, if the closing sale price per share of our common stock, for each of at least 20 trading days during the period of 30 consecutive trading days ending on the last trading day of the previous fiscal quarter, is greater than or equal to 120% of the conversion price per share of our common stock;

•		During the five business day period immediately following any five consecutive trading day period in which the trading price per one thousand dollar principal amount of the Notes for each trading day of such period was less than 98% of the product of the closing price per share of our common stock on such day and the conversion rate in effect on such day; or
•		Upon the occurrence of specified corporate transactions or other specified events.

On or after July 1, 2014, holders may convert their Notes at any time prior to the close of business on the scheduled trading day immediately preceding the stated maturity date regardless of whether any of the conditions noted above is satisfied.

     We will deliver cash and shares of our common stock, if any, upon conversion of each $1,000 principal amount of the Notes, as follows:

•

An amount in cash equal to the sum of, for each of the 20 Volume-Weighted Average Price (the “VWAP”) trading days during the conversion period, the lesser of the daily conversion value for such VWAP trading day and fifty dollars (representing 1/20th of one thousand dollars); and

•

A number of shares based upon, for each of the 20 VWAP trading days during the conversion period, any excess of the daily conversion value above fifty dollars.

Credit Facility

     In 2005, we entered into the Amended and Restated Credit Agreement, dated as of March 9, 2005, among Molina Healthcare Inc., certain lenders, and Bank of America N.A., as Administrative Agent (the “Credit Facility”). Effective May 2007, we entered into a third amendment of the Credit Facility that increased the size of the revolving line of credit to $200.0 million, maturing in May 2012. The Credit Facility is intended to be used for working capital and general corporate purposes, and subject to obtaining commitments from existing or new lenders and satisfaction of other specified conditions, we may increase the Credit Facility to up to $250.0 million.

     Borrowings under the Credit Facility are based, at our election, on the London Interbank Offered Rate, or LIBOR, or the base rate plus an applicable margin. The base rate equals the higher of Bank of America’s prime rate or 0.500% above the federal funds rate. We also pay a commitment fee on the total unused commitments of the lenders under the Credit Facility. The applicable margins and commitment fee are based on our ratio of consolidated funded debt to consolidated earnings before interest, taxes, depreciation and amortization, or EBITDA. The applicable margins range between 0.750% and 1.750% for LIBOR loans and between 0.000% and 0.750% for base rate loans. The commitment fee ranges between 0.150% and 0.275%. In addition, we are required to pay a fee for each letter of credit issued under the Credit Facility equal to the applicable margin for LIBOR loans and a customary fronting fee. As of September 30, 2008 and December 31, 2007, there were no amounts outstanding under the Credit Facility.

     Our obligations under the Credit Facility are secured by a lien on substantially all of our assets and by a pledge of the capital stock of our Michigan, Missouri, New Mexico, Ohio, Texas, Utah, and Washington health plan subsidiaries. The Credit Facility includes usual and customary covenants for credit facilities of this type, including covenants limiting liens, mergers, asset sales, other fundamental changes, debt, acquisitions, dividends and other distributions, capital expenditures, investments, and a fixed charge coverage ratio. The amended Credit Facility also requires us to maintain a ratio of total consolidated debt to total consolidated EBITDA of not more than 2.75 to 1.00 at any time. At September 30, 2008, we were in compliance with all financial covenants in the Credit Facility.

7. Stockholders’ Equity

     In April 2008, our board of directors authorized the repurchase of up to $30 million of our common stock on the open market or through privately negotiated transactions. We used working capital to fund the repurchases under this program. The timing and amount of repurchases were primarily made pursuant to a Rule 10b5-1 trading plan effective as of May 5, 2008, and terminated when the aggregate cost of the repurchases totaled $30 million on June 12, 2008. During the quarter ended June 30, 2008, we repurchased approximately 1.1 million shares.

     In July 2008, our board of directors authorized the repurchase of up to an additional one million shares of our common stock. We used working capital to fund the repurchases under this program. The timing and amount of repurchases were primarily made pursuant to a Rule 10b5-1 trading plan effective as of August 1, 2008. During the quarter ended September 30, 2008, we repurchased approximately 91,000 shares for an aggregate purchase price of $2.7 million. See Note 10, “Subsequent Events.”

8. Commitments and Contingencies

Legal

     The health care industry is subject to numerous laws and regulations of federal, state, and local governments. Compliance with these laws and regulations can be subject to government review and interpretation, as well as regulatory actions unknown and unasserted at this time. Penalties associated with violations of these laws and regulations include significant fines and penalties, exclusion from participating in publicly-funded programs, and the repayment of previously billed and collected revenues.

     We are involved in legal actions in the normal course of business, some of which seek monetary damages, including claims for punitive damages, which are not covered by insurance. The outcome of such legal actions is inherently uncertain. Nevertheless, we believe that these actions (including the previously disclosed Starko and Ward litigation matters), when finally concluded and determined, are not likely to have a material adverse effect on our consolidated financial position, results of operations, or cash flows.

Provider Claims

     Many of our medical contracts are complex in nature and may be subject to differing interpretations regarding amounts due for the provision of various services. Such differing interpretations have led certain medical providers to pursue us for additional compensation. The claims made by providers in such circumstances often involve issues of contract compliance, interpretation, payment methodology, and intent. These claims often extend to services provided by the providers over a number of years.

     Various providers have contacted us seeking additional compensation for claims that we believe to have been settled. These matters, when finally concluded and determined, will not, in our opinion, have a material adverse effect on our consolidated financial position, results of operations, or cash flows.

Regulatory Capital and Dividend Restrictions

     Our principal operations are conducted through our HMO subsidiaries operating in California, Michigan, Missouri, Nevada, New Mexico, Ohio, Texas, Washington, and Utah. Our HMOs are subject to state regulations that, among other things, require the maintenance of minimum levels of statutory capital, as defined by each state, and restrict the timing, payment, and amount of dividends and other distributions that may be paid to us as the sole stockholder. To the extent the subsidiaries must comply with these regulations, they may not have the financial flexibility to transfer funds to us. The net assets in these subsidiaries (after intercompany eliminations), which may

not be transferable to us in the form of cash dividends, loans, or advances, were $340.1 million at September 30, 2008, and $332.2 million at December 31, 2007. The National Association of Insurance Commissioners, or NAIC, adopted model rules effective December 31, 1998, which, if implemented by a state, set new minimum capitalization requirements for insurance companies, HMOs, and other entities bearing risk for health care coverage. The requirements take the form of risk-based capital, or RBC, rules. Michigan, Nevada, New Mexico, Ohio, Texas, Utah, and Washington have adopted these rules, although the rules as adopted may vary somewhat from state to state. California and Missouri have established their own minimum capitalization requirements for insurance companies.

     As of September 30, 2008, our HMOs had aggregate statutory capital and surplus of approximately $349.9 million, compared with the required minimum aggregate statutory capital and surplus of approximately $209.2 million. All of our HMOs were in compliance with the minimum capital requirements at September 30, 2008. We have the ability and commitment to provide additional capital to each of our HMOs when necessary to ensure that they continue to meet statutory and regulatory capital requirements.

9. Related Party Transactions

     We have an equity investment in a medical service provider that provides certain vision services to our members. We account for this investment under the equity method of accounting because we have an ownership interest in the investee in excess of 20%. As of September 30, 2008 and 2007, our carrying amount for this investment totaled $3.6 million and $3.5 million, respectively. During 2007, we paid this provider a $0.9 million network access fee that was fully amortized as of June 30, 2008. During the second quarter of 2008, we advanced this provider $0.3 million, which was fully offset against capitation payments owed to the provider as of June 30, 2008. During the third quarter of 2008, we advanced this provider $0.2 million, which will be offset against capitation payments owed to the provider in 2008. For the three months ended September 30, 2008 and 2007, we paid $4.1 million and $3.4 million, respectively, for medical service fees to this provider. For the nine months ended September 30, 2008 and 2007, we paid $11.2 million and $9.2 million, respectively, for medical service fees to this provider.

     We are a party to a fee-for-service agreement with Pacific Hospital of Long Beach (“Pacific Hospital”). Pacific Hospital is owned by Abrazos Healthcare, Inc., the shares of which are held as community property by the husband of Dr. Martha Bernadett, our Executive Vice President, Research and Development. Amounts paid under the terms of this fee-for-service agreement were $29,000 and $48,000 for the three months ended September 30, 2008 and 2007, respectively, and $139,000 and $90,000 for the nine months ended September 30, 2008 and 2007, respectively. We also have a capitation arrangement with Pacific Hospital, where we pay a fixed monthly fee based on member type. We paid Pacific Hospital for capitation services totaling approximately $1.5 million and $1.2 million for the three months ended September 30, 2008 and 2007, respectively, and $3.2 million and $3.3 million for the nine months ended September 30, 2008 and 2007, respectively. We believe that both arrangements with Pacific Hospital are based on prevailing market rates for similar services. Also as of September 30, 2008, we had an advance outstanding to Pacific Hospital totaling $91,000, which is offsetting capitation payments in 2008.

     In 2006, we assumed an office lease from Millworks Capital Ventures which at that time had a remaining term of 52 months. Millworks Capital Ventures is owned by John C. Molina, our Chief Financial Officer, and his wife. The monthly base lease payment is approximately $18,000 and is subject to an annual increase. Based on a market report prepared by an independent realtor, we believe the terms and conditions of the assumed lease were at that time at fair market value. We are currently using the office space under the lease for an office expansion. Payments made under this lease totaled $68,000 and $57,000 for the three months ended September 30, 2008 and 2007, respectively, and $200,000 and $188,000 for the nine months ended September 30, 2008 and 2007, respectively.

     We lease two medical clinics that are owned by the Mary R. Molina Living Trust and the Molina Marital Trust. These leases have 5 five-year renewal options. Rental expense for these leases totaled $16,000 and $24,000 for the three months ended September 30, 2008 and 2007, respectively, and $65,000 and $73,000 for the nine months ended September 30, 2008 and 2007, respectively.

10. Subsequent Events

     Florida subsidiary. In August 2008, we announced our intention to acquire Florida NetPASS, LLC (“NetPASS”), a provider of care management and administrative services to approximately 55,000 Florida MediPass members in South and Central Florida. We expect the closing of the transaction to occur in the first quarter of 2009, at a purchase price of approximately $42 million, subject to adjustments. On October 1, 2008, we completed the initial closing of the transaction, under which we acquired one percent of the ownership interests of

NetPASS for $9 million. Additionally, we deposited $9 million to an escrow account that will be used for the purpose of reimbursing the State of Florida for any sums due under a final settlement agreement with the state.

     On October 7, 2008, we announced that our wholly owned subsidiary, Molina Healthcare of Florida, Inc., was awarded a Medicaid managed care contract by the State of Florida. The term of the contract will commence on December 1, 2008, at which time Molina Healthcare of Florida will begin its initial enrollment of NetPASS Medicaid members, with the full transition of NetPASS members expected to be completed in the first quarter of 2009.

     Stock repurchases. From October 1, 2008 through October 30, 2008, we repurchased approximately 722,000 shares of our common stock for an aggregate purchase price of $17.3 million (average cost of approximately $23.92 per share). These purchases have completed the Company’s stock purchase plan announced in July 2008. Through October 30, 2008, we have repurchased approximately 1.9 million shares at an aggregate purchase price of $50 million pursuant to the two repurchase plans announced during the year.

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations.

     This document and the following discussion of our financial condition and results of operations should be read in conjunction with the accompanying consolidated financial statements and the notes to those statements appearing elsewhere in this report and the audited financial statements and Management’s Discussion and Analysis appearing in our Annual Report on Form 10-K for the year ended December 31, 2007.

Overview

Summary highlights of our quarter ended September 30, 2008 include:

•    Net earnings of $0.62 per diluted share, consistent with the third quarter of 2007.

•    Quarterly premium revenues of $792 million, up 26% over 2007.

•    Aggregate membership up nearly 16% over 2007.

•    Consolidated medical care ratio of 84.6%, up from 83.7% over 2007.

		Three Months Ended September 30,								Nine Months Ended September 30,
		2008				2007				2008				2007
		(Dollar amounts in thousands, except per-share data)
Earnings per diluted share		$	0.62			$	0.62			$	1.67			$	1.43
Premium revenue		$	791,554			$	628,402			$	2,282,345			$	1,791,764
Operating income		$	30,429			$	28,815			$	85,138			$	67,694
Net income		$	17,186			$	17,513			$	46,857			$	40,419
Medical care ratio			84.6	%			83.7	%			84.9	%			84.8	%
G&A expenses as a percentage of total revenue			11.1	%			11.7	%			11.0	%			11.3	%
Total ending membership											1,239,000				1,070,000

Revenue

     Premium revenue is fixed in advance of the periods covered and, except as described below, is not generally subject to significant accounting estimates. For the nine months ended September 30, 2008, we received approximately 92% of our premium revenue as a fixed amount per member per month, or PMPM, pursuant to our contracts with state Medicaid agencies, Medicare and other managed care organizations for which we operate as a subcontractor. These premium revenues are recognized in the month that members are entitled to receive health care services. The state Medicaid programs and the federal Medicare program periodically adjust premium rates.

     The amount of the premiums paid to us may vary substantially between states and among various government programs. PMPM premiums for members of the State Children’s Health Insurance Program (SCHIP) are generally among our lowest, with rates as low as approximately $80 PMPM in California and Utah. Premium revenues for Medicaid members are generally higher. Among the Temporary Aid for Needy Families (TANF) Medicaid population — the Medicaid group that includes most mothers and children — PMPM premiums range between approximately $100 in California to $300 in New Mexico. Among our Medicaid Aged, Blind or Disabled (ABD) membership, PMPM premiums range from approximately $450 in California and Texas to over $1,000 in New Mexico and Ohio. Medicare premiums are approximately $1,200 PMPM, with Medicare revenue totaling $72.4 million and $32.1 million for the nine months ended September 30, 2008 and 2007, respectively.

     Approximately 3% of our premium revenue for the nine months ended September 30, 2008 was realized under a Medicaid cost-plus reimbursement agreement that our Utah plan has with that state. For the nine months ended September 30, 2008, we also received approximately 5% of our premium revenue in the form of “birth income” — a one-time payment for the delivery of a child — from the Medicaid programs in Michigan, Missouri, Ohio, Texas, and Washington. Such payments are recognized as revenue in the month the birth occurs.

     Certain components of premium revenue are subject to accounting estimates. Chief among these are (1) that portion of premium revenue paid to our New Mexico health plan by the State of New Mexico that may be refunded to the state if certain minimum amounts are not expended on defined medical care costs, (2) that portion of the revenue of our Ohio health plan that is at risk if certain performance measures are not met, (3) the additional premium revenue our Utah health plan is entitled to receive from the State of Utah as an incentive payment for saving the State of Utah money in relation to fee-for-service Medicaid, and (4) the profit-sharing agreement between our Texas health plan and the State of Texas, where we pay a rebate to the State of Texas if our Texas health plan generates pretax income above a certain specified percentage, according to a tiered rebate schedule.

     Our contract with the State of New Mexico requires that we spend a minimum percentage of premium revenue on certain explicitly defined medical care costs. Our contract is for a three-year period, and the minimum percentage is based on premiums and medical care costs over the entire contract period. Through June 30, 2008, we have recorded adjustments totaling $12.9 million to increase premium revenue associated with this requirement. The

revenue resulted from a reversal of previously recorded amounts due the State of New Mexico because we exceeded the minimum percentage for the six months ended June 30, 2008. At June 30, 2008, there was no liability recorded under the terms of this contract provision. Any change to the terms of this provision, including revisions to the definitions of premium revenue or medical care costs, the period of time over which the minimum percentage is measured or the manner of its measurement, or the percentage of revenue required to be spent on the defined medical care costs, may trigger a change in this amount. If the State of New Mexico disagrees with our interpretation of the existing contract terms, an adjustment to this amount may be required.

     Under our contract with the State of Ohio, up to 1% of our Ohio health plan’s revenue may be refundable to the state if certain performance measures are not met. At September 30, 2008, we believe that we are compliant with all of the performance measures and have not reserved any amounts for potential repayment to the state.

     In prior years, we estimated amounts we believed were recoverable under our savings sharing agreement with the State of Utah based on available information and our interpretation of our contract with the State. The State may not agree with our interpretation or our application of the contract language, and it may also not agree with the manner in which we have processed and analyzed our member claims and encounter records. Thus, the ultimate amount of savings sharing revenue that we realize from prior years may be subject to negotiation with the State. During 2007, as a result of an ongoing disagreement with the State of Utah, we wrote off the entire receivable, totaling $4.7 million. Our Utah health plan continues to work with the State to assure an appropriate determination of amounts due to us under the savings share agreement. When additional information is known, or agreement is reached with the State regarding the appropriate savings sharing payment amount for prior years, we will adjust the amount of savings sharing revenue recorded in our financial statements as appropriate in light of such new information or agreement.

     As of September 30, 2008, we had a liability of approximately $6.6 million accrued pursuant to our profit-sharing agreement with the State of Texas for the 2007 and 2008 contract years ending August 31. During the third quarter of 2008, we paid the State of Texas $1.1 million relating to the 2007 contract year. Because the final settlement calculations include a claims run-out period of nearly one year, the amounts recorded, based on our estimates, may be adjusted. We believe that the ultimate settlement will not differ materially from our estimate.

     Historically, membership growth has been the primary reason for our increasing revenues, although more recently our revenues have also grown due to the more care intensive benefits associated with our ABD and Medicare members. We have increased our membership through both internal growth and acquisitions. The following table sets forth the approximate total number of members by state health plan as of the dates indicated:

		As of				As of				As of
		September 30,				December 31,				September 30,
		2008				2007				2007
Total Ending Membership by Health Plan:
California			313,000				296,000				288,000
Michigan			207,000				209,000				211,000
Missouri (1)			77,000				68,000				—
Nevada (2)			—				—				—
New Mexico			84,000				73,000				69,000
Ohio			179,000				136,000				138,000
Texas			29,000				29,000				30,000
Utah			55,000				55,000				50,000
Washington			295,000				283,000				284,000
Total			1,239,000				1,149,000				1,070,000
Total Ending Membership by State for the Medicare Advantage Plans:
California			1,560				1,115				875
Michigan			1,663				1,090				814
Nevada			627				520				178
New Mexico			249				—				—
Texas			458				—				—
Utah			2,162				1,860				1,802
Washington			967				507				446
Total			7,686				5,092				4,115

		As of				As of				As of
		September 30,				December 31,				September 30,
		2008				2007				2007
Total Ending Membership by State for the Aged, Blind or Disabled Population:
California			12,523				11,837				10,912
Michigan			30,396				31,399				31,488
New Mexico			6,464				6,792				6,844
Ohio			19,647				14,887				14,965
Texas			16,221				16,018				16,515
Utah			7,025				6,795				7,056
Washington			3,002				2,814				2,715
Total			95,278				90,542				90,495

The following table provides details of total member months (defined as the aggregation of each month’s ending membership for the period) by state for the periods indicated:

		Three Months Ended
		September 30,								% of Increase
		2008				2007				(Decrease)
California			936,000				859,000				9.0	%
Michigan			627,000				640,000				(2.0	)
Missouri (1)			228,000				—				—
Nevada (2)			2,000				—				—
New Mexico			249,000				200,000				24.5
Ohio			530,000				416,000				27.4
Texas			87,000				90,000				(3.3	)
Utah			161,000				142,000				13.4
Washington			884,000				854,000				3.5
Total			3,704,000				3,201,000				15.7	%

		Nine Months Ended
		September 30,								% of Increase
		2008				2007				(Decrease)
California			2,765,000				2,619,000				5.6	%
Michigan			1,904,000				1,967,000				(3.2	)
Missouri (1)			678,000				—				—
Nevada (2)			6,000				—				—
New Mexico			716,000				589,000				21.6
Ohio			1,465,000				1,155,000				26.8
Texas			257,000				247,000				4.0
Utah			482,000				438,000				10.0
Washington			2,622,000				2,570,000				2.0
Total			10,895,000				9,585,000				13.7	%

Expenses

     Our operating expenses include expenses related to the provision of medical care services and general and administrative, or G&A, expenses. Our results of operations are impacted by our ability to effectively manage expenses related to health care services and to accurately estimate costs incurred. Expenses related to medical care services are captured in the following four categories:

•

Fee-for-service: Physician providers paid on a fee-for-service basis are paid according to a fee schedule set by the state or by our contracts with these providers. We pay hospitals in a variety of ways, including per diem amounts, diagnostic-related groups, or DRGs, percent of billed charges, case rates, and capitation. We also have stop-loss agreements with the hospitals with which we contract; under certain circumstances, we pay escalated charges in connection with these stop-loss agreements. Under all fee-for-service arrangements, we retain the financial responsibility for medical care provided. Expenses related to fee-for-service contracts

			are recorded in the period in which the related services are dispensed. The costs of drugs administered in a physician or hospital setting that are not billed through our pharmacy benefit managers are included in fee-for-service costs.
	•		Capitation: Many of our primary care physicians and a small portion of our specialists and hospitals are paid on a capitation basis. Under capitation contracts, we typically pay a fixed PMPM payment to the provider without regard to the frequency, extent, or nature of the medical services actually furnished. Under capitated contracts, we remain liable for the provision of certain health care services. Certain of our capitated contracts also contain incentive programs based on service delivery, quality of care, utilization management, and other criteria. Capitation payments are fixed in advance of the periods covered and are not subject to significant accounting estimates. These payments are expensed in the period the providers are obligated to provide services. The financial risk for pharmacy services for a small portion of our membership is delegated to capitated providers.
	•		Pharmacy: Pharmacy costs include all drug, injectibles, and immunization costs paid through our pharmacy benefit managers. As noted above, drugs and injectibles not paid through our pharmacy benefit managers are included in fee-for-service costs, except in those limited instances where we capitate drug and injectible costs.
	•		Other: Other medical care costs include medically related administrative costs, certain provider incentive costs, reinsurance cost, and other health care expense. Medically related administrative costs include, for example, expenses relating to health education, quality assurance, case management, disease management, 24-hour on-call nurses, and a portion of our information technology costs. Salary and benefit costs are a substantial portion of these expenses. For the nine months ended September 30, 2008 and 2007, medically related administrative costs were approximately $56.2 million and $47.9 million, respectively.

     The following table provides the details of our consolidated medical care costs for the periods indicated (dollars in thousands except PMPM amounts):

		Three Months Ended September 30,
		2008												2007
										% of												% of
		Amount				PMPM				Total				Amount				PMPM				Total
Fee-for-service		$	439,699			$	118.71				65.7	%		$	339,841			$	106.15				64.6	%
Capitation			113,920				30.76				17.0				95,879				29.95				18.2
Pharmacy			88,414				23.86				13.2				67,844				21.19				12.9
Other			27,322				7.38				4.1				22,338				6.98				4.3
Total		$	669,355			$	180.71				100.0	%		$	525,902			$	164.27				100.0	%

		Nine Months Ended September 30,
		2008												2007
										% of												% of
		Amount				PMPM				Total				Amount				PMPM				Total
Fee-for-service		$	1,262,327			$	115.87				65.2	%		$	984,375			$	102.70				64.8	%
Capitation			335,418				30.79				17.3				276,742				28.87				18.2
Pharmacy			263,372				24.17				13.6				194,354				20.28				12.8
Other			75,414				6.92				3.9				63,773				6.65				4.2
Total		$	1,936,531			$	177.75				100.0	%		$	1,519,244			$	158.50				100.0	%

     Our medical care costs include amounts that have been paid by us through the reporting date as well as estimated liabilities for medical care costs incurred but not paid by us as of the reporting date. See “Critical Accounting Policies” below for a comprehensive discussion of how we estimate such liabilities.

     G&A expenses largely consist of wage and benefit costs for our employees, premium taxes, and other administrative expenses. Some G&A services are provided locally, while others are delivered to our health plans from our Long Beach headquarters pursuant to an administrative services agreement. The primary centralized functions are claims processing, information systems, finance and accounting services, and legal and regulatory services. Locally provided functions include member services, plan administration, and provider relations. G&A expenses include premium taxes for each of our health plans in California, Michigan, New Mexico, Ohio, Texas, and Washington.

Results of Operations

     The following table sets forth selected operating ratios. All ratios with the exception of the medical care ratio are shown as a percentage of total revenue. The medical care ratio is shown as a percentage of premium revenue because there is a direct relationship between the premium revenue earned and the cost of health care.

		Three Months Ended								Nine Months Ended
		September 30,								September 30,
		2008				2007				2008				2007
Premium revenue			99.4	%			98.8	%			99.2	%			98.8	%
Investment income			0.6				1.2				0.8				1.2
Total revenue			100.0	%			100.0	%			100.0	%			100.0	%
Ratio of direct medical care costs to premium revenue			82.1	%			81.0	%			82.4	%			82.1	%
Ratio of administrative costs included in medical care costs to premium revenue			2.5				2.7				2.5				2.7
Medical care ratio			84.6	%			83.7	%			84.9	%			84.8	%
General and administrative expense ratio, excluding premium taxes			8.0	%			8.4	%			8.0	%			8.0	%
Premium taxes included in general and administrative expenses			3.1				3.3				3.0				3.3
Total general and administrative expense ratio			11.1	%			11.7	%			11.0	%			11.3	%
Depreciation and amortization expense ratio			1.1	%			1.1	%			1.1	%			1.1	%
Effective tax rate			39.6	%			38.1	%			40.4	%			38.1	%
Operating income			3.8	%			4.5	%			3.7	%			3.7	%
Income before income taxes			3.6	%			4.4	%			3.4	%			3.6	%
Net income			2.2	%			2.8	%			2.0	%			2.2	%

Three Months Ended September 30, 2008 Compared with Three Months Ended September 30, 2007

     The following tables summarize premium revenue, medical care costs, medical care ratio, and premium taxes by health plan for the three months ended September 30, 2008 and September 30, 2007 (dollars in thousands except PMPM amounts):

		Three Months Ended September 30, 2008
		Premium Revenue								Medical Care Costs								Medical				Premium Tax
		Total				PMPM				Total				PMPM				Care Ratio				Expense
California		$	102,383			$	109.37			$	91,224			$	97.45				89.1	%		$	2,995
Michigan			127,535				203.39				101,596				162.03				79.7				6,412
Missouri			59,223				259.17				47,730				208.88				80.6				—
Nevada			2,196				1,053.04				2,499				1198.68				113.8				—
New Mexico			84,386				338.65				73,723				295.86				87.4				2,838
Ohio			162,553				306.74				148,660				280.52				91.5				8,851
Texas			30,986				357.01				24,730				284.93				79.8				510
Utah			41,860				260.24				36,012				223.88				86.0				—
Washington			178,639				202.19				136,609				154.62				76.5				2,959
Other (1)			1,793				—				6,572				—				—				(5	)
Total		$	791,554			$	213.70			$	669,355			$	180.71				84.6	%		$	24,560

		Three Months Ended September 30, 2007
		Premium Revenue								Medical Care Costs								Medical				Premium Tax
		Total				PMPM				Total				PMPM				Care Ratio				Expense
California		$	93,154			$	108.39			$	76,443			$	88.95				82.1	%		$	2,382
Michigan			119,752				187.19				100,378				156.90				83.8				7,069
New Mexico			72,543				361.23				56,984				283.76				78.6				2,828
Ohio			125,452				302.02				111,387				268.16				88.8				5,645
Texas			24,997				279.39				19,041				212.82				76.2				450
Utah			27,513				193.52				26,534				186.63				96.4				—
Washington			164,367				192.43				130,216				152.45				79.2				2,748
Other (1)			624				—				4,919				—				—				7
Total		$	628,402			$	196.29			$	525,902			$	164.27				83.7	%		$	21,129

     Net Income

     Net income for the quarter ended September 30, 2008 was $17.2 million, or $0.62 per diluted share, compared with net income of $17.5 million, or $0.62 per diluted share, for the third quarter of 2007.

     Premium Revenue

     Premium revenue for the third quarter of 2008 was $791.6 million, an increase of $163.2 million, or 26%, over the $628.4 million of premium revenue for the third quarter of 2007. Medicare premium revenue for the third quarter of 2008 was $28.1 million compared with $12.7 million in the third quarter of 2007. Excluding the impact of the November 1, 2007 acquisition of the Missouri plan, consolidated membership increased 8.6% between September 30, 2007 and September 30, 2008. Significant contributors to the $163.2 million increase in quarterly premium revenue included the following:

	•		A $59.2 million increase as a result of the acquisition of the Company’s Missouri health plan on November 1, 2007. The Missouri health plan received a blended rate increase of approximately 8.5% effective July 1, 2008.
	•		A $37.1 million increase at the Ohio health plan due to higher enrollment, particularly in the CFC population. Effective September 1, 2008, the Ohio health plan added approximately 4,000 Aged, Blind or Disabled (ABD) members in the Central and West Central regions.
	•		A $15.4 million increase in Medicare premium revenue across all health plans where we operate Medicare programs, primarily due to increased enrollment and the recognition of $2.6 million in risk adjustment revenue.
	•		An $8.2 million increase in Medicaid revenue at the California health plan, primarily due to increased membership. The California health plan’s Medicaid revenue decreased $1.3 million from the second quarter of 2008. Sequentially, premium revenue on a PMPM basis declined approximately 3%, reflecting the rate cuts implemented by the State of California for the period July 1, 2008 through August 17, 2008. Premium revenue for the California health plan has been recorded at rates in effect immediately prior to July 1, 2008 for the period August 18, 2008 through September 30, 2008 as the result of a court injunction issued on August 18, 2008.
	•		A $4.3 million increase in Medicaid premium revenue at the Michigan health plan, primarily due to $3.7 million in supplemental revenue from the Michigan Department of Community Health. The supplemental revenue is intended to offset the unintended effects of the Michigan Business Tax (MBT) that replaced Michigan’s Single Business Tax (SBT) as of January 1, 2008.
			The unintended effect of the MBT is the taxation of both the premiums and the net income of health plans, driving the effective federal and state combined tax rate on the Michigan health plan to nearly 49%. The $3.7 million in supplemental revenue was intended to offset MBT’s taxation of gross receipts for the nine months ended September 30, 2008.
			Effective October 1, 2008, the Michigan health plan received an estimated blended rate increase of approximately 5.5%, plus an additional increase of approximately 0.9% for ongoing MBT relief. The rate increase is tied to an expansion of benefits and coverage that will result in increased medical care costs for the Michigan health plan in the future.
			After allowing for the supplemental revenue and the aforementioned ongoing MBT relief, we anticipate our 2008 Michigan tax expense will be approximately $0.5 million higher (before federal tax benefit) than the amount computed using the SBT methodology.

     Investment Income

     Investment income during the third quarter of 2008 totaled $4.8 million compared with $7.6 million in the third quarter of 2007, a decrease of $2.8 million, primarily due to declining interest rates and slightly lower invested balances as a result of cash used in the share repurchase program.

     Medical Care Costs

     Medical care costs as a percentage of premium revenue (the medical care ratio) increased to 84.6% in the third quarter of 2008 from 83.7% in the third quarter of 2007. Sequentially, the medical care ratio increased from 84.2% for the quarter ended June 30, 2008. Excluding Medicare, our medical care ratio was 84.9% in the third quarter of 2008, 83.8% in the third quarter of 2007, and 84.2% in the second quarter of 2008.

	•		The medical care ratio of the Missouri health plan was 80.6% for the quarter, down from 83.0% in the second quarter of 2008. The 8.5% premium increase discussed above was partially offset by increased unit costs due to revised provider contracts and a fee schedule increase effective July 1, 2008.
	•		The medical care ratio of the California health plan increased to 89.1% in the third quarter of 2008 from 82.1% in the third quarter of 2007 and 84.9% in the second quarter of 2008. The increase in the plan’s medical care ratio was caused primarily by a decrease in premium rates as discussed above and higher fee-for-service and pharmacy costs.
	•		The medical care ratio of the New Mexico health plan increased to 87.4% in the third quarter of 2008 from 78.6% in the third quarter of 2007 and 78.0% in the second quarter of 2008. The sequential increase was primarily due to the reduced benefit from the release of amounts reserved as a result of the minimum medical cost ratio provision in the New Mexico health plan’s state contract. The Company recognized $6.2 million of revenue under this provision in the second quarter of 2008, but none for the third quarter of 2008. Additionally, the New Mexico health plan received a blended rate decrease of approximately 3% effective July 1, 2008 for its non-Medicare programs.
	•		The medical care ratio of the Ohio health plan, by line of business, was as follows:

		Three Months Ended
		Sept. 30, 2008				June 30, 2008				Sept. 30, 2007
Covered Families and Children (CFC)			89.9	%			90.7	%			85.5	%
Aged, Blind or Disabled (ABD)			94.6				91.5				94.4
Aggregate			91.5	%			91.0	%			88.8	%