** **

**U.S. SECURITIESAND EXCHANGE COMMISSION**

**WASHINGTON,DC 20549**

 

**FORM 10-Q/A**

**AMENDMENT NO. 1**

 

| **(Mark One)**                                                                                                                                                                                                                                                                                                                                                                                                                                                            |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| **ý**                                                                                                                                                                                                                                                                                                                                                                                                                                                                | **QUARTERLY  REPORT PURSUANT TO SECTION 13 or 15(d) OF THE SECURITIES EXCHANGE  ACT OF 1934.** |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                      |
| **For the quarterly period ended September 30,  2005**                                                                                                                                                                                                                                                                                                                                                                                                               |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                      |   |   |   |   |
| **OR**                                                                                                                                                                                                                                                                                                                                                                                                                                                                    |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                      |   |   |   |
| **o**                                                                                                                                                                                                                                                                                                                                                                                                                                                                     | **TRANSITION  REPORT PURSUANT TO SECTION 13 or 15(d) OF THE SECURITIES EXCHANGE  ACT OF 1934.** |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                      |   |   |   |   |
| **For the transition period  from                                   to                                   ** |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                      |   |   |   |   |
| **Commission file number  000-26749**                                                                                                                                                                                                                                                                                                                                                                                                                                     |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                      |   |   |   |   |
| **NATIONAL MEDICAL HEALTH CARD SYSTEMS, INC.**                                                                                                                                                                                                                                                                                                                                                                                                                       |
| (Exact Name of Registrant  as Specified in Its Charter)                                                                                                                                                                                                                                                                                                                                                                                                                   |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                      |   |   |   |
| **Delaware**                                                                                                                                                                                                                                                                                                                                                                                                                                                              | ** ** | **11-2581812** |
| (State or Other  Jurisdiction of Incorporation or Organization)                                                                                                                                                                                                                                                                                                                                                                                                           |   | (IRS Employer  Identification No.) |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                      |   |   |
| **26 Harbor Park Drive, Port  Washington, NY**                                                                                                                                                                                                                                                                                                                                                                                                                            | ** ** | ** ** | **11050** |
| (Address of Principal  Executive Offices)                                                                                                                                                                                                                                                                                                                                                                                                                                 |   |   | (Zip Code) |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                      |   |
| Registrant’s Telephone Number, Including Area Code **(516) 626-0007**                                                                                                                                                                                                                                                                                                                                                                                                |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                      |
| **Not Applicable**                                                                                                                                                                                                                                                                                                                                                                                                                                                        |
| Former Name, Former  Address and Former Fiscal Year, if Changed Since Last Report.                                                                                                                                                                                                                                                                                                                                                                                        |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                           |  |  |  |  |  |  |  |  |  |

 

Indicate by check whether the registrant: (1) hasfiled all reports required to be filed by Section 13 or 15(d) of theSecurities Exchange Act of 1934 during the preceding 12 months (or for suchshorter period that the registrant was required to file such reports), and (2) hasbeen subject to such filing requirements for the past 90 days.    Yes  ý     No  o

 

Indicate by check whether the registrant is anaccelerated filer (as defined in Rule 12b-2 of the Exchange Act.)     Yes  ý     No  o

 

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

 

**APPLICABLEONLY TO CORPORATE ISSUERS:**

 

The number of sharesoutstanding of the issuer’s Common Stock, as of November 4, 2005 was5,001,586 shares.

 

 

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NATIONAL MEDICAL HEALTH CARD SYSTEMS, INC. ANDSUBSIDIARIES

 

**ExplanatoryNote**

 

National Medical Health CardSystems, Inc. (“NMHC”) received a standard review letter from the Staff ofthe  Securities  and Exchange Commission (“SEC”) as part ofits periodic examination of public company disclosure. In  connection with a review by the SEC, this Amendment No. 1  to the quarterly report on Form 10-Q ofNMHC hereby  amends the information inits Form 10-Q for the quarter ended September 30, 2005,  as filed with the SEC on November 9,2005, by amending the information contained in Items 1 and 2 of Part I to(i) remove certain non-GAAP performancemeasures and (ii)revise the disclosure to provide the total costs related to nonvested awards andclarify certain other information contained therein. For the convenience of the reader, this Form10-Q/A sets forth the original Form 10-Q in its entirety.

 

This amendment continues to speak as of the filingdate of our original Form 10-Q for the quarter ended September 30, 2005. Wehave not amended, modified, supplemented or updated the disclosures containedin this amendment to reflect events that have occurred since the filing of theoriginal Form 10-Q, nor have we amended, modified, supplemented or updatedthese disclosures in any way other than as described above. Accordingly, thisamendment should be read in conjunction with our filings made with the SECafter November 9, 2005, the filing date of the original Form 10-Q.

 

2

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| **INDEX**    | ** ** |
|--------------|------------|
|         |       |   |   |
|         |       | FORWARD-LOOKING STATEMENTS | 4 |
|         |       |   | 5 |
| PART I  | -          | FINANCIAL INFORMATION |   |
|         |       |   | 5 |
| ITEM  1      | -          | CONDENSED  FINANCIAL STATEMENTS: |   |
|         |       |   |   |
|         |       | CONSOLIDATED BALANCE SHEET as of

September 30, 2005 (unaudited) and June 30,  2005 | 5 |
|         |       |
|         |       |   |   |
|         |       | CONSOLIDATED  STATEMENT OF INCOME (unaudited)

for the three months ended September 30, 2005 and  2004 | 6 |
|         |       |
|         |       |   |   |
|         |       | CONSOLIDATED  STATEMENT OF CASH FLOWS (unaudited)

for the three months ended September 30, 2005 and  2004 | 7 |
|         |       |
|         |       |   |   |
|         |       | CONDENSED  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS | 8 |
|         |       |   |   |
| ITEM 2       | -          | MANAGEMENT’S  DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS | 18 |
|         |       |   |   |
| ITEM 3       | -          | QUANTITATIVE  AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK | 29 |
|         |       |   |   |
| ITEM 4       | -          | CONTROLS AND  PROCEDURES | 29 |
|         |       |   |   |
| PART II | -          | OTHER INFORMATION | 30 |
|         |       |   |   |
| ITEM 1       | -          | LEGAL PROCEEDINGS | 30 |
|         |       |   |   |
| ITEM 2       | -          | UNREGISTERED  SALES OF EQUITY SECURITIES AND USE OF PROCEEDS | 30 |
|         |       |   |   |
| ITEM 3       | -          | DEFAULTS  UPON SENIOR SECURITIES | 30 |
|         |       |   |   |
| ITEM 4       | -          | SUBMISSION  OF MATTERS TO A VOTE OF SECURITY HOLDERS | 30 |
|         |       |   |   |
| ITEM 5       | -          | OTHER INFORMATION | 30 |
|         |       |   |   |
| ITEM  6      | -          | EXHIBITS | 30 |

 

3

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**Forward-Looking Statements**

 

When used herein, the words “may,”“could,” “estimate,” “believe,” “anticipate,” “think,” “intend,” “expect” andsimilar expressions identify forward-looking statements within the meaning ofthe Private Securities Litigation Reform Act of 1995. Such statements arenot guarantees of future performance and involve known and unknown risks anduncertainties, and other factors, which could cause actual results to differmaterially from those in the forward-looking statements. Readers are cautionednot to place undue reliance on such statements, which speak only as of the datehereof. Forward-looking statements made by the National Medical Health CardSystems, Inc. (“NMHC” or the “Company”) are intended to apply only at thetime they are made, unless explicitly stated to the contrary. Moreover, whetheror not stated in connection with a forward-looking statement, the Company makesno commitment to revise or update any forward-looking statements in order toreflect events or circumstances after the date any such statement is made. Ifthe Company were in any particular instance to update or correct aforward-looking statement, investors and others should not conclude that theCompany would make additional updates or corrections thereafter.

 

For a discussion of such risks anduncertainties, including risks relating to pricing, competition in the biddingand proposal process, our ability to consummate contract negotiations withprospective clients, dependence on key members of management, governmentregulation, acquisitions and affiliations, the market for pharmacy benefitmanagement (“PBM”) services, and other factors, readers are urged to carefullyreview and consider various disclosures made by the Company which attempt toadvise investors of the factors which affect NMHC’s business, including,without limitation, the disclosures made under the caption “Description ofBusiness – Risk Factors Affecting NMHC’s Business” in Item 1 and “Management’sDiscussion and Analysis of Financial Condition and Results of Operations” inItem 7 of NMHC’s Annual Report on Form 10-K, for the fiscal year ended June 30,2005, filed with the U.S. Securities and Exchange Commission on September 22,2005, as amended.

 

4

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**PART I — FINANCIAL INFORMATION**

 

**ITEM 1 –**CONDENSED FINANCIAL STATEMENTS

 

NATIONAL MEDICAL HEALTH CARD SYSTEMS, INC. ANDSUBSIDIARIES

 

**CONSOLIDATED BALANCE SHEET**

**($ inthousands)**

 
| ** **                                                                                                                                              | ** ** | **September 30,  2005** | ** ** | **June 30,  2005** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------|------------|-------------------------|------------|
| ** **                                                                                                                                              | ** ** | **(Unaudited)**              | ** ** | ** **              | ** ** |
| **Assets**                                                                                                                                              |       |                         |       |                    |       |
| **Current:**                                                                                                                                            |       |                         |       |                    |       |
|                                                                                                                                                    |       |                         |       |                    |       |
| Cash and cash equivalents (including cash equivalent  investments of $287 and $193, respectively)                                                       |       | $                            | 8,531      |                    | $          | 7,272 |   |
| Restricted cash                                                                                                                                         |       | 4,997                        |       | 3,994                   |       |
| Accounts receivable, less allowance for doubtful  accounts of $2,118 and $1,953, respectively                                                           |       | 104,743                      |       | 103,129                 |       |
|                                                                                                                                                    |       |                         |       |                    |       |
| Rebates receivable                                                                                                                                      |       | 58,256                       |       | 40,377                  |       |
| Inventory                                                                                                                                               |       | 5,317                        |       | 4,119                   |       |
| Due from affiliates                                                                                                                                     |       | —                       |       | 31                      |       |
| Deferred tax assets                                                                                                                                     |       | 2,013                        |       | 2,117                   |       |
| Other current assets                                                                                                                                    |       | 4,218                        |       | 5,759                   |       |
| **Total current assets**                                                                                                                                |       | 188,075                      |       | 166,798                 |       |
|                                                                                                                                                    |       |                         |       |                    |       |
| Property, equipment and software development costs,  net                                                                                                |       | 12,448                       |       | 12,177                  |       |
| Intangible assets, net of accumulated amortization  of $3,555 and $3,273, respectively                                                                  |       | 3,719                        |       | 3,951                   |       |
| Goodwill                                                                                                                                                |       | 99,804                       |       | 99,710                  |       |
| Other assets                                                                                                                                            |       | 1,327                        |       | 1,295                   |       |
| **Total Assets**                                                                                                                                        |       | $                            | 305,373    |                    | $          | 283,931 |   |
|                                                                                                                                                    |       |                         |       |                    |       |
| **Liabilities, Redeemable Preferred Equity, and  Common Stockholders’ Equity**                                                                     |       |                         |       |                    |       |
| **Current Liabilities:**                                                                                                                                |       |                         |       |                    |       |
|                                                                                                                                                    |       |                         |       |                    |       |
| Accounts payable and accrued expenses                                                                                                                   |       | $                            | 205,313    |                    | $          | 188,843 |   |
| Revolving credit facility and loans payable-current                                                                                                     |       | 1,860                        |       | 1,860                   |       |
| Current portion of capital lease obligations                                                                                                            |       | 30                           |       | 29                      |       |
| Income taxes payable                                                                                                                                    |       | 112                          |       | —                  |       |
| Other current liabilities                                                                                                                               |       | 202                          |       | 503                     |       |
| **Total current liabilities**                                                                                                                           |       | 207,517                      |       | 191,235                 |       |
|                                                                                                                                                    |       |                         |       |                    |       |
| Capital lease obligations, less current portion                                                                                                         |       | 9                            |       | 16                      |       |
| Long term loans payable and other liabilities                                                                                                           |       | 994                          |       | 998                     |       |
| Deferred tax liability                                                                                                                                  |       | 6,071                        |       | 5,964                   |       |
| **Total liabilities**                                                                                                                                   |       | 214,591                      |       | 198,213                 |       |
|                                                                                                                                                    |       |                         |       |                    |       |
| **Commitments and Contingencies**                                                                                                                       |       |                         |       |                    |       |
| **Redeemable Preferred Equity:**                                                                                                                        |       |                         |       |                    |       |
|                                                                                                                                                    |       |                         |       |                    |       |
| Redeemable convertible preferred stock $.10 par  value; 15,000,000 shares authorized, 6,956,522 issued and outstanding                                  |       | 75,983                       |       | 75,864                  |       |
|                                                                                                                                                    |       |                         |       |                    |       |
| **Common Stockholders’ Equity:**                                                                                                                   |       |                         |       |                    |       |
| Common stock, $.001 par value, 35,000,000 shares  authorized, 9,638,884 and 9,461,826 shares issued, 4,998,984 and 4,821,926  outstanding, respectively |       |                         |       |                    |       |
|                                                                                                                                                    |       | 10                           |       | 9                       |       |
| Additional paid-in-capital                                                                                                                              |       | 118,670                      |       | 115,061                 |       |
| Accumulated deficit                                                                                                                                     |       | (52,002                      | )          | (53,337                 | )          |
| Treasury stock at cost, 4,639,900 shares                                                                                                                |       | (51,879                      | )          | (51,879                 | )          |
| **Total common stockholders’ equity**                                                                                                              |       | 14,799                       |       | 9,854                   |       |
| **Total Liabilities, Redeemable Preferred Equity,  and Common Stockholders’ Equity**                                                               |       | $                            | 305,373    |                    | $          | 283,931 |   |

 

*Seeaccompanying condensed notes to consolidated financial statements*

 

5

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NATIONAL MEDICAL HEALTH CARD SYSTEMS, INC. ANDSUBSIDIARIES

 

**CONSOLIDATED STATEMENT OF INCOME**

**(Amounts in thousands, except per share amounts)**

**(Unaudited)**

 
| ** **                                                                                                                                                              | ** ** | **Three months ended September 30,** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                                                                                                                                              | ** ** | **2005**                                  | ** ** | **2004** | ** ** |
|                                                                                                                                                                    |       |                                      |       |   |   |
| Revenue (includes co-payments collected of $4,799  and $2,277, respectively; and excludes co-payments retained by the pharmacies  of $77,453 and $53,921, respectively) |       | $                                         | 214,692    |   | $ | 184,842 |   |
|                                                                                                                                                                    |       |                                      |       |   |   |
| Cost of claims (excludes co-payments retained by the  pharmacies of $77,453 and $53,921, respectively)                                                                  |       | 191,130                                   |       | 165,165 |   |
| Gross Profit                                                                                                                                                            |       | 23,562                                    |       | 19,677 |   |
|                                                                                                                                                                    |       |                                      |       |   |   |
| Selling, general and administrative expenses                                                                                                                            |       | 18,638                                    |       | 15,079 |   |
|                                                                                                                                                                    |       |                                      |       |   |   |
| Operating income                                                                                                                                                        |       | 4,924                                     |       | 4,598 |   |
|                                                                                                                                                                    |       |                                      |       |   |   |
| Other income (expense):                                                                                                                                                 |       |                                      |       |   |   |
| Interest expense                                                                                                                                                        |       | (104                                      | )          | (139 | ) |
| Interest income                                                                                                                                                         |       | 174                                       |       | 10 |   |
| Other income, net                                                                                                                                                       |       | 12                                        |       | 50 |   |
|                                                                                                                                                                    |       | 82                                        |       | (79 | ) |
|                                                                                                                                                                    |       |                                      |       |   |   |
| Income before provision for income taxes                                                                                                                                |       | 5,006                                     |       | 4,519 |   |
| Provision for income taxes                                                                                                                                              |       | 2,139                                     |       | 1,853 |   |
|                                                                                                                                                                    |       |                                      |       |   |   |
| Net income                                                                                                                                                              |       | 2,867                                     |       | 2,666 |   |
|                                                                                                                                                                    |       |                                      |       |   |   |
| Preferred stock cash dividend                                                                                                                                           |       | 1,412                                     |       | 1,412 |   |
| Accretion of transaction expenses                                                                                                                                       |       | 120                                       |       | 119 |   |
| Net income available to common stockholders                                                                                                                             |       | $                                         | 1,335      |   | $ | 1,135 |   |
|                                                                                                                                                                    |       |                                      |       |   |   |
| Earnings per common share:                                                                                                                                              |       |                                      |       |   |   |
| Basic                                                                                                                                                                   |       | $                                         | 0.27       |   | $ | 0.26 |   |
| Diluted *                                                                                                                                                               |       | $                                         | 0.24       |   | $ | 0.22 |   |
|                                                                                                                                                                    |       |                                      |       |   |   |
| Weighted average number of common shares  outstanding:                                                                                                                  |       |                                      |       |   |   |
| Basic                                                                                                                                                                   |       | 4,862                                     |       | 4,400 |   |
| Diluted *                                                                                                                                                               |       | 12,102                                    |       | 11,904 |   |

 

*Seeaccompanying condensed notes to consolidated financial statements*

 

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* =The number of weighted average diluted shares was calculated using the “as ifconverted” method for the redeemable preferred stock.

 

6

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NATIONAL MEDICAL HEALTH CARD SYSTEMS, INC. ANDSUBSIDIARIES

 

**CONSOLIDATED STATEMENT OF CASHFLOWS**

**(Amounts in thousands)**

**(Unaudited)**

 
| ** **                                                                         | ** ** | **Three months ended  September 30,** | ** ** |
|------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                         | ** ** | **2005**                                   | ** ** | **2004** | ** ** |
| **Cash flows from operating activities:**                                          |       |                                       |       |   |   |
| Net income                                                                         |       | $                                          | 2,867      |   | $ | 2,666 |   |
| Adjustments to reconcile net income to net cash  provided by operating activities: |       |                                       |       |   |   |
|                                                                               |       |                                       |       |   |   |
| Depreciation and amortization                                                      |       | 1,807                                      |       | 1,572 |   |
| Employee stock option expense                                                      |       | 668                                        |       | — |   |
| Amortization of deferred gain                                                      |       | (12                                        | )          | (50 | ) |
| Amortization of deferred financing costs                                           |       | 28                                         |       | — |   |
| Provision for doubtful accounts                                                    |       | 165                                        |       | 156 |   |
| Deferred income taxes                                                              |       | 221                                        |       | 20 |   |
| Changes in assets and liabilities, net of effect  from acquisitions:               |       |                                       |       |   |   |
| Restricted cash                                                                    |       | (1,003                                     | )          | 95 |   |
| Accounts receivable                                                                |       | (1,779                                     | )          | (806 | ) |
| Rebates receivable                                                                 |       | (17,879                                    | )          | 2,999 |   |
| Inventory                                                                          |       | (1,198                                     | )          | (1,622 | ) |
| Other current assets                                                               |       | 1,541                                      |       | (365 | ) |
| Due from affiliates                                                                |       | 31                                         |       | — |   |
| Other assets                                                                       |       | (60                                        | )          | 374 |   |
| Accounts payable and accrued expenses                                              |       | 17,166                                     |       | (4,382 | ) |
| Income taxes payable and other current liabilities                                 |       | 662                                        |       | 3,070 |   |
| Other long term liabilities                                                        |       | 8                                          |       | (817 | ) |
| Net cash provided by operating activities                                          |       | 3,233                                      |       | 2,910 |   |
|                                                                               |       |                                       |       |   |   |
| **Cash flows from investing activities:**                                          |       |                                       |       |   |   |
| Capital expenditures                                                               |       | (1,796                                     | )          | (945 | ) |
| Acquisition of PPP, net of cash acquired                                           |       | (425                                       | )          | (358 | ) |
| Net cash used in investing activities                                              |       | (2,221                                     | )          | (1,303 | ) |
|                                                                               |       |                                       |       |   |   |
| **Cash flows from financing activities:**                                          |       |                                       |       |   |   |
| Proceeds from exercise of stock options                                            |       | 1,665                                      |       | 120 |   |
| Proceeds from revolving credit facility                                            |       | 38,725                                     |       | 266,349 |   |
| Repayment of revolving credit facility                                             |       | (38,725                                    | )          | (266,352 | ) |
| Payment of preferred stock dividends                                               |       | (1,412                                     | )          | (1,412 | ) |
| Repayment of debt and capital lease obligations                                    |       | (6                                         | )          | (81 | ) |
| Net cash provided by (used in) financing activities                                |       | 247                                        |       | (1,376 | ) |
|                                                                               |       |                                       |       |   |   |
| Net increase in cash and cash equivalents                                          |       | 1,259                                      |       | 231 |   |
| Cash and cash equivalents at beginning of period                                   |       | 7,272                                      |       | 3,388 |   |
| Cash and cash equivalents at end of period                                         |       | $                                          | 8,531      |   | $ | 3,619 |   |

 

*Seeaccompanying condensed notes to consolidated financial statements*

 

7

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NATIONAL MEDICAL HEALTH CARD SYSTEMS, INC. ANDSUBSIDIARIES

 

**CONSOLIDATED NOTES TO CONSOLIDATEDFINANCIAL STATEMENTS**

**(All $ in thousands, except share and per shareamounts)**

**(Unaudited)**

 

1.                                       BASIS OF PRESENTATION

 

The unaudited consolidated financial statementsinclude the accounts of National Medical Health Card Systems, Inc. (the “Company”or “NMHC”) and its wholly owned subsidiaries, Pharmacy Associates, Inc. (“PAI”),Interchange PMP, Inc. (“PMP”), Centrus Corporation (“Centrus”), NationalMedical Health Card IPA, Inc. (“IPA”), Specialty Pharmacy Care, Inc. (“Specialty”), Integrail, Inc. (“NMHCIntegrail”), NMHCRX Mail Order, Inc. (“NMHCmail”), NMHCRX Contracts, Inc.(“Contracts”), Portland Professional Pharmacy and Portland ProfessionalPharmacy Associates (collectively, “PPP” or “NMHC Ascend”), Inteq Corp. andInteq TX Corp. (collectively, “Inteq”), PCN DE Corp. and Pharmaceutical CareNetwork (collectively, “PCN”) and PBM Technology Inc. (“PBM Tech”) (See Note4). Also included on a consolidated basis are the accounts of NMHC Funding, LLC(“Funding”), a limited liability company of which the Company and itssubsidiaries are the owners of all of the membership interests. Unless thecontext otherwise requires, references herein to the “Company” or “NMHC” referto the Company and its subsidiaries, on a consolidated basis. All materialinter-company balances and transactions have been eliminated in consolidation.

 

The unaudited consolidated financial statements havebeen prepared by the Company in accordance with United States generallyaccepted accounting principles for interim financial information andsubstantially in the form prescribed by the U.S. Securities and ExchangeCommission (the “SEC”) in instructions to Form 10-Q and in Article 10of Regulation S-X. Accordingly, the interim financial information does notinclude all of the information and footnotes required by such accountingprinciples for complete financial statements. In the opinion of the Company’smanagement, the September 30, 2005 and 2004 unaudited interim financialstatements include all adjustments consisting of normal recurring adjustments,necessary for a fair presentation of results for these interim periods. In theopinion of the Company’s management, the disclosures contained in this Form 10-Q/Aare adequate to make the information presented not misleading when read inconjunction with the Notes to Consolidated Financial Statements included in theCompany’s Form 10-K for the year ended June 30, 2005, as amended. The results of operations forthe three month period ended September 30, 2005 are not necessarilyindicative of the operating results to be expected for the full year.

 

For information concerning the Company’s significantaccounting policies, reference is made to the Company’s Annual Report on Form 10-Kfor the year ended June 30, 2005 (the “Annual Report”) filed with the SEC, as amended.

 

2.                                       STOCK-BASED COMPENSATION

 

At September 30, 2005, the Company had onestock-based employee compensation plan, which is more fully described in Note 6.Prior to July 1, 2005, the Company accounted for this plan under therecognition and measurement provisions of APB Opinion No. 25, *Accounting for Stock Issued to Employees*,and related Interpretations, as permitted by FASB Statement No. 123, *Accounting for Stock-Based Compensation*. Nostock-based employee compensation cost was recognized in the Statement ofOperations for the three months ended September 30, 2004, as all optionsgranted under this plan had an exercise price equal to the market value of theunderlying

 

8

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common stock on the date of grant. Effective July 1,2005, the Company adopted the fair value recognition provisions of FASBStatement No. 123(R), *Share-BasedPayment*, using the modified-prospective-transition method. Underthat transition method, compensation cost recognized in the three months ended September 30,2005 includes: (a) compensation cost for all share-based payments grantedprior to, but not yet vested as of July 1, 2005, based on the grant datefair value estimated in accordance with the original provisions of Statement123, and (b) compensation cost for all share-based payments grantedsubsequent to July 1, 2005, based on the grant-date fair value estimatedin accordance with the provisions of Statement 123(R). Results for priorperiods have not been restated.

 

Forthe three months ended September 30, 2005, the fair value of the optionswas estimated using a binomial valuation model with the followingweighted-average assumptions used: no dividend yield, weighted-average expectedlife of the option of 7 years, risk-free interest rate of 4.1%, volatility of69.5%, post-vesting terminations of 1%, and a sub-optimal exercise factor of4.1. The weighted-average value of options granted was $18.08 during the threemonths ended September 30, 2005.

 

As a result of adopting Statement 123(R) on July 1,2005, the Company’s income before income taxes for the three months ended September 30, 2005 is $668 lower than if it hadcontinued to account for share-based compensation under APB Opinion 25.  The after-tax effect of this charge was $536, or $0.11 per basic earnings per share, or EPS, and $0.04 per diluted EPS using the "as if converted" method for thethree months ended September 30, 2005. As of September 30, 2005, the total unrecognized compensation costrelated to nonvested stock awards was $7,261 and the related weighted-averageperiod over which it is expected to be recognized is approximately 3.1 years.

 

Prior to the adoption of Statement 123(R), the Companypresented all tax benefits of deductions resulting from the exercise of stockoptions as operating cash flows in the Consolidated Statement of Cash Flows. Statement123(R) requires the cash flows resulting from the tax benefits resulting fromtax deductions in excess of the compensation cost recognized for those options(excess tax benefits) to be classified as financing cash flows. For the threemonths ended September 30, 2005, the excess tax benefit classified as afinancing cash inflow was not material.

 

The following table illustrates the effect on netincome and earnings per share if the Company had applied the fair valuerecognition provisions of Statement 123 to options granted under the Company’sstock option plan in the three months ended September 30, 2004. Forpurposes of this pro forma disclosure, the value of the options is estimatedusing the Black-Scholes option-pricing model with the followingweighted-average assumptions used for all grants in the three months ended September 30,2004: no dividend yield, weighted-average expected life of the option ofbetween 4 and 8 years, risk-free interest rate of 3.4%, and volatility of 74.3%for all grants. The weighted-average value of options granted was $17.45 forthe three months ended September 30, 2004.

 

9

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| ** **                                                                                                                                                                          | ** ** | **Three Months  Ended September  30, 2004** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------|------------|
| Net income available to common stockholders, as  reported                                                                                                                           |       | $                                           | 1,135      |   |
| Less: Total stock-based employee compensation  expense determined under fair value based method for all awards, net of  related tax effect applied using the provisions of FAS 123. |       | (454                                        | )          |
| Pro forma net income available to common  stockholders                                                                                                                              |       | $                                           | 681        |   |
| Pro forma earnings per share:                                                                                                                                                       |       |                                        |       |
| Basic – as reported                                                                                                                                                            |       | $                                           | 0.26       |   |
| Basic – pro forma                                                                                                                                                              |       | $                                           | 0.15       |   |
|                                                                                                                                                                                |       |                                        |       |
| Diluted – as reported                                                                                                                                                          |       | $                                           | 0.22       |   |
| Diluted – pro forma                                                                                                                                                            |       | $                                           | 0.13       |   |

 

3.                                       NEW MOUNTAIN TRANSACTION

 

The Company entered into an amended andrestated preferred stock purchase agreement, dated as of November 26,2003, with New Mountain Partners, L.P. (the “purchase agreement”). Pursuant tothe purchase agreement, the Company agreed, subject to various conditions, toissue to New Mountain Partners a total of 6,956,522 shares of series A 7%convertible preferred stock (the “series A preferred stock”) at a purchaseprice of $11.50 per share, for aggregate proceeds of approximately $80,000. On March 19,2004, the Company completed the sale of the series A preferred stock toNew Mountain Partners and used approximately $49,000 of the proceeds ofthe sale of the series A preferred stock to purchase, pursuant to a tenderoffer, 4,448,900 shares of the Company’s issued and outstanding common stock(the “common stock”) at $11.00 per share (collectively, the “New MountainTransaction”). Prior to the closing of the New Mountain Transaction, Bert E.Brodsky, the former chairman of the board of directors, and certainstockholders related to him, held (assuming the exercise of 330,000 options andwarrants held by Mr. Brodsky, which occurred in April 2004), in theaggregate, approximately 59% of the common stock and had agreed to tender4,448,900 shares, or approximately 54% of the common stock, held by them, intothe tender offer. No other stockholders tendered shares in the offer.

 

Following the completion of the tender offer,and assuming the exercise of 330,000 options and warrants held by Mr. Brodsky,which occurred in April 2004, New Mountain Partners owned securities at March 19,2004 that were initially convertible into approximately 64% of the common stockand prior to conversion of the series A preferred stock were entitled tocast that number of votes that is equal to approximately 60% of the Company’saggregate voting power. Following the closing of the New Mountain Transaction,New Mountain Partners was entitled to and did nominate and elect 60% of themembers of the Company’s board of directors.

 

10

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The Company used the remaining proceeds fromthe issuance and sale of the series A preferred stock of approximately$24,000, excluding expenses related to the closing of the New MountainTransaction, for the Inteq Acquisition described in Note 4 – BusinessAcquisitions and for working capital purposes.

 

The preferred stock provides for an initialannual cash dividend equal to 7% of the investment amount, which decreases to3.5% after the fifth anniversary of issuance. The preferred stock isconvertible into the Company’s common stock at a price of $11.50 per share ofcommon stock, or an aggregate of approximately 7,000,000 shares of the Company’scommon stock.

 

The series A preferred stock may beredeemed at the Company’s option subsequent to the fourth anniversary of itsissuance, subject to certain conditions. After the tenth anniversary of theissuance of the series A preferred stock, each holder of shares of series Apreferred stock may require the Company to redeem all or a part ofthat holder’s shares of series A preferred stock.

 

4.                                       BUSINESS ACQUISITIONS

 

On March 7, 2005, the Company acquiredall of the outstanding stock of Pharmaceutical Care Network, a Californiacorporation, from the California Pharmacists Association (the “PCN Acquisition”).The aggregate purchase price of the PCN Acquisition was $13,000 in cash. Inaddition, the Company has agreed to pay the California Pharmacists Association(“CphA”) earn-outs, as additional purchase price, up to $30,000 over a periodof three years if certain financial and performance targets are achieved. Thefunds for the payment of the purchase price in connection with the PCNAcquisition were obtained out of the Company’s working capital and the JPMorgancredit facility (See Note 5). The PCN operations complement the Company’sbusiness while strengthening the Company’s presence in the Californiamarketplace as well as in the Medicaid managed care market.

 

In addition to the $13,000 purchase price for the PCN Acquisition,there were $561 of acquisition related expenses incurred by the Company. Of the$13,000, $10,500 was paid to CPhA and certain of PCN’s current and former employeeswho participated in its Long Term Incentive Plan, and $2,500 was deposited intoescrow to secure CPhA’s obligations under the purchase agreement. At the timeof the acquisition, PCN had approximately $30,942 of assets which included$16,711 of cash, $2,734 of restricted cash, $3,204 of accounts receivable,$6,090 of rebates receivable, $1,139 of other assets, and $1,064 of propertyand equipment. They also had approximately $27,040 of liabilities whichincluded $26,848 of claims and accounts payable, $97 of other currentliabilities and $95 of other long-term liabilities. As a result of the PCNAcquisition, $2,842 of severance and exit costs have been accrued as of September 30,2005, with $1,223 recorded as a deferred tax asset and $1,619 recorded asadditional goodwill. Of this amount, $592 was paid as of September 30,2005. The acquisition was accounted for under the purchase method of accountingand the results of PCN’s operations were included in the consolidated financialstatements commencing as of the closing date of the PCN Acquisition. The excessof the acquisition costs over the fair value of identifiable net assetsacquired was $11,957, which consists of the following components: “know how”and computer software valued at $870, which will be amortized over ten (10) years, customerrelationships valued at

 

11

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$380, which will be amortized over ten (10) years,and goodwill of $10,707, which will not be amortized for book purposes per SFAS142. As of September 30, 2005, $190 of additional earn-out has beenaccrued based upon the tentative achievement of certain financial andperformance targets.

 

On April 1, 2004, the Company enteredinto an Asset Purchase Agreement with Inteq PBM, LP, a Texas limitedpartnership (the “Purchaser”), The INTEQ-RX Group, LLP and certain other ownersnamed therein (together with The INTEQ-RX Group, LLP, the “The Inteq Group”),pursuant to which the Company agreed to acquire certain assets of the The InteqGroup relating to their pharmacy benefit management business (the “InteqAcquisition”). The aggregate purchase price of the Inteq Acquisition was$31,500 in cash. In addition, the Company agreed to pay The Inteq Group, asadditional purchase price, up to $4,200 over a period of one year if theacquired PBM business achieved certain financial performance targets during theone-year period following the closing.

 

In addition, $3,000, out of the $4,200potential to be paid to The Inteq Group, was placed in escrow to secure theCompany’s obligations to pay The Inteq Group additional purchase price ifcertain targets were achieved during the first year, and such escrowed amountis included in other assets in the consolidated balance sheet. To date, $1,024out of a total potential of $4,200, of additional consideration has been earnedand released from escrow.

 

OnJuly 31, 2003, the Company entered into a Stock Purchase Agreement withPortland Professional Pharmacy (“PPRX”), Portland Professional PharmacyAssociates (“PRXA”, and together with PPRX, “PPP” or “NMHC Ascend”) and theindividual shareholders (the “PPP Shareholders”) to purchase all of the sharesof PPP for $3,150 (the “PPP Acquisition”). PPP provides specialty-pharmacyservices in a broad range of areas, including women’s health, pediatric care,men’s health and transplant. In addition, the Company agreed to pay to the PPPShareholders up to $7,000 over a three-year period if the PPP business achievedcertain financial targets. At the Company’s sole discretion, as much as 50% ofthe $7,000 can be paid in the form of Company stock. For the first yearended July 31, 2004, $716 was earned and was paid on September 15,2004. Of this amount, $358 was paid in cash and $358 was paid in the form ofthe Company’s common stock (12,650 shares at $28.30 per share). For the secondyear ended July 31, 2005, $851 was earned and was paid on September 15,2005. Of this amount, $426 was paid in cash and $425 was paid in the form ofthe Company’s common stock (17,127 shares at $24.84 per share). For the thirdyear, through September 30, 2005, $134 has been earned and will be settledin September 2006.

 

Eachof PRXA and PPRX continues to operate under their respective names, and alsodoes business under the name NMHC Ascend.

 

TheCompany entered into an Asset Purchase Agreement (the “Asset Purchase Agreement”),dated as of January 29, 2002, with HSL, HSL Acquisition Corp., a Delawarecorporation and a wholly-owned subsidiary of the Company (“Sub”), and thesecurity holders of HSL named therein, pursuant to which the Company agreed toacquire certain assets of HSL relating to the pharmacy benefit managementbusiness (PBM) conducted by HSL under the name “Centrus”

 

12

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(the“Centrus Acquisition”). The aggregate purchase price of the Centrus Acquisitionwas $40,000 in cash. In addition, the Company has agreed to pay HSL asadditional purchase price up to $4,000 over a period of three (3) years ifthe acquired Centrus business achieves certain financial performance targetsduring the two-year period following the Centrus closing. The financialperformance targets were achieved during the first two years and $4,000 hasbeen earned. Of this amount, $1,000 was paid in May 2003, $2,000 was paidin May 2004, and another $1,000 was paid in May 2005.

 

Thesummarized unaudited pro forma results of operations set forth below for thethree months ended September 30, 2005 and 2004 assumes the PCN Acquisitionhad occurred as of the beginning of these periods.

 
| ** **                                                       | ** ** | **Three Months Ended  September 30, 2005** | ** ** | **Three Months Ended  September 30, 2004** | ** ** |
|------------------------------------------------------------------|------------|-------------------------------------------------|------------|-------------------------------------------------|------------|
| Revenue                                                          |       | $                                               | 214,692    |                                            | $          | 207,281 |   |
| Net income                                                       |       | $                                               | 2,867      |                                            | $          | 2,238 |   |
| Net income available to common Stockholders                      |       | $                                               | 1,335      |                                            | $          | 707 |   |
| Earnings per common share:                                       |       |                                            |       |                                            |       |
| Basic                                                            |       | $                                               | 0.27       |                                            | $          | 0.16 |   |
| Diluted                                                          |       | $                                               | 0.24       |                                            | $          | 0.06 |   |
| Pro forma weighted-average number of common shares  outstanding: |       |                                            |       |                                            |       |
| Basic                                                            |       | 4,862                                           |       | 4,400                                           |       |
| Diluted                                                          |       | 12,102                                          |       | 11,904                                          |       |

 

Thispro forma financial information is presented for information purposes only. Proforma adjusted net income per common share, including acquisitions, may notbe indicative of actual results, primarily because pro forma earnings includehistorical results of operations of the acquired entity and do not reflect anycost savings or potential sales erosion that may result from the Company’sintegration efforts. In addition, while PCN has traditionally recorded allrevenue on a gross basis, the Company has adjusted the historical amounts toreflect certain contracts on a revenue basis consistent with NMHC’s policies.

 

Thechange in the carrying amount of goodwill for the three months ended September 30,2005 is as follows:

 
| Balance as of June 30, 2005      |   | $      | 99,710 |   |
|---------------------------------------|--------|--------|--------|--------|
| PCN acquisition                       |   | (50    | )      |
| PCN additional consideration earned   |   | (46    | )      |
| PPP additional consideration earned   |   | 190    |   |
|                                  |   |   |   |
| Balance as of September 30, 2005 |   | $      | 99,804 |   |

 

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Approximately$81,323 of the Company’s September 30, 2005 goodwill is deductible forincome tax purposes on a straight-line basis over 15 years.

 

Acquiredintangible assets subject to amortization consisted of the following:

 
| ** **             | ** ** | **September 30, 2005** | ** ** | **June 30, 2005**       | ** ** |
|------------------------|------------|-----------------------------|------------|------------------------------|------------|
| **Asset Class**        | ** ** | **Gross  Carrying  Amount** | ** ** | **Accumulated Amortization** | ** ** | **Gross  Carrying  Amount** | ** ** | **Accumulated Amortization** | ** ** |
| Customer relationships |       | $                           | 5,326      |                         | $          | 2,597 |   | $ | 5,296 |   | $ | 2,410 |   |
| Non-compete agreements |       | 220                         |       | 168                          |       | 220 |   | 156 |   |
| Employment agreements  |       | 186                         |       | 139                          |       | 186 |   | 133 |   |
| Trade name             |       | 100                         |       | 44                           |       | 100 |   | 37 |   |
| Company know how       |       | 1,442                       |       | 607                          |       | 1,422 |   | 537 |   |
|                   |       | $                           | 7,274      |                         | $          | 3,555 |   | $ | 7,224 |   | $ | 3,273 |   |

 

5.                                       DEBT

 

On January 28, 2005, the Company andcertain of its subsidiaries entered into a five-year $65,000 cash flow based,line of credit with a syndicate of commercial banks led by JPMorgan Chase Bank,N.A. (JPMorgan). Subject to certain conditions including the consent of theexisting lenders, the new line of credit (the “JPMorgan credit facility”) may beincreased by an aggregate of $35,000.

 

Depending on the timing and dollar amountof each loan request, the Company will either borrow at a spread above LIBOR,the overnight Federal Funds rate or JPMorgan’s prime rate. The initial spreadwas 1.75% for LIBOR and Federal Funds loans and 0.75% for prime rate loans. Afterreceipt of the Company’s consolidated financial statements for the fiscal yearended June 30, 2005, the spreads decreased due to a favorable ratio ofdebt to annual EBITDA. The current spread is 1.50% for LIBOR and Federal Fundsloans and 0.50% for prime rate loans.

 

The JPMorgan credit facility is secured bythe Company’s consolidated assets. The JPMorgan credit facility requires theCompany to be in compliance with financial and other covenants. The threedefined financial covenants include: consolidated net worth; consolidated fixed charge ratio; and consolidateddebt to EBITDA ratio. The Company was in compliance with all covenants at September 30,2005.

 

6.                                       STOCK OPTIONS

 

During the three months ended September 30,2005, the Company granted stock options under the 1999 Stock Option Plan, asamended (the “Plan”). The options granted during this period are exercisable atprices ranging from $24.01 to $27.52 and terminate ten years from the grantdate.

 

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The total number of shares of common stock of theCompany reserved by the Company for issuance under the Plan is 4,850,000 plusan indeterminable number of shares of common stock of the Company issuablepursuant to the anti-dilution provisions of the Plan or upon the exercise of “reloadoptions.”  There are no optionsoutstanding that contain the “reload” provision. There are 1,389,561 sharesissuable pursuant to options granted under the Plan as of September 30,2005. The following table summarizes information about stock option activityfor the three months ended September 30, 2005:

 
|                                           |   | **Number of  Options** |   | **Weighted-Average  Exercise Price  Per Share** |   |
|------------------------------------------------|--------|------------------------|--------|-------------------------------------------------|--------|
| Outstanding options at June 30, 2005      |   | 1,441,213              |   | $                                               | 16.52  |   |
| Canceled                                       |   | (9,749                 | )      | 23.04                                           |   |
| Granted                                        |   | 119,931                |   | 26.24                                           |   |
| Exercised                                      |   | (159,931               | )      | 10.02                                           |   |
|                                           |   |                   |   |                                            |   |
| Outstanding options at September 30, 2005 |   | 1,391,464              |   | 18.06                                           |   |
|                                                |        |                        |        |                                                 |        |  |

 

Thefollowing table summarizes information about stock options outstanding at September 30,2005:

 
| ** **              | ** **  | **Outstanding**       | ** ** | **Exercisable**                             | ** ** |
|-------------------------|-------------|-----------------------|------------|---------------------------------------------|------------|
| **Option  Price Range** | ** **  | **Number of  Shares** | ** ** | **Weighted-  average  Remaining Life** | ** ** | **Weighted-  average  Exercise  Price** | ** ** | **Number  of  Shares** | ** ** | **Weighted-  average  Exercise  Price** | ** ** |
| $                       | 1.67   |                  | to         |                                        | $          | 2.51 |   |   | 17,000 |   | 0.24 years |   | $ | 1.75 |   | 17,000 |   | $ | 1.75 |   |
| $                       | 2.52   |                  | to         |                                        | $          | 3.78 |   |   | 4,105 |   | 0.80 years |   | $ | 3.14 |   | 4,105 |   | $ | 3.14 |   |
| $                       | 3.79        |                  | to         |                                        | $          | 5.69 |   |   | 1,800 |   | 0.97 years |   | $ | 4.41 |   | 1,800 |   | $ | 4.41 |   |
| $                       | 5.70        |                  | to         |                                        | $          | 8.55 |   |   | 47,087 |   | 1.97 years |   | $ | 7.70 |   | 44,800 |   | $ | 7.69 |   |
| $                       | 8.56        |                  | to         |                                        | $          | 12.84 |   |   | 454,772 |   | 2.16 years |   | $ | 9.97 |   | 397,695 |   | $ | 9.78 |   |
| $                       | 12.85  |                  | to         |                                        | $          | 19.28 |   |   | 141,485 |   | 5.61 years |   | $ | 13.86 |   | 42,690 |   | $ | 13.98 |   |
| $                       | 19.29       |                  | to         |                                        | $          | 28.94 |   |   | 607,136 |   | 8.63 years |   | $ | 23.89 |   | 60,262 |   | $ | 24.89 |   |
| $                       | 28.95       |                  | to         |                                        | $          | 36.66 |   |   | 118,079 |   | 3.65 years |   | $ | 31.45 |   | 72,719 |   | $ | 32.24 |   |
|                    |        |                  |       |                                        |       |   |   |   |   |   |   |   |   |   |   |   |
| $                       | 1.67        |                  | to         |                                        | $          | 36.66 |   |   | 1,391,464 |   | 5.42 years |   | $ | 18.06 |   | 641,071 |   | $ | 13.61 |   |

 

7.                                       EARNINGS PER SHARE

 

A reconciliation of shares used in calculating basicand diluted earnings per share follows:

 

15

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| ** **                                                              | ** ** | **Three Months EndedSeptember 30,** | ** ** |
|-------------------------------------------------------------------------|------------|------------------------------------------|------------|
| ** **                                                              | ** ** | **2005**                                 | ** ** | **2004** | ** ** |
| Basic                                                                   |       | 4,861,853                                |       | 4,399,668 |   |
| Effect of assumed exercise of employee stock options                    |       | 283,863                                  |       | 548,291 |   |
| Effect of assumed conversion of redeemable  convertible preferred stock |       | 6,956,522                                |       | 6,956,522 |   |
| Diluted weighted average number of shares  outstanding                  |       | 12,102,238                               |       | 11,904,481 |   |

 

Basic net income per common share is computed bydividing the net income available to common stockholders by theweighted-average number of common shares outstanding during the period. For thethree months ended September 30, 2005 and 2004, diluted net income pershare is computed by dividing the net income by the weighted-average number ofcommon and dilutive common equivalent shares (consisting of employee stockoptions and redeemable preferred stock as if converted) outstanding during theperiod.

 

8.                                       ACCOUNTSPAYABLE AND ACCRUED EXPENSES

 

Accounts payable and accrued expenses consist of thefollowing:

 
| ** **                                    | ** ** | **September 30,  2005** | ** ** | **June 30,  2005** | ** ** |
|-----------------------------------------------|------------|------------------------------|------------|-------------------------|------------|
| Claims payable to pharmacies                  |       | $                            | 130,520    |                    | $          | 118,660 |   |
| Rebates payable to sponsors                   |       | 57,547                       |       | 45,436                  |       |
| Trade and other payables and accrued expenses |       | 17,246                       |       | 24,747                  |       |
|                                          |       |                         |       |                    |       |
|                                          |       | $                            | 205,313    |                    | $          | 188,843 |   |

 

9.                                       RELATED PARTYTRANSACTIONS

 

TheCompany receives certain services from the Chairman of the Board as per aconsulting agreement signed at the end of his employment with the Company. Duringthe three months ended September 30, 2005 and 2004, $31 and $11,respectively were paid under this agreement.

 

Inaddition, the Company rents two houses from Living in Style, LLC, an entityowned partially by an executive officer and the current Chairman of the Board. Duringthe three months ended September 30, 2005 and 2004, $36 and $35,respectively, were paid for rent for these two houses.

 

10.                                 MAJOR CUSTOMERS AND PHARMACIES

 

Forthe three months ended September 30, 2005 and 2004, approximately 14% and20%, respectively, of the consolidated revenue of the Company was from one plansponsor, MVP Health Plan, Inc., administering multiple plans. Amounts duefrom the sponsor as of September 30, 2005 approximated $9.2 million.

 

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Forthe three months ended September 30, 2005 and 2004, no pharmacy chainaccounted for more than 10% of the total cost of claims.

 

11.                                 SUPPLEMENTAL CASH FLOW INFORMATION

 

Duringthe three months ended September 30, 2005 and 2004, the Company paid $84and $135 in interest, and $8 and $119 in income taxes, respectively.

 

12.                                 LITIGATION

 

Anaction was commenced against the Company on April 30, 2002 by MidwestHealth Plan Inc. (“MHP”) in the United States District Court for the EasternDistrict of Michigan. The amended complaint alleged, among other things, thatthe parties entered into a contract dated July 1999 (the “Agreement”), andfurther alleged that the Company overcharged MHP for the administration ofprescription benefit services in contravention to the terms of the Agreementand breached its fiduciary duties by making a profit. In August 2005, theCompany paid MHP $2,000 in cash in complete settlement of all outstandingclaims by both parties, and the case was dismissed with prejudice. This amountwas accrued to selling, general and administrative expenses as of June 30,2005.

 

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** **

**ITEM 2 –**MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTSOF OPERATIONS 

 

OPERATING INCOME

($ in thousands)

Three months ended September 30,

 
| ** **                                    | ** ** | **2005** | ** ** | **Increase/  (Decrease)** | ** ** | **2004** | ** ** |
|-----------------------------------------------|------------|----------|------------|---------------------------|------------|----------|------------|
| Revenue                                       |       | $        | 214,692    |                      | 16.1       | %        | $          | 184,842 |   |
| Cost of Claims                                |       | 191,130  |       | 15.7                      | %          | 165,165  |       |
| Gross profit                                  |       | 23,562   |       | 19.7                      | %          | 19,677   |       |
| Selling,  general, and administrative expense |       | 18,638   |       | 23.6                      | %          | 15,079   |       |
| Operating Income                              |       | $        | 4,924      |                      | 7.1        | %        | $          | 4,598 |   |

 

**Results ofOperations**

 

***Three Months Ended September 30, 2005 Compared to Three MonthsEnded September 30, 2004***

 

Revenueincreased $29.9 million, or approximately 16.1%, from $184.8 million for thethree months ended September 30, 2004, to $214.7 million for the threemonths ended September 30, 2005. Revenue recognized for contracts recordedon a gross revenue basis was $184.0 million for the three months ended September 30,2004 and $212.4 million for the three months ended September 30, 2005.Revenue recognized for contracts recorded on a net revenue basis was $0.8 millionfor the three months ended September 30, 2004 and $2.3 million for thethree months ended September 30, 2005. The specific terms of the contractsthat we enter into with our sponsors will determine whether we recognize thegross revenue related to the cost of the prescriptions filled (see CriticalAccounting Policies and Estimates – Revenue Recognition). For those contractsthat we recognize net revenue, there is no impact on gross profit since neitherthe prescription revenue nor the related costs of the prescriptions isrecorded. Whether revenues are recorded on either a gross or net basis, werecord the gross amount billed in accounts receivable and the related claimspayable to the pharmacies on the balance sheet. We include in revenue onlythose co-payments collected in our mail service facility in Miramar, Florida.For the three months ended September 30, 2005, there was approximately$4.8 million of co-payments included in revenue versus $2.3 million for thethree months ended September 30, 2004. Co-payments retained by pharmacieson prescriptions filled for our members and not included in our revenue were$77.5 million and $53.9 million, for the three months ended September 30,2005 and 2004, respectively.

 

Ofthe $29.9 million increase in revenue during the three months ended September 30,2005, $18.9 million was attributable to the inclusion of revenue generated byPCN that was not included in the quarter ended September 30, 2004.Co-payments received from the mail service operations accounted for $2.5million of the increase. Another approximately $13.8 million of the increasewas due to revenue related to new sponsors or new services offered during thequarter ended September 30, 2005 excluding contracts recorded on a netrevenue basis. An

 

18

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additionalnet increase of approximately $9.8 million was attributable to other existingsponsors related to, among other things, higher costs for pharmaceuticals,availability of new drugs, plan participant growth and an increase in theaverage number of claims per plan participant, as well as changes in othermiscellaneous revenue items. These revenue increases were offset by revenuedecreases related to the termination of existing customer contracts leading toa reduction in revenue of approximately $15.1 million.

 

Cost of claims increased $26.0 million, orapproximately 15.7%, from $165.2 million for the three months ended September 30,2004 to $191.1 million for the three months ended September 30, 2005. PCNaccounted for $16.3 million of this increase. Increases in cost of claimstotaling approximately $13.3 million related to the activity of new sponsors,and another $10.7 million was attributable to the growth in existing sponsors.These cost increases were partially offset by the loss of sponsors whichreduced cost of claims by approximately $14.3 million. As a percentage ofrevenue, cost of claims decreased from 89.4% to 89.0% for the three monthsended September 30, 2004 and September 30, 2005, respectively. Thecontracts we recognized on a net revenue basis decreased our overall costs as apercentage of revenue due to the cost not being recognized on the contractsrecorded on the net revenue basis.

 

Grossprofit increased from $19.7 million for the three months ended September 30,2004 to $23.6 million for the three months ended September 30, 2005,representing a $3.9 million, or 19.7%, increase. PCN accounted for $2.6 millionof this increase, while another $1.3 million of incremental gross profit wasgenerated by the expanding mail service and specialty operations. Gross profit,as a percentage of revenue, increased from 10.6% to 11.0% for the three monthsended September 30, 2004 and September 30, 2005, respectively. Thecontracts that we recognize on a net revenue basis have the effect of improvingour gross margin as a percentage of revenue due to the fact that recordedrevenue and cost is lower since only the administrative fees related to thesecontracts are recorded. Competitive pressures which have led to a decline insome prices that we charge to our sponsors have had the effect of partiallyoffsetting the increases in gross margin described above.

 

Selling,general, and administrative expenses increased $3.6 million, or approximately23.6%, from $15.1 million for the three months ended September 30, 2004 to$18.6 million for the three months ended September 30, 2005. Approximately$2.4 million of this increase in selling, general, and administrative expensesis related to the acquisition of PCN. The major components of the $2.4 millionincrease in expenses related to the acquisition: 1) salaries and benefits –approximately $1.4 million, 2) IT related expenditures – approximately $0.3million, 3) office related expenditures – approximately $0.2 million, 4)depreciation and amortization – approximately $0.2 million, and 5) otherrelated expenditures – approximately $0.3 million. Another $0.3 million relatesto costs incurred as a result of compliance with the Sarbanes-Oxley Act andhigher audit fees. In addition, $0.7 million of the increase is the result ofcompensation expense relating to employee stock options, which were required tobe included in SG&A expenses beginning with the quarter ended September 30,2005.

 

Selling, general, and administrative expenses as apercent of revenue increased from 8.2% for the three months ended September 30,2004 to 8.7% for the three months ended September 30, 2005. Selling,general, and administrative expenses as a percent of revenue for the threemonths ended September 30, 2005 would have been 8.4% excluding thecompensation expense relating to employee stock options, which was included inthe current quarter, in accordance with FAS 123(R), which was adopted effectiveJuly 1, 2005 but not in the prior quarter.

 

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For the three months ended September 30, 2005,we earned other income, net, of approximately $82,000. For the three monthsended September 30, 2004, we incurred other expense, net, of approximately$79,000. The components of the approximate $161,000 increase in other income,net were an approximate $35,000 decrease in interest expense, an approximate$164,000 increase in interest income, offset by an approximate $38,000 reducedgain on assets sold. The primary reasons for the net increase in income werehigher cash balances due to increasing profitability and additional cash flowfrom operations, which resulted in a reduction of borrowings and relatedinterest expense and an increase in interest income on excess cash balances. Inaddition the gain on one of our two sales leaseback transactions was fullyrecognized as of September 30, 2004, resulting in a reduction of otherincome for the current period.

 

Incomebefore the provision for income taxes increased approximately $0.5 million, or11%, from approximately $4.5 million, for the quarter ended September 30,2004, to approximately $5.0 million for the quarter ended September 30,2005. The primary factor leading to this increase in income before income taxeswas the rise in gross profit, offset by the increase in selling, general andadministrative expenses related to the new acquisition and the initialexpensing of employee stock options.

 

Theeffective tax rate was approximately 42.7% for the quarter ended September 30,2005, compared to 41% for the quarter ended September 30, 2004. Theincrease in the effective tax rate for the three months ended September 30,2005 was the result of the expensing of employee incentive stock options inaccordance with FAS 123(R). This compensation expense, which is not deductiblefor tax purposes, increased our effective tax rate by 2.7%. The tax rate of42.7% represents our current estimated tax rate for the full 2006 fiscal year.

 

Netincome for the quarter ended September 30, 2005 was approximately $2.9million as compared to approximately $2.7 million for the quarter ended September 30,2004, which is an 8% increase. The increase in net income is attributable tothe same factors causing the increase in income before income taxes, offset bythe increase in the effective tax rate.

 

Inaddition, there were two charges against income available to commonstockholders related to the New Mountain Transaction (See Note 3 of Part 1,Item 1). The first of these charges relates to preferred stock cash dividends,which amounted to approximately $1.4 million for both the three months ended September 30,2005 and the three months ended September 30, 2004. The preferred stockprovides for an initial cash dividend equal to 7% of the investment amount(currently $80 million), which decreases to 3.5% after the fifth anniversary ofissuance. The dividends of approximately $1.4 million represent the amountaccrued and paid for the three months ended September 30, 2005 and September 30,2004, respectively. The second charge is for the accretion of transactionexpenses which were approximately $120,000 for the three months ended September 30,2005, and $119,000 for the three months ended September 30, 2004. Certaintransaction costs related to the New Mountain preferred stock investment ofapproximately $4.7 million were deducted from net proceeds and the carryingvalue of the preferred stock. These transaction costs are accreted to thepreferred stock carrying value over the ten-year life of the preferred stockinvestment.

 

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Afterdeducting these two charges from net income there remained net income availableto common stockholders of approximately $1.3 million for the three months endedSeptember 30, 2005, as compared to $1.1 million for the three months endedSeptember 30, 2004.

 

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# **Liquidity and Capital Resources**

 

Ourprimary cash requirements are for capital expenditures and operating expenses,including cost of pharmaceuticals, software and hardware upgrades and thefunding of accounts receivable and inventory in our mail service and specialtypharmacy facilities. Also, we require cash to execute our strategy of pursuingacquisitions of other PBM companies or of companies providing related services.As of September 30, 2005, we had a working capital deficit of $19.4million as compared to a working capital deficit of $24.4 million as of June 30,2005. The primary reason for the improvement in working capital was the profitsgenerated by NMHC during the three months ended September 30, 2005. Wehave now acquired seven companies since July 2000 utilizing primarilycash. This has had the effect of increasing our working capital deficits untilsufficient profitability is earned to offset these deficits.

 

Netcash provided by operating activities was $3.2 million for the three monthsended September 30, 2005, compared to $2.9 million for the three monthsended September 30, 2004. Cash flows from operating activities wereimpacted negatively in the fiscal 2006 period as a result of the increase inrebates receivable. This temporary increase was caused by a delay in thesubmission of our quarterly rebate billings to the pharmaceutical manufacturersdue to the integration of PCN claims into our rebate billing process.

 

Historically,the timing of our accounts receivable and accounts payable has generally been anet source of cash from operating activities. This is the result of the termsof trade in place with plan sponsors on the one hand, and our pharmacy networkon the other hand. These terms generally lead to our payments to participatingpharmacies being slower than its corresponding collections from plan sponsors.We believe that this situation is not unusual in the pharmacy benefitmanagement industry and expects to operate on similar terms for the foreseeablefuture. However, there can be no assurance that such terms of trade willcontinue in the future and, if they were to change materially, we could requireadditional working capital financing. Furthermore, if such terms of trade wereto change materially, and/or if we were unable to obtain additional workingcapital financing, there could be a material adverse effect on our business,financial condition, or results of operations.

 

Our accounts receivable have increased at arate faster than revenue because there are certain contracts, such as ourPreferred Partnership Program, in which, in general, we bill these pass-throughsponsors on a gross revenue basis but only recognize their revenue on a netbasis. The primary factor that leads to recognizing net revenue on thesePreferred Partnership Program contracts is that the amount that we earn isfixed. Under the Preferred Partnership Program contracts, which, in general,are full pass-through contracts, we receive a fixed charge per claim and asmall fixed percentage of the rebates subject to minimums; and all otherpharmacy costs

 

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are charged to the plan sponsor. The entireamount paid to the pharmacy is billed to the plan sponsor, and there is nomargin retained by us. For the three months ended September 30, 2005,billings from pass-through contracts increased 144% ($97.2 million) which wasthe primary reason for the 42% increase in accounts receivable.

 

Netcash used in investing activities was $2.2 million for the three months ended September 30,2005, as compared to $1.3 million for the three months ended September 30,2004. This increase of $0.9 million in net cash used in investing activitieswas the result of an increase in capital expenditures of $0.8 million alongwith an increase in the cash paid for the PPP Acquisition of $0.1 millioncompared to the three months ended September 30, 2004. The cash paymentsof $426,000 during the three months ended September 30, 2005 and $358,000for the three months ended September 30, 2004 for the PPP Acquisition arefor additional payments due under the earn-out provision (See Note 4 of Part 1,Item 1). We have accrued $134,000 through September 30, 2005 as additionalpurchase price related to the earn-out provision, which will be paid in September 2006.

 

Duringthe three months ended September 30, 2005, we generated $0.2 million fromfinancing activities compared to $1.4 million used by financing activities inthe three months ended September 30, 2004. This increase of $1.6 millionis the result of a $1.5 million increase in the proceeds from the exercise ofemployee stock options and a reduction of $0.1 million in the repayment ofcapital leases as all but two of our capital leases have ended.

 

OnJanuary 28, 2005, we entered into a five-year $65.0 million cash flowbased, line of credit with a syndicate of commercial banks led by JPMorganChase Bank, N.A. (“JPMorgan”). Subject to certain conditions, including theconsent of existing lenders, the new line of credit may be increased by anaggregate of $35.0 million. The JPMorgan credit facility contains variouscovenants that, among other things, require us to maintain certain financialratios, which are consolidated net worth, consolidated fixed charge ratio andconsolidated debt to EBITDA (earnings before interest, taxes, depreciation andamortization) ratio. As of September 30, 2005 there was no principal balanceoutstanding under the JPMorgan credit facility, and we were in compliance withour financial covenants.

 

Twoof these financial covenants are based upon the EBITDA generated by us overspecified periods of time. These covenants, consolidated fixed charge ratio andconsolidated debt to EBITDA ratio, are evaluated by JPMorgan as a measure ofour liquidity and our ability to meet all of our obligations under the creditfacility. EBITDA is presented as cash flow from operations plus or minus thenet changes in assets and liabilities and the changes in certain non-cashreconciling items from net cash from operations to net income over the reportedperiods. While EBITDA is not a measure of financial performance or liquidityunder generally accepted accounting principles, it is provided as informationfor investors for analytical purposes in light of the financial covenantsreferred to above. EBITDA is not meant to be considered a substitute orreplacement for net income as prepared in accordance with United Statesgenerally accepted accounting principles. EBITDA, which increased byapproximately $0.5 million or 8%, from $6.2 million for the three months ended September 30,2004 to $6.7 million for the three months ended September 30, 2005, iscalculated as follows (see Consolidated Statement of Cash Flows comprising Item1 hereof for more details):

 

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| ** **                                                          | ** ** | **Three Months Ended September 30,** | ** ** |
|---------------------------------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                                          | ** ** | **2005**                                  | ** ** | **2004** | ** ** |
| Cash flow from  operations                                          |       | $                                         | 3,233      |   | $ | 2,910 |   |
| Provision for  income taxes                                         |       | 2,139                                     |       | 1,853 |   |
| Interest  (income) expense, net                                     |       | (70                                       | )          | 129 |   |
| Net change in  assets and Liabilities                               |       | 2,511                                     |       | 1,454 |   |
| Non-cash items  to reconcile net cash from operations to net income |       | (1,070                                    | )          | (126 | ) |
|                                                                |       |                                      |       |   |   |
| EBITDA                                                              |       | $                                         | 6,743      |   | $ | 6,220 |   |

 

Wehave entered into various capital lease transactions for hardware and software.We have also assumed various capital leases through our acquisitions. As of September 30,2005, there are two capital leases remaining in effect.

 

Wehave entered into various real estate operating leases with both related andunrelated parties. We have entered into various equipment operating leases anda sale-leaseback with unrelated third parties for office and mail serviceequipment. These leases have different payment terms and expiration dates. SeeNote 11 to the Consolidated Financial Statements comprising Item 8 of Form 10–Kfor the year ended June 30, 2005 for a further description of thesevarious leases.

 

The total future payments under these contractual obligations as of September 30,2005, are as follows:

 
| ** **                          | ** ** | **Payments Due by Period** | ** ** | ** **              | ** ** |
|-------------------------------------|------------|----------------------------|------------|-------------------------|------------|
| **Contractual Obligations**         | ** ** | **($ in thousands)**  | ** ** | **More  than  5 Years** | ** ** |
| **Total**                           | ** ** | **Less than  1 Year**      | ** ** | **1-3  Years**          | ** ** | **4-5  Years** |
| Long Term Debt                      |       | $                          | —     |                    | $          | — |   | $ | — |   | $ | — |   | $ | — |   |
| Capital Lease  Obligations          |       | 39                         |       | 30                      |       | 9 |   | — |   | — |   |
| Operating Leases                    |       | 23,722                     |       | 7,245                   |       | 9,870 |   | 4,030 |   | 2,577 |   |
| Sale-leasebacks                     |       | 175                        |       | 140                     |       | 35 |   | — |   | — |   |
| Total  Contractual Cash Obligations |       | $                          | 23,936     |                    | $          | 7,415 |   | $ | 9,914 |   | $ | 4,030 |   | $ | 2,577 |   |

 

Theshareholders of PCN are eligible to receive additional consideration of up to$30.0 million, if certain financial and performance targets are met over thethree year period beginning March 1, 2005. As of September 30, 2005,$190,000 has been accrued based upon the tentative achievement of certainfinancial and performance targets.

 

Theshareholders of the Inteq Group were eligible to receive additionalconsideration of up to $4.2 million, if certain financial targets were metduring the year ending April 1, 2005. Of this

 

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potentialamount, $3.0 million was deposited in escrow at the time of closing. As of September 30,2005, $1.0 million was earned and paid.

 

Theshareholders of PPP are eligible to receive additional consideration of up to$7.0 million, if certain financial targets are met over the three year periodbeginning August 1, 2003. Such amounts earned are payable within 45 daysafter the first, second, and third anniversary of the date of acquisition. Inthe sole discretion of NMHC, up to 50% of any amounts earned can be paid in theform of our stock in lieu of cash. For the year ended July 31, 2004,$716,000 has been earned and was paid on September 15, 2004. Of thisamount, $358,000 was paid in cash and $358,000 was satisfied by the issuance of12,650 shares of our common stock. For the year ended July 31, 2005,$851,000 has been earned and was paid on September 15, 2005. Of thisamount, $426,000 was paid in cash and $425,000 was satisfied by the issuance of17,127 shares of our common stock. As of September 30, 2005, $134,000 hasbeen accrued as additional purchase price and will be paid in September 2006.

 

Weentered into an amended and restated preferred stock purchase agreement, datedas of November 26, 2003, with New Mountain Partners, L.P. (the “purchaseagreement”). Pursuant to the purchase agreement, we agreed, subject to variousconditions, to issue to New Mountain Partners a total of 6,956,522 shares of series Apreferred stock at a purchase price of $11.50 per share, for aggregate proceedsof approximately $80 million. On March 19, 2004, we completed the sale ofthe series A preferred stock to New Mountain Partners and usedapproximately $49 million of the proceeds of the sale of the series Apreferred stock to purchase, pursuant to a tender offer, 4,448,900 shares ofour outstanding common stock at $11.00 per share..

 

Followingthe completion of the tender offer, New Mountain Partners owned securities at March 19,2004 that were initially convertible into approximately 64% of our issued andoutstanding common stock and prior to conversion of the series A preferredstock were entitled to cast that number of votes that is equal to approximately60% of our aggregate voting power. Following the closing of the New MountainTransaction, New Mountain Partners were entitled to and did nominate and elect60% of the members of our board of directors.

 

Weused the remaining proceeds from the issuance and sale of the series Apreferred stock of approximately $24 million, excluding expenses relatedto the closing of the New Mountain Transaction, for the Inteq Acquisition (SeeNote 4 of Part 1, Item 1) and working capital purposes.

 

Thepreferred stock provides for an initial annual cash dividend equal to 7% of theinvestment amount, which decreases to 3.5% after the fifth anniversary ofissuance. The preferred stock is convertible into common stock at a price of$11.50 per share of common stock, or an aggregate of approximately 7 millionshares of our common stock.

 

Theseries A preferred stock may be redeemed at our option subsequent tothe fourth anniversary of its issuance, subject to certain conditions. Afterthe tenth anniversary of the issuance of the series A preferred stock,each holder of shares of series A preferred stock may require us toredeem all or a part of that holder’s shares of series A preferredstock.

 

Weanticipate that current cash positions and available credit facilities, afterour seven acquisitions together with anticipated cash flow from operations,will be sufficient to satisfy our

 

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contemplatedcash requirements for at least 24 months. This is based upon current levels ofcapital expenditures and anticipated operating results for the next 24 months.However, it is one of our stated goals to acquire other pharmacy benefitmanagement companies and companies providing related services. Depending on ourevaluation of future acquisitions, additional cash may be required tocomplete these acquisitions. In addition, we will require cash to acquireadditional inventory for our mail service and specialty distribution divisionsto service our expanding operations. In the event that our plans change or ourassumptions prove to be inaccurate, or the proceeds from the new revolvingcredit facility and the New Mountain Transaction prove to be insufficient tofund operations and acquisitions, we could be required to seek additionalfinancing sooner than anticipated. There can be no assurance that suchfinancing could be obtained at rates or on terms acceptable to us, if at all.

 

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**OtherMatters**

 

***Inflation***

 

Managementdoes not believe that inflation has had a material adverse impact on our netincome.

 

**Critical Accounting Policies and Estimates**

 

***General***

 

Ourdiscussion and analysis of NMHC’s financial condition and results of operationsare based upon our unaudited consolidated financial statements, which have beenprepared in accordance with United States generally accepted accountingprinciples. The preparation of these financial statements requires us to makeestimates and judgments that affect the reported amounts of assets,liabilities, revenue and expenses; these estimates and judgments also affectrelated disclosures of contingent assets and liabilities. On an on-going basis,we evaluate our estimates and judgments, including those related to revenuerecognition, bad debt, intangible assets, income taxes, softwarecapitalization, and share-based payments. We base our estimates on experienceand on various other assumptions that are believed to be reasonable under thecircumstances, the results of which form the basis for making judgmentsabout the carrying values of assets and liabilities that are not readilyapparent from other sources. Actual results may differ from theseestimates under different assumptions or conditions.

 

Webelieve that of our significant accounting policies (See Note 1 to theConsolidated Financial Statements comprising Item 8 of Form 10-K for theyear ended June 30, 2005), the following may involve a higher degreeof judgment and complexity than others:

 

***Revenue Recognition***

 

(a)                                  Since January 1, 2000, all servicesprovided by NMHC have been on a fee for service basis. Under the fee forservice arrangement, we are paid by our sponsors for our contractually agreedupon rates based upon actual claims adjudicated, plus a fixed transaction fee.

 

Revenue under the fee for service arrangement isrecognized when the claims are adjudicated. Included as revenue are ouradministrative fees and charges relating to pharmaceuticals dispensed by ournetwork of pharmacies. Revenue is reduced by the amount of rebates paid to oursponsors.

 

(b)                                 The specific terms of the contracts that weenter into with our sponsors will determine whether we recognize the grossrevenue related to the cost of the prescriptions filled. There are severalfactors from EITF 99-19 that led us to recognize the majority of our revenue ona gross basis. These include: we act as a principal and not an agent and arethe primary obligor in the relationship among the pharmacies, the sponsors andNMHC, we have credit risk, we have certain latitude in establishing price, andwe have discretion in supplier selection. In certain cases, primarily becausethe amount we earn is fixed, we have not recognized the gross revenue or costrelated to prescriptions filled for a specific

 

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sponsor. This has no impact on our gross profitsince neither the prescription revenue nor the related cost of theprescriptions is recorded. Whether revenues are recorded on either a gross ornet basis, we record the gross amount billed in accounts receivable and therelated claims payable to the pharmacies on the balance sheet.

 

(c)                                  We include in revenue only those co-paymentscollected from individual members by our mail service facility in Miramar,Florida. Co-payments retained by pharmacies on the remainder of theprescriptions filled for our members are not included in our reported revenue.We disclose these amounts parenthetically on the face of our ConsolidatedStatement of Income.

 

(d)                                 Rebates are recognized when we are entitledto them in accordance with the terms of our arrangements with drugmanufacturers, third party rebate administrators, and sponsors, and when theamount of the rebates is determinable. We record the gross rebate receivableand the appropriate payable to the sponsors based on estimates, which aresubject to final settlement. The estimates are based upon the claims submittedand our rebate experience, and are adjusted as additional information becomesavailable.

 

***Bad Debt***

 

Wemaintain allowances for doubtful accounts for estimated losses resulting fromthe liability of our sponsors to make required payments. If the financialcondition of our sponsors were to deteriorate, resulting in an impairment oftheir ability to make payments, additional allowances may be required.

 

***Goodwill and Intangible AssetImpairment***

 

Inassessing the recoverability of our goodwill and other intangibles, we mustmake assumptions regarding estimated future cash flows and other factors todetermine the fair value of the respective assets. If these estimates or theirrelated assumptions change in the future, we may be required to record impairmentcharges for these assets not previously recorded. On July 1, 2001 weadopted Statement of Financial Accounting Standards No. 142, “Goodwill andOther Intangible Assets,” and are required to analyze our goodwill forimpairment issues on a periodic basis thereafter. To date, we have not recordedany impairment losses related to goodwill and other intangible assets.

 

***Deferred Taxes***

 

Weperiodically consider whether or not to record a valuation allowance to reduceour deferred tax assets to the amount that is more likely than not to berealized. While we have considered future taxable income and ongoing taxplanning strategies in assessing the need for the valuation allowance, in theevent we were to determine that we would be able to realize our deferred taxassets in the future in excess of its net recorded amount, an adjustment to thedeferred tax asset would increase income in the period such determination wasmade. Likewise, should we determine that we would not be able to realize all orpart of our net deferred tax asset in the future, an adjustment to thedeferred tax asset would be charged to income in the period such determinationwas made.

 

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***Capitalized Software***

 

Thecosts of software developed for internal use incurred during the preliminaryproject stage are expensed as incurred. Direct costs incurred during theapplication development stage which provide additional functionality arecapitalized. Costs incurred during the post-implementation/operation stage areexpensed as incurred. Capitalized software development costs are amortized on astraight-line basis over their estimated useful lives, commencing on the datethe software is placed into use, primarily three years.

 

***Share-Based Payments***

 

Followingthe adoption of FASB Statement No. 123(R), *Share-Based Payment*, we now include in our consolidatedstatement of income an estimate of the compensation cost resulting from theissuance of employee stock options. The calculation of this compensation costis dependent upon various valuation assumptions such as expected option life,volatility, risk-free interest rates, expected forfeiture rates, andpost-vesting terminations. While we believe that our employee stock optionrelated assumptions are reasonable, actual vesting and exercise patterns may besignificantly different.

 

**ITEM 3 - **QUANTITATIVE AND QUALITATIVE DISCLOSURESABOUT MARKET RISK 

 

NotApplicable.

 

**ITEM 4 –  **CONTROLS AND PROCEDURES 

 

Disclosurecontrols and procedures are the controls and procedures designed to ensure thatinformation that we are required to disclose in our reports under theSecurities Exchange Act of 1934, as amended (“Exchange Act”) is recorded,processed, summarized and reported within the time periods required. They include,without limitation, controls and procedures designed to ensure that informationis accumulated and communicated to management in order to allow timelydecisions regarding required disclosure.

 

Underthe supervision and with the participation of management, chiefly our principalexecutive officer and our principal financial officer, we evaluated theeffectiveness of the design and operation of our disclosure controls andprocedures (as defined in Rules 13a-15(e) and 15d-15(e) underthe Exchange Act), as of September 30, 2005. Based on that evaluation, ourprincipal executive officer and our principal financial officer have concludedthat these controls and procedures are effective in alerting them to materialinformation, on a timely basis, required to be included in our periodicSecurities and Exchange Commission filings. There have been no changes in ourinternal controls over financial reporting (as defined in Rules 13a-15(f) and15d-15(f) under the Exchange Act) that occurred in this period that havematerially affected, or are reasonably likely to materially affect, ourinternal controls over financial reporting.

 

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### **PART II– OTHER INFORMATION**

 

**ITEM 1 –**LEGAL PROCEEDINGS 

 

Thelegal proceeding described below should be read in conjunction with the legalproceeding disclosure in the following earlier reports: Part I, Item 3 andNote 11 to the consolidated financial statements of our Annual Report on Form 10-Kfor the year ended June 30, 2005.

 

Anaction was commenced against us on April 30, 2002 by Midwest Health PlanInc. (“MHP”) in the United States District Court for the Eastern District ofMichigan. The amended complaint alleged, among other things, that the partiesentered into a contract dated July 1999 (the “Agreement”), and furtheralleged that we overcharged MHP for the administration of prescription benefitservices in contravention to the terms of the Agreement and breached ourfiduciary duties by making a profit. On August 10, 2005, we paid MHP $2million in cash in complete settlement of all outstanding claims by bothparties, and the case was dismissed with prejudice.

 

**ITEM 2 –**UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

 

We agreed to pay the shareholders of PPP up to $7 million over athree-year period if the PPP business achieved certain financial targets (SeeNote 4 of Part 1, Item 1). For the year ended July 31, 2005, $851,000has been earned and was paid on September 15, 2005. Of this amount,$426,000 was paid in cash and $425,000 was satisfied by the issuance of 17,127shares of our common stock. The issuance of common stock was intended to beexempt from the registration requirements of the Securities Act of 1933, asamended, by virtue of Section 4(2) under the Securities Act becausethe securities were not offered to the public. No underwriters were involved inthe connection with the issuance of these securities.

 

**ITEM 3 –**DEFAULTS UPON SENIOR SECURITIES

 

None.

 

**ITEM 4 -  **SUBMISSION OF MATTERS TO A VOTE OF SECURITYHOLDERS 

 

None.

 

**ITEM 5 –**OTHER INFORMATION 

 

None.

 

**ITEM 6 –**EXHIBITS 

 

Exhibits

 

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| **Exhibit  Number** | ** ** | **Description of Exhibit**                                                                                                                                   |
|---------------------|------------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                |       |                                                                                                                                                                   |
| 3.1                 |       | Certificate  of Incorporation of NMHC (2)                                                                                                                              |
| 3.2                 |       | Certificate  of Amendment to the Certificate of Incorporation of NMHC (5)                                                                                              |
| 3.3                 |       | Amended  and Restated Bylaws of NMHC (5)                                                                                                                               |
| 3.4                 |       | Amended  and Restated Audit Committee Charter (5)                                                                                                                      |
| 3.5                 |       | Amendment  No. 1 to Amended and Restated By-Laws of NMHC                                                                                                          |
| 3.6                 |       | Nominating  and Corporate Governance Committee Charter (6)                                                                                                             |
| 4.1                 |       | Form of  Warrant Agreement, including form of Representatives’ Warrants (1)                                                                             |
| 4.2                 |       | Certificate  of Designation, Preferences and Rights of Series A 7% Convertible  Preferred Stock of NMHC (5)                                                       |
| 10.1                |       | Credit  Agreement dated January 28, 2005 among NMHC, the Lenders party thereto  and JPMorgan Chase, as Administrative Agent (7)                                   |
| 10.2                |       | Lease  Expansion and Modification Agreement dated July 31, 2003 between Sunbeam  Development Corporation and NMHCRx Mail Order, Inc. (3)                     |
| 10.3                |       | AmerisourceBergen  Prime Vendor Agreement, dated July 21, 2003 between NMHCRx Mail  Order, Inc. d/b/a NMHCmail and AmerisourceBergen Drug Corporation (3)    |
| 10.4                |       | Amendment  to Lease Agreement, dated as of October 23, 2003, by and among BFS  Realty, LLC and National Medical Health Card Systems, Inc. (4)                |
| 10.5                |       | Amendment  to Lease Agreement (30 Sea Cliff), dated as of October 30, 2003, between  Living in Style, LLC and National Medical Health Card Systems, Inc. (4) |
| 10.6                |       | Amendment  to Lease Agreement (32 Sea Cliff), dated as of October 30, 2003, between  Living in Style, LLC and National Medical Health Card Systems, Inc. (4) |
| 14.                 |       | Amended  and Restated Code of Ethics (8)                                                                                                                               |
| 31.1                |       | Rule 13a-14(a)/15d-14(a) Certification  of CEO pursuant to Section 302 of the Sarbanes-Oxley Act                                                        |
| 31.2                |       | Rule 13a-14(a)/15d-14(a) Certification  of CFO pursuant to Section 302 of the Sarbanes-Oxley Act                                                        |
| 32.1                |       | Section 1350  Certification of CEO as adopted by Section 906 of the Sarbanes-Oxley Act                                                                       |
| 32.2                |       | Section 1350  Certification of CFO as adopted by Section 906 of the Sarbanes-Oxley Act                                                                       |

 

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(1)           Denotes document filedas an Exhibit to NMHC’s Registration Statement on Form S-1(Registration Number:  333-72209) andincorporated herein by reference.

(2)           Denotes document filed as an Exhibit toNMHC’s Definitive Proxy Statement on Schedule 14-A filed on December 21,2001 and incorporated herein by reference.

(3)           Denotes document filed as an Exhibit toNMHC’s Report on Form 10-K for the year ended June 30, 2003 andincorporated herein by reference.

(4)           Denotes document filed as an Exhibit toNMHC’s Report on Form 10-K/A Amendment Number 2 for the year ended June 30,2003 and incorporated herein by reference.

(5)           Denotes document filed as an Exhibit toNMHC’s Form 10-Q for the quarter ended March 31, 2004 andincorporated herein by reference.

(6)           Denotes document filed as an appendix to NMHC’sDefinitive Proxy Statement on Schedule 14-A filed on October 28, 2005and incorporated herein by reference.

 

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(7)           Denotes document filed as an exhibit toNMHC’s Form 8-K filed on February 3, 2005 and incorporated herein byreference.

(8)           Denotes document filed on October 28,2004 as an exhibit to NMHC’s Definitive Proxy Statement on Schedule 14-Aand incorporated herein by reference.

 

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# SIGNATURES

 

Pursuant to the requirements of the SecuritiesExchange Act of 1934, as amended, the Registrant has duly caused this report tobe signed on its behalf by the undersigned thereunto duly authorized.

 

 

NATIONAL MEDICAL HEALTH CARDSYSTEMS, INC.

(Registrant)

 

 
| Date:   September 15, 2006 | By:                                                                  | /s/ James F. Smith |   |
|-------------------------------------------|----------------------------------------------------------------------|--------------------|--------|
|                                      | James F. Smith                                                       |
|                                      | President and Chief Executive Officer (Principal  Executive Officer) |
|                                      |                                                                 |
|                                      |                                                                 |
|                                      |                                                                 |
|                                      | By:                                                                  | /s/ Stuart Diamond |   |
|                                      | Stuart Diamond                                                       |
|                                      | Chief Financial Officer  (Principal Financial Officer)               |
|                                           |                                                                      |                    |        |  |

 

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