** **

**U.S. SECURITIES ANDEXCHANGE COMMISSION**

**WASHINGTON,DC 20549**

**FORM10-Q/A****AMENDMENT NO. 1**
| **(Mark One)**                                                                                                                                                                                     |                                                                                           |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------------------------------------------------------------------------------------------|
|                                                                                                                                                                                               |                                                                                           |
| **x**                                                                                                                                                                                              | **QUARTERLY REPORT PURSUANT TO SECTION 13 or 15(d)  OF THE SECURITIES EXCHANGE ACT OF 1934.**  |
| ** **                                                                                                                                                                                         |
| **For the  quarterly period ended March 31, 2006**                                                                                                                                                 |
| ** **                                                                                                                                                                                         |
| **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 filenumber 000-26749

**NATIONALMEDICAL HEALTH CARD SYSTEMS, INC.**(Exact Name of Registrant as Specified in Its Charter)

| **Delaware**                     |   | **11-2581812**                     |
|----------------------------------|--------|------------------------------------|
| (State or Other  Jurisdiction of |   | (IRS Employer  Identification No.) |
| Incorporation or  Organization)  |   |                               |

 

| **26 Harbor Park Drive, Port Washington, NY** |   | **11050**  |
|-----------------------------------------------|--------|------------|
| (Address of  Principal Executive Offices)     |   | (Zip Code) |

 

**(516)626-0007**Registrant’s Telephone Number, Including Area Code

**NotApplicable**Former Name, Former Address and Former Fiscal Year, if Changed Since LastReport.

Indicateby check mark whether the registrant: (1) has filed all reports required to befiled by Section 13 or 15(d) of the Securities Exchange Act of 1934 during thepreceding 12 months (or for such shorter period that the registrant wasrequired to file such reports), and (2) has been subject to such filingrequirements for the past 90 days. Yes x   No o

Indicateby check mark whether the registrant is a large accelerated filer, anaccelerated filer, or a non-accelerated filer. See definition of accelerated filer and large accelerated filer in Rule12b-2 of the Exchange Act.) (Check one):

Large acceleratedfiler o      Acceleratedfiler x      Non-accelerated filer o

Indicateby check mark whether the registrant is a shell company (as defined in Rule12b-2 of the Exchange Act.)Yes o   No x

**APPLICABLEONLY TO CORPORATE ISSUERS:**

The number ofshares outstanding of the issuer’s common stock, as of May 8, 2006 was5,291,428 shares.

 

 

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**NATIONAL MEDICAL HEALTH CARDSYSTEMS, INC. AND SUBSIDIARIES**

**Explanatory Note**

Aspreviously disclosed in National MedicalHealth Card Systems, Inc.’s (“NMHC”) Form 8-K filed with the  Securities and Exchange Commission (“SEC”) on September 12, 2006, onSeptember 11, 2006, in connection with the preparation of its annualreport on Form 10-K for the year ended June 30, 2006, NMHC concluded thatit should restate its previously issued financial statements for its thirdfiscal quarter ended March 31, 2006 to reflect the correction of tworebate cash receipts from one pharmaceutical manufacturer which resulted inNMHC recognizing additional rebate revenue during the quarter endedMarch 31, 2006 (the “Restatement”). In connection with the Restatement, this Amendment No. 1 to the quarterly report on Form 10-Q/A of NMHC hereby amends the information in itsForm 10-Q for the third fiscal quarter ended March 31, 2006, as filed with the SEC on February 9, 2006, to reflect adjustments to NMHC’s revenueand cost of claims for the three month period ended March 31, 2006. Theimpact of error realized in the estimation of rebates receivable and payable atDecember 31, 2005 on NMHC’s income statement was an understatement of operatingincome of $662,000 ($380,000 net of tax) for the quarter ended March 31,2006.  The Restatement has beenincorporated in Items 1 and 2 of Part I of this Form 10-Q/A to revise thedisclosure impacted by such restatement.  For the convenience of the reader, this Form 10-Q/A sets forth the original Form 10-Q in its entirety.  There was no impact on the results for thefull year ended June 30, 2006.  Fora more detailed description of the Restatement, see Note 2, “Restatement ofFinancial Statements,” to the accompanying consolidated financial statementsand the section entitled “Restatement” in Management’s Discussion andAnalysis of Financial Condition and Results of Operations contained in thisForm 10-Q/A.

This amendmentcontinues to speak as of the filing date of our original Form 10-Q for thequarter ended March 31, 2006.  We havenot restated, amended, modified, supplemented or updated the disclosurescontained in this amendment to reflect events that have occurred since thefiling of the original Form 10-Q, nor have we restated, amended, modified,supplemented or updated these disclosure in any other way other than asdescribed above.  Accordingly, thisamendment should be read in conjunction with our filings made with the SEC afterMay 10, 2006, the filing date of the original Form 10-Q.

2

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**NATIONAL MEDICAL HEALTH CARDSYSTEMS, INC. AND SUBSIDIARIES**

**INDEX**
| ** ** | ** ** | ** **                                                                                                       | **Page** |
|------------|------------|------------------------------------------------------------------------------------------------------------------|----------|
|            |       | FORWARD-LOOKING  STATEMENTS                                                                                      | 4        |
|       |       |                                                                                                             |     |
| PART  I    | —     | FINANCIAL  INFORMATION                                                                                           | 5        |
|       |       |                                                                                                             |     |
| ITEM 1     | —     | CONDENSED FINANCIAL STATEMENTS:                                                                                  | 5        |
|       |       |                                                                                                             |     |
|       |       | CONSOLIDATED  BALANCE SHEET as of March 31, 2006 (unaudited) and June 30, 2005                                   | 5        |
|       |       |                                                                                                             |     |
|       |       | CONSOLIDATED STATEMENT OF INCOME (unaudited) for the  three months and nine months ended March 31, 2006 and 2005 | 6        |
|       |       |                                                                                                             |     |
|       |       | CONSOLIDATED STATEMENT OF CASH FLOWS (unaudited) for  the nine months ended March 31, 2006 and 2005         | 7        |
|       |       |                                                                                                             |     |
|       |       | CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS                                                             | 8        |
|       |       |                                                                                                             |     |
| ITEM 2     | —     | MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL  CONDITION AND RESULTS OF OPERATIONS                      | 20       |
|       |       |                                                                                                             |     |
| ITEM 3     | —     | QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET  RISK                                                      | 32       |
|       |       |                                                                                                             |     |
| ITEM  4    | —     | CONTROLS  AND PROCEDURES                                                                                         | 32       |
|       |       |                                                                                                             |     |
| PART  II   | —     | OTHER  INFORMATION                                                                                               | 34       |
|       |       |                                                                                                             |     |
| ITEM 1     | —     | LEGAL PROCEEDINGS                                                                                                | 34       |
|       |       |                                                                                                             |     |
| ITEM 1A    | —     | RISK FACTORS                                                                                                     | 34       |
|       |       |                                                                                                             |     |
| ITEM 2     | —     | UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF  PROCEEDS                                                     | 34       |
|       |       |                                                                                                             |     |
| ITEM 3     | —     | DEFAULTS UPON SENIOR SECURITIES                                                                                  | 34       |
|       |       |                                                                                                             |     |
| ITEM 4     | —     | SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS                                                              | 34       |
|       |       |                                                                                                             |     |
| ITEM 5     | —     | OTHER INFORMATION                                                                                                | 34       |
|       |       |                                                                                                             |     |
| ITEM 6     | —     | EXHIBITS                                                                                                         | 34       |

 

3

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NATIONAL MEDICALHEALTH CARD SYSTEMS, INC. AND SUBSIDIARIES

**Forward-Looking Statements**

When used herein, the words “may,” “could,” “estimate,” “believe,”“anticipate,” “think,” “intend,” “expect” and similar expressions identifyforward-looking statements within the meaning of the Private SecuritiesLitigation Reform Act of 1995. Such statements are not guarantees of futureperformance and involve known and unknown risks and uncertainties, and otherfactors, which could cause actual results to differ materially from those inthe forward-looking statements. Readers are cautioned not to place unduereliance on such statements, which speak only as of the date hereof.  Forward-looking statements made by NationalMedical Health Card Systems, Inc. (“NMHC”, “our”, “we” or the “Company”) areintended to apply only at the time they are made, unless explicitly stated tothe contrary.  Moreover, whether or notstated in connection with a forward-looking statement, the Company makes nocommitment to revise or update any forward-looking statements in order toreflect events or circumstances after the date any such statement is made.  If the Company were in any particularinstance to update or correct a forward-looking statement, investors and othersshould not conclude that the Company would make additional updates orcorrections thereafter.

For a discussion of such risks and uncertainties, including risksrelating to pricing, competition in the bidding and proposal process, ourability to consummate contract negotiations with prospective clients,dependence on key members of management, government regulation, acquisitionsand affiliations, the market for pharmacy benefit management services, andother factors, readers are urged to carefully review and consider various disclosuresmade by the Company which attempt to advise investors of the factors whichaffect NMHC’s business, including, without limitation, the disclosures madeunder the caption “Description of Business — Risk Factors Affecting NMHC’sBusiness” in Item 1 and “Management’s Discussion and Analysis of FinancialCondition and Results of Operations” in Item 7 of NMHC’s Annual Report on Form10-K, for the fiscal year ended June 30, 2005, filed with the U.S. Securitiesand Exchange Commission on September 22, 2005, as amended.

 

4

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**PART I—FINANCIALINFORMATION**

ITEM 1—CONDENSED FINANCIAL STATEMENTSNATIONAL MEDICAL HEALTH CARD SYSTEMS, INC. AND SUBSIDIARIES

**CONSOLIDATEDBALANCE SHEET($ in thousands)**
| ** **                                                                                                                                              | ** ** | **March 31,** | ** ** | **June 30,** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------|------------|-------------------|------------|
| ** **                                                                                                                                              | ** ** | **2006_**          | ** ** | **_2005**         | ** ** |
| **Assets**                                                                                                                                              | ** ** | ** **         | ** ** | ** **        | ** ** |
| **Current:**                                                                                                                                            | ** ** | ** **         | ** ** | ** **        | ** ** |
| Cash and cash equivalents  (including cash equivalent investments of $291 and $193, respectively)                                                       |       | $                  | 10,244     |              | $          | 7,272 |   |
| Restricted cash                                                                                                                                         |       | 4,606              |       | 3,994             |       |
| Accounts  receivable, less allowance for doubtful accounts of $2,437 and $1,953,  respectively                                                          |       | 99,859             |       | 103,129           |       |
| Rebates receivable                                                                                                                                      |       | 57,870             |       | 40,377            |       |
| Inventory                                                                                                                                               |       | 4,331              |       | 4,119             |       |
| Due from  affiliates                                                                                                                                    |       | —             |       | 31                |       |
| Deferred tax  assets                                                                                                                                    |       | 1,812              |       | 2,117             |       |
| Other current  assets                                                                                                                                   |       | 1,652              |       | 5,759             |       |
| **Total current assets**                                                                                                                                | ** ** | 180,374            |       | 166,798           |       |
| Property,  equipment and software development costs, net                                                                                                |       | 13,754             |       | 12,177            |       |
| Intangible  assets, net of accumulated amortization of $4,034 and $3,273, respectively                                                                  |       | 3,240              |       | 3,951             |       |
| Goodwill                                                                                                                                                |       | 100,108            |       | 99,710            |       |
| Other assets                                                                                                                                            |       | 1,202              |       | 1,295             |       |
| **Total Assets**                                                                                                                                        | ** ** | $                  | 298,678    |              | $          | 283,931 |   |
| **Liabilities,  Redeemable Preferred Equity, and Common Stockholders’ Equity**                                                                     |       |               |       |              |       |
| **Current Liabilities:**                                                                                                                                |       |               |       |              |       |
| Claims payable  to pharmacies                                                                                                                           |       | $                  | 115,215    |              | $          | 118,660 |   |
| Rebates payable  to sponsors                                                                                                                            |       | 58,652             |       | 45,436            |       |
| Trade and other  payables and accrued expenses                                                                                                          |       | 18,076             |       | 24,747            |       |
| Revolving credit  facility and loans payable-current                                                                                                    |       | —             |       | 1,860             |       |
| Current portion  of capital lease obligations                                                                                                           |       | 24                 |       | 29                |       |
| Other current liabilities                                                                                                                               |       | 141                |       | 503               |       |
| **Total current liabilities**                                                                                                                           | ** ** | 192,108            |       | 191,235           |       |
| Capital lease  obligations, less current portion                                                                                                        |       | —             |       | 16                |       |
| Long term loans  payable and other liabilities                                                                                                          |       | 835                |       | 998               |       |
| Deferred tax  liability                                                                                                                                 |       | 6,903              |       | 5,964             |       |
| **Total liabilities**                                                                                                                                   | ** ** | 199,846            |       | 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                                 |       | 76,220             |       | 75,864            |       |
| **Common  Stockholders’ Equity:**                                                                                                                  | ** ** | ** **         | ** ** | ** **        | ** ** |
| Common stock,  $.001 par value, 35,000,000 shares authorized, 9,920,689 and 9,461,826 shares  issued, 5,280,789 and 4,821,926 outstanding, respectively |       | 10                 |       | 9                 |       |
| Additional  paid-in-capital                                                                                                                             |       | 124,605            |       | 115,061           |       |
| Accumulated  deficit                                                                                                                                    |       | (50,124            | )          | (53,337           | )          |
| Treasury stock  at cost, 4,639,900 shares                                                                                                               |       | (51,879            | )          | (51,879           | )          |
| **Total common stockholders’  equity**                                                                                                             | ** ** | 22,612             |       | 9,854             |       |
| **Total Liabilities, Redeemable Preferred Equity,  and Common Stockholders’ Equity**                                                               | ** ** | $                  | 298,678    |              | $          | 283,931 |   |

 

*Seeaccompanying condensed notes to consolidated financial statements*

 

5

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NATIONAL MEDICALHEALTH CARD SYSTEMS, INC. AND SUBSIDIARIES

**CONSOLIDATED STATEMENT OF INCOME**

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

**(Unaudited)**
| ** **                                                                                                                                                                                                     | ** ** | **Three months ended  March 31,** | ** ** | **Nine months ended  March 31,** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------------|------------|-------------------------------------------------|------------|
| ** **                                                                                                                                                                                                     | ** ** | **2006**                                         | ** ** | **2005**                                        | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                                                                                                                                                                                                     | ** ** | **(Restated)**                                   | ** ** | ** **                                      | ** ** | ** ** | ** ** | ** ** | ** ** |
| Revenue (includes  co-payments collected of $4,728, $4,322, $13,846 and $10,772, respectively;  and excludes co-payments retained by the pharmacies of $82,544, $74,932,  $243,043 and $203,623, respectively) |       | $                                                | 216,801    |                                            | $          | 199,342 |   | $ | 651,402 |   | $ | 584,734 |   |
| Cost of claims  (excludes co-payments retained by the pharmacies of $82,544, $74,932,  $243,043 and $203,623, respectively)                                                                                    |       | 194,381                                          |       | 177,150                                         |       | 581,742 |   | 520,940 |   |
| Gross profit                                                                                                                                                                                                   |       | 22,420                                           |       | 22,192                                          |       | 69,660 |   | 63,794 |   |
| Selling, general  and administrative expenses                                                                                                                                                                  |       | 19,308                                           |       | 16,629                                          |       | 56,897 |   | 48,699 |   |
| Operating income                                                                                                                                                                                               |       | 3,112                                            |       | 5,563                                           |       | 12,763 |   | 15,095 |   |
| Other income  (expense):                                                                                                                                                                                       |       |                                             |       |                                            |       |   |   |   |   |
| Interest expense                                                                                                                                                                                               |       | (64                                              | )          | (167                                            | )          | (246 | ) | (534 | ) |
| Interest income                                                                                                                                                                                                |       | 433                                              |       | 123                                             |       | 1,053 |   | 161 |   |
| Other income (expense),  net                                                                                                                                                                                   |       | 20                                               |       | 16                                              |       | (20 | ) | 1,777 |   |
|                                                                                                                                                                                                           |       | 389                                              |       | (28                                             | )          | 787 |   | 1,404 |   |
| Income before  provision for income taxes                                                                                                                                                                      |       | 3,501                                            |       | 5,535                                           |       | 13,550 |   | 16,499 |   |
| Provision for income  taxes                                                                                                                                                                                    |       | 1,493                                            |       | 2,270                                           |       | 5,777 |   | 6,765 |   |
| Net income                                                                                                                                                                                                     |       | 2,008                                            |       | 3,265                                           |       | 7,773 |   | 9,734 |   |
| Redeemable convertible  preferred stock cash dividends                                                                                                                                                         |       | 1,381                                            |       | 1,380                                           |       | 4,204 |   | 4,204 |   |
| Accretion of  transaction expenses                                                                                                                                                                             |       | 117                                              |       | 117                                             |       | 356 |   | 356 |   |
| Net income  available to common stockholders                                                                                                                                                                   |       | $                                                | 510        |                                            | $          | 1,768 |   | $ | 3,213 |   | $ | 5,174 |   |
| Earnings per  common share:                                                                                                                                                                                    |       |                                             |       |                                            |       |   |   |   |   |
| Basic                                                                                                                                                                                                          |       | $                                                | 0.10       |                                            | $          | 0.39 |   | $ | 0.63 |   | $ | 1.16 |   |
| Diluted *                                                                                                                                                                                                      |       | $                                                | 0.10       |                                            | $          | 0.27 |   | $ | 0.61 |   | $ | 0.81 |   |
| Weighted average  number of common shares outstanding:                                                                                                                                                         |       |                                             |       |                                            |       |   |   |   |   |
| Basic                                                                                                                                                                                                          |       | 5,200                                            |       | 4,584                                           |       | 5,111 |   | 4,468 |   |
| Diluted *                                                                                                                                                                                                      |       | 5,302                                            |       | 12,123                                          |       | 5,268 |   | 12,090 |   |

 

*See accompanying condensed notes to consolidatedfinancial statements*

* = For the threeand nine months ended March 31, 2005, the number of weighted average dilutedshares was calculated using the “as if converted” method for the redeemableconvertible preferred stock.  For thethree and nine months ended March 31, 2006, the redeemable convertiblepreferred stock was anti-dilutive and the “as if converted” method was not usedto calculate the number of weighted average diluted shares.

 

6

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NATIONAL MEDICALHEALTH CARD SYSTEMS, INC. AND SUBSIDIARIES

**CONSOLIDATED STATEMENT OF CASHFLOWS**

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

**(Unaudited)**
| ** **                                                                         | ** ** | **Nine months ended** | ** ** |
|------------------------------------------------------------------------------------|------------|---------------------------------|------------|
| ** **                                                                         | ** ** | **March 31,**              | ** ** |
| ** **                                                                         | ** ** | **2006**                        | ** ** | **2005** | ** ** |
| **Cash flows from operating  activities:**                                         |       |                            |       |   |   |
| Net income                                                                         |       | $                               | 7,773      |   | $ | 9,734 |   |
| Adjustments to  reconcile net income to net cash provided by operating activities: |       |                            |       |   |   |
| Depreciation and  amortization                                                     |       | 5,399                           |       | 4,682 |   |
| Employee stock  option expense                                                     |       | 1,867                           |       | — |   |
| Issuance of  restricted stock units                                                |       | 46                              |       | — |   |
| Amortization of  deferred gain                                                     |       | (37                             | )          | (92 | ) |
| Amortization of  deferred financing costs                                          |       | 84                              |       | — |   |
| Loss on disposal  of capital assets                                                |       | 54                              |       | — |   |
| Provision for  doubtful accounts                                                   |       | 525                             |       | 756 |   |
| Deferred income  taxes                                                             |       | 1,276                           |       | 901 |   |
| Excess tax  benefits from exercise of stock options                                |       | (1,237                          | )          | — |   |
| Changes in  assets and liabilities:                                                |       |                            |       |   |   |
| Restricted cash                                                                    |       | (612                            | )          | 582 |   |
| Accounts  receivable                                                               |       | 2,745                           |       | (24,585 | ) |
| Rebates  receivable                                                                |       | (17,493                         | )          | (2,058 | ) |
| Inventory                                                                          |       | (212                            | )          | (3,068 | ) |
| Other current  assets                                                              |       | 2,131                           |       | (1,954 | ) |
| Due from  affiliates                                                               |       | 31                              |       | 1 |   |
| Other assets                                                                       |       | 9                               |       | 3,327 |   |
| Claims payable  to pharmacies                                                      |       | (3,445                          | )          | 8,317 |   |
| Rebates payable  to sponsors                                                       |       | 13,216                          |       | 21,836 |   |
| Trade and other  payables and accrued expenses                                     |       | (6,869                          | )          | (19,832 | ) |
| Income taxes  payable and other current liabilities                                |       | 2,164                           |       | 6,828 |   |
| Other long term  liabilities                                                       |       | (126                            | )          | (925 | ) |
| Net cash provided by  operating activities                                         |       | 7,289                           |       | 4,450 |   |
| **Cash  flows from investing activities:**                                         |       |                            |       |   |   |
| Capital  expenditures                                                              |       | (5,869                          | )          | (4,295 | ) |
| Proceeds from  sale of capital assets                                              |       | 169                             |       | — |   |
| Acquisition of  PCN, net of cash acquired                                          |       | —                          |       | 3,153 |   |
| Acquisition of  Inteq, net of cash acquired                                        |       | 116                             |       | (139 | ) |
| Acquisition of  PPP, net of cash acquired                                          |       | (426                            | )          | (358 | ) |
| Net cash used in  investing activities                                             |       | (6,010                          | )          | (1,639 | ) |
| **Cash  flows from financing activities:**                                         |       |                            |       |   |   |
| Proceeds from  exercise of stock options                                           |       | 4,681                           |       | 3,251 |   |
| Proceeds from  revolving credit facility                                           |       | 72,075                          |       | 695,758 |   |
| Repayment of  revolving credit facility                                            |       | (72,075                         | )          | (695,796 | ) |
| Payment of  redeemable convertible preferred stock cash dividends                  |       | (4,204                          | )          | (4,204 | ) |
| Deferred  financing costs                                                          |       | —                          |       | (367 | ) |
| Excess tax  benefits from exercise of stock options                                |       | 1,237                           |       | — |   |
| Repayment of  debt and capital lease obligations                                   |       | (21                             | )          | (343 | ) |
| Net cash provided by  (used in) financing activities                               |       | 1,693                           |       | (1,701 | ) |
| Net increase in  cash and cash equivalents                                         |       | 2,972                           |       | 1,110 |   |
| Cash and cash  equivalents at beginning of period                                  |       | 7,272                           |       | 3,388 |   |
| Cash and cash equivalents at end of period                                         |       | $                               | 10,244     |   | $ | 4,498 |   |

 

*See accompanying condensed notes to consolidatedfinancial statements*

 

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NATIONAL MEDICALHEALTH CARD SYSTEMS, INC. AND SUBSIDIARIES

**CONDENSED NOTES TO CONSOLIDATEDFINANCIAL STATEMENTS**

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

**(Unaudited)**

1.             NATURE OF BUSINESS

National MedicalHealth Card Systems, Inc. and its wholly owned subsidiaries (collectively the “Company”or “NMHC”) provides comprehensive pharmacy benefit management (“PBM”) servicesto plan sponsors, which include managed care organizations, local governments,unions, corporations and third party health care plan administrators throughits network of licensed pharmacies throughout the United States.  The Company’s PBM services include electronicpoint-of-sale pharmacy claims management, retail pharmacy network management,mail service pharmacy claims management, specialty pharmacy claims management,benefit design consultation, preferred drug management programs, drug reviewand analysis, consulting services, disease information services, data access,reporting and information analysis and physician profiling.  In addition, the Company operates a mailservice pharmacy, a specialty pharmacy and a health informatics company.

The unauditedconsolidated financial statements include the accounts of the Company.  The Company does not have any subsidiaries inwhich it does not own 100% of the outstanding stock.  All of the Company’s subsidiaries areincluded in the unaudited consolidated financial statements.  All material intercompany balances andtransactions have been eliminated in consolidation.

The unaudited consolidatedfinancial statements have been prepared by the Company in accordance withUnited States generally accepted accounting principles for interim financialinformation and substantially in the form prescribed by the U.S. Securities andExchange Commission (the “SEC”) in instructions to Form 10-Q and in Article 10of Regulation S-X.  Accordingly, theinterim financial information does not include all of the information andfootnotes required by such accounting principles for complete financialstatements.  In the opinion of theCompany’s management, the March 31, 2006 and 2005 unaudited interim financialstatements include all adjustments consisting of normal recurring adjustments,necessary for a fair presentation of results for these interim periods.  In the opinion 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 for the three andnine months ended March 31, 2006 are not necessarily indicative of theoperating results to be expected for the full year.

Certain amounts in the prior period have been reclassified to conformto the current period presentation.  Forinformation concerning the Company’s significant accounting policies, referenceis made to the Company’s Annual Report on Form 10-K for the year ended June 30,2005 (the “Annual Report”) filed with the SEC, asamended.

2.             RESTATEMENTOF FINANCIAL STATEMENTS

We are restating the Company’s previously issuedfinancial statements for the third fiscal quarter ended March 31, 2006 toreflect the correction of two rebate cash receipts from one pharmaceuticalmanufacturer which resulted in the Company recognizing additional rebate 

8

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revenue during the quarter endedDecember 31, 2005. The restatement reflects adjustments to the Company’srevenue and cost of claims for the three month periods ended March 31,2006.  The tax effects on the correctionshave also been reflected in these restatements. The impact of the correctionson the consolidated statement of income is shown in the accompanying tables. Adjustmentsto the statement of income for the three monthperiod ended  March31, 2006 primarily represent adjustments to correct the understatement of theCompany’s revenue, cost of claims and resultant gross profit.  Income tax expense and net income wereadjusted to reflect the income tax effect of the understated gross profit. However, there was no impact on the results forthe full year ended June 30, 2006.

The following table presents the effect of theRestatement on the consolidated statement of operations for the three monthsended March 31, 2006:
| ** **                                             | ** ** | **Three Months Ended March 31, 2006  (In Thousands)** | ** ** |
|--------------------------------------------------------|------------|-------------------------------------------------------------------------------------|------------|
| ** **                                             | ** ** | **As Previously  Reported**                                                    | ** ** | **Adjustments** | ** ** | **As Restated** | ** ** |
| Revenue:                                               |       | $                                                                                   | 215,717    |   | $ | 1,084 |   | $ | 216,801 |   |
| Cost of Claims:                                        |       | 193,959                                                                             |       | 422 |   | 194,381 |   |
| Gross Profit:                                          |       | 21,758                                                                              |       | 662 |   | 22,420 |   |
| Selling, general and administrative expenses:          |       | 19,308                                                                              |       | — |   | 19,308 |   |
| Operating Income:                                      |       | 2,450                                                                               |       | 662 |   | 3,112 |   |
| Other Income/(expense), net:                           |       | 389                                                                                 |       | — |   | 389 |   |
| Income before provision for income taxes:              |       | 2,839                                                                               |       | 662 |   | 3,501 |   |
| Provision for income taxes:                            |       | 1,211                                                                               |       | 282 |   | 1,493 |   |
| Net Income:                                            |       | $                                                                                   | 1,628      |   | $ | 380 |   | $ | 2,008 |   |
| Redeemable convertible preferred stock cash  dividends |       | 1,381                                                                               |       | — |   | 1,381 |   |
| Accretion of transaction expenses                      |       | 117                                                                                 |       | — |   | 117 |   |
| Net income available to commonstockholders             |       | $                                                                                   | 130        |   | $ | 380 |   | $ | 510 |   |
| Earnings per common share:                             |       |                                                                                |       |   |   |   |   |
| Basic                                                  |       | $                                                                                   | 0.03       |   | $ | 0.07 |   | $ | 0.10 |   |
| Diluted                                                |       | $                                                                                   | 0.02       |   | $ | 0.08 |   | $ | 0.10 |   |
| Weighted average number of common shares  outstanding: |       |                                                                                |       |   |   |   |   |
| Basic                                                  |       | 5,200                                                                               |       |   |   | 5,200 |   |
| Diluted                                                |       | 5,302                                                                               |       |   |   | 5,302 |   |

 

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3.             STOCK-BASED COMPENSATION

At March 31, 2006, the Company had one stock-based employeecompensation plan, which is more fully described in Note 6.  Prior to July 1, 2005, the Company accountedfor this plan under the recognition and measurement provisions of APB OpinionNo. 25, *Accounting for Stock Issued to Employees*,and related interpretations, as permitted by FASB Statement No. 123, *Accounting for Stock-Based Compensation*.  No stock-based employee compensation cost wasrecognized in the Consolidated Statement of Income for the three and ninemonths ended March 31, 2005, as all options granted under this plan had anexercise price at least equal to the market value of the underlying commonstock on the date of grant.  EffectiveJuly 1, 2005, the Company adopted the fair value recognition provisions of FASBStatement No. 123(R), *Share-Based Payment*,using the modified-prospective-transition method.  Under that transition method, compensationcost recognized in the three and nine months ended March 31, 2006 includes: (a)compensation cost for all share-based payments granted prior to, but not yetvested as of July 1, 2005, based on the grant date fair value estimated inaccordance with the original provisions of FASB Statement No. 123, and (b)compensation cost for all share-based payments granted subsequent to July 1, 2005,based on the grant-date fair value estimated in accordance with the provisionsof FASB Statement No. 123(R).  Resultsfor prior periods have not been restated.

Forthe nine months ended March 31, 2006, the fair value of the options wasestimated using a binomial valuation model with the following weighted-averageassumptions used: no dividend yield, weighted-average expected life of theoption of 6 or 7 years, risk-free interest rate between 4.1% and 4.64%,volatility between 54.0% and 69.5%, post-vesting terminations of 1% and asub-optimal exercise factor between 4.0 and 4.1.  The weighted-average value of options grantedduring the nine months ended March 31, 2006 was $27.92.

As a result of adopting FASB Statement No. 123(R) on July 1, 2005, theCompany’s income before income taxes for the three and nine months ended March31, 2006 are $602 and $1,867 lower, respectively, than if it had continued toaccount for share-based compensation under APB Opinion No. 25.  The after-tax effect of this charge was $491, or $0.09 per basic earningsper share, or EPS,and $0.09 per diluted EPS using the “as if converted” method for thethree months ended March 31, 2006 and $1,511, or $0.30 per basic EPS and $0.15 per diluted EPS using the “as if converted” method  for the nine months ended March31, 2006, respectively.  As of March 31,2006, the total unrecognized compensation cost related to nonvested stockawards was $10,952 and the related weighted-average period over which it isexpected to be recognized is approximately 3.36 years.

Prior to the adoption of FASB Statement No. 123(R), the Companypresented all tax benefits of deductions resulting from the exercise of stockoptions as operating cash flows in the Consolidated Statement of CashFlows.  FASB Statement No. 123(R)requires the cash flows resulting from the tax benefits resulting from taxdeductions in excess of the compensation cost recognized for those options(excess tax benefits) to be classified as financing cash flows.

10

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The following table illustrates the effect on net income and earningsper share if the Company had applied the fair value recognition provisions ofFASB Statement No. 123 to options granted under the Company’s stock option planduring the three and nine months ended March 31, 2005.  For purposes of this pro forma disclosure,the value of the options is estimated using the Black-Scholes option-pricingmodel with the following weighted-average assumptions used for all grantsduring the nine months ended March 31, 2005: no dividend yield,weighted-average expected life of the option of between 3 and 7 years,risk-free interest rate of between 3.40% and 4.46%, and volatility between72.2% and 75.0% for all grants.  Theweighted-average value of options granted during the nine months ended March31, 2005 was $14.71.
| ** **                                                                                                                                                                           | ** ** | **Three Months  Ended  March 31, 2005** | ** ** | **Nine Months  Ended  March 31, 2005** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------------------|------------|-------------------------------------------------------|------------|
| Net income available  to common stockholders, as reported                                                                                                                            |       | $                                                      | 1,768      |                                                  | $          | 5,174 |   |
| 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 FASB 123 |       | (1,092                                                 | )          | (3,492                                                | )          |
| Pro forma net  income available to common stockholders                                                                                                                               |       | $                                                      | 676        |                                                  | $          | 1,682 |   |
| Pro forma  earnings per share:                                                                                                                                                       |       |                                                   |       |                                                  |       |
| Basic—as  reported                                                                                                                                                              |       | $                                                      | 0.39       |                                                  | $          | 1.16 |   |
| Basic—pro forma                                                                                                                                                                 |       | $                                                      | 0.15       |                                                  | $          | 0.38 |   |
| Diluted—as reported                                                                                                                                                             |       | $                                                      | 0.27       |                                                  | $          | 0.81 |   |
| Diluted—pro forma                                                                                                                                                               |       | $                                                      | 0.13       |                                                  | $          | 0.33 |   |

 

4.             NEW MOUNTAIN TRANSACTION

The Companyentered 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 purchaseagreement, the Company agreed, subject to various conditions, to issue to NewMountain Partners a total of 6,956,522 shares of series A 7% redeemableconvertible 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 Companycompleted the sale of the series A preferred stock to New MountainPartners and used approximately $49,000 of the proceeds of the sale of theseries A preferred stock to purchase, pursuant to a tender offer,4,448,900 shares of the Company’s issued and outstanding common stock (the “commonstock”) at $11.00 per share (collectively, the “New Mountain Transaction”).  Prior to the closing of the New MountainTransaction, Bert E. Brodsky, the former chairman of the board of directors,and certain stockholders related to him, held (assuming the exercise of 330,000options and warrants held by Mr. Brodsky, which occurred in April 2004), in theaggregate,

11

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approximately 59%of the common stock and had agreed to tender 4,448,900 shares, or approximately54% of the common stock, held by them, into the tender offer.  No other stockholders tendered shares in theoffer.

Following thecompletion of the tender offer, and assuming the exercise of 330,000 optionsand warrants held by Mr. Brodsky, which occurred in April 2004, New MountainPartners owned securities at March 19, 2004 that were initially convertibleinto approximately 64% of the common stock and prior to conversion of theseries A preferred stock were entitled to cast that number of votes thatis equal to approximately 60% of the Company’s aggregate voting power.  Following the closing of the New MountainTransaction, New Mountain Partners was entitled to and did nominate and elect60% of the members of the Company’s board of directors.

The Company usedthe remaining proceeds from the issuance and sale of the series Apreferred stock of approximately $24,000, excluding expenses related to theclosing of the New Mountain Transaction, for the Inteq Acquisition described inNote 4—Business Acquisitions and for working capital purposes.

The series Apreferred 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 series A preferred stockis convertible into the Company’s common stock at a price of $11.50 per shareof common stock, or an aggregate of 6,956,522 shares of the Company’s commonstock.

The series Apreferred stock may be redeemed at the Company’s option subsequent to thefourth anniversary of its issuance, subject to certain conditions.  After the tenth anniversary of the issuanceof the series A preferred stock, each holder of shares of series Apreferred stock may require the Company to redeem all or a part of that holder’sshares of series A preferred stock.

5.             BUSINESS ACQUISITIONS

On March 7, 2005,the Company acquired all of the outstanding stock of Pharmaceutical CareNetwork, a California corporation, from the California Pharmacists Association(the “PCN Acquisition”).  The aggregatepurchase price of the PCN Acquisition was $13,000 in cash.  In addition, the Company has agreed to paythe California Pharmacists Association (“CphA”) earn-outs, as additionalpurchase price, up to $30,000 over a period of three years if certain financialand performance targets are achieved.  Asof March 31, 2006, the financial and performance targets have not beenachieved.  The funds for the payment ofthe purchase price in connection with the PCN Acquisition were obtained out ofthe Company’s working capital and the JPMorgan credit facility (See Note5).  The PCN operations complement theCompany’s business while strengthening the Company’s presence in the Californiamarketplace as well as in the managed Medicaid market.

In addition to the$13,000 purchase price for the PCN Acquisition, there were $561 of acquisitionrelated expenses incurred by the Company. Of the $13,000, $10,500 was paid to CPhA and certain of PCN’s currentand former employees who participated in its Long Term Incentive Plan, and$2,500 was deposited into escrow to secure CPhA’s obligations under the

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purchaseagreement.  At the time of theacquisition, PCN had approximately $30,942 of assets which included $16,711 ofcash, $2,734 of restricted cash, $3,204 of accounts receivable, $6,090 ofrebates receivable, $1,139 of other assets, and $1,064 of property andequipment.  They also had approximately$27,040 of liabilities which included $26,848 of claims and accounts payable,$97 of other current liabilities and $95 of other long-term liabilities.  As a result of the PCN Acquisition, $2,842 ofseverance and exit costs have been accrued as of March 31, 2006, with $1,223recorded as a deferred tax asset and $1,619 recorded as additionalgoodwill.  Of this amount, $1,315 waspaid as of March 31, 2006.  Theacquisition was accounted for under the purchase method of accounting and theresults of PCN’s operations were included in the consolidated financialstatements commencing as of the closing date of the PCN Acquisition.  The excess of the acquisition costs over thefair value of identifiable net assets acquired was $11,957, which consists ofthe following components: “know how” and computer software valued at $870,which will be amortized over ten (10) years, customer relationships valued at$380, which will be amortized over ten (10) years, and goodwill of $10,707,which will not be amortized for book purposes per SFAS 142.

On April 1, 2004,the Company entered into an Asset Purchase Agreement with Inteq PBM, LP, aTexas limited partnership (the “Purchaser”), The INTEQ-RX Group, LLP andcertain other owners named therein (together with The INTEQ-RX Group, LLP, the “TheInteq Group”), pursuant to which the Company agreed to acquire certain assetsof The Inteq Group relating to their PBM business (the “Inteq Acquisition”).  The aggregate purchase price of the InteqAcquisition was $31,500 in cash.  Inaddition, the Company agreed to pay The Inteq Group, as additional purchaseprice, up to $4,200 over a period of one year if the acquired PBM businessachieved certain financial performance targets during the one-year periodfollowing the closing.

In addition,$3,000, out of the $4,200 potential to be paid to The Inteq Group, was placedin escrow to secure the Company’s obligations to pay The Inteq Group additionalpurchase price if certain targets were achieved during the first year. Of thisamount, $1,024 of additional consideration was earned and released from escrow,with the balance of $1,976 being returned to the Company.

On July 31, 2003, the Company entered into a StockPurchase Agreement with Portland Professional Pharmacy (“PPRX”), PortlandProfessional Pharmacy Associates (“PRXA”, and together with PPRX, “PPP” or “NMHCAscend”) and the individual shareholders (the “PPP Shareholders”) to purchaseall of the shares of PPP for $3,150 (the “PPP Acquisition”). PPP providesspecialty-pharmacy services in a broad range of areas, including women’shealth, pediatric care, men’s health and transplant.  In addition, the Company agreed to pay to thePPP Shareholders up to $7,000 over a three-year period if the PPP businessachieved certain financial targets. At the Company’s sole discretion, as muchas 50% of the $7,000 can be paid in the form of Company stock.  For the first year ended July 31, 2004, $716was 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 second year ended July 31, 2005, $851was 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 

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$24.84 per share). For the third year, through March 31, 2006, $649 has been earned andwill be settled in September 2006.

Each of PRXA and PPRX continues to operate under theirrespective names, and also does business under the name NMHC Ascend.

The summarizedunaudited pro forma results of operations set forth below for the three andnine months ended March 31, 2005 assumes the PCN Acquisition had occurred as ofthe beginning of these periods.
| ** **                                                       | ** ** | **Three Months Ended  March 31, 2005** | ** ** |
|------------------------------------------------------------------|------------|------------------------------------------------------------|------------|
| Revenue                                                          |       | $                                                          | 212,965    |   |
| Net income                                                       |       | $                                                          | 2,486      |   |
| Net income  available to common Stockholders                     |       | $                                                          | 989        |   |
| Earnings per  common share:                                      |       |                                                       |       |
| Basic                                                            |       | $                                                          | 0.22       |   |
| Diluted                                                          |       | $                                                          | 0.19       |   |
| Pro forma  weighted-average number of Common shares outstanding: |       |                                                       |       |
| Basic                                                            |       | 4,584                                                      |       |
| Diluted                                                          |       | 5,167                                                      |       |

 
| ** **                                                       | ** ** | **Nine Months Ended  March 31, 2005** | ** ** |
|------------------------------------------------------------------|------------|-----------------------------------------------------------|------------|
| Revenue                                                          |       | $                                                         | 628,672    |   |
| Net income                                                       |       | $                                                         | 8,604      |   |
| Net income available  to common Stockholders                     |       | $                                                         | 4,104      |   |
| Earnings per  common share:                                      |       |                                                      |       |
| Basic                                                            |       | $                                                         | 0.92       |   |
| Diluted                                                          |       | $                                                         | 0.72       |   |
| Pro forma  weighted-average number of Common shares outstanding: |       |                                                      |       |
| Basic                                                            |       | 4,468                                                     |       |
| Diluted                                                          |       | 12,090                                                    |       |

 

For proformapurposes during the three months ended March 31, 2005, all of the Company’sredeemable convertible preferred stock issued to New Mountain Partners, L.P.was excluded from the diluted earnings per share calculation because itsinclusion would have been anti-dilutive.

This pro formafinancial information is presented for information purposes only.  Pro forma adjusted net income per commonshare, including acquisitions, may not be indicative of actual results,primarily because pro forma earnings include historical results of operationsof the 

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acquired entityand do not reflect any cost savings or potential sales erosion that may resultfrom the Company’s integration efforts. In addition, while PCN has traditionally recorded all revenue on a grossbasis, the Company has adjusted the historical amounts to reflect certaincontracts on a revenue basis consistent with NMHC’s policies.

The change in thecarrying amount of goodwill for the nine months ended March 31, 2006 is asfollows:

| Balance as of June 30, 2005          |   | $    | 99,710  |   |
|--------------------------------------|--------|------|---------|--------|
| PCN acquisition                      |   | (71  | )       |
| PCN additional  consideration earned |   | (236 | )       |
| PPP additional  consideration earned |   | 705  |    |
| Balance as of  March 31, 2006        |   | $    | 100,108 |   |

 

Approximately$81,740 of the Company’s March 31, 2006 goodwill is deductible for income taxpurposes on a straight-line basis over 15 years.

Acquiredintangible assets subject to amortization consisted of the following:
| ** **             | ** ** | **March 31, 2006**        | ** ** | **June 30, 2005**            | ** ** |
|------------------------|------------|---------------------------|------------|------------------------------|------------|
| **Asset Class**        | ** ** | **Gross Carrying Amount** | ** ** | **Accumulated Amortization** | ** ** | **Gross Carrying Amount** | ** ** | **Accumulated Amortization** | ** ** |
| Customer Relationships |       | $5,326                    |       | $2,968                       |       | $5,296 |   | $2,410 |   |
| Non-compete agreements |       | 220                       |       | 188                          |       | 220 |   | 156 |   |
| Employment agreements  |       | 186                       |       | 152                          |       | 186 |   | 133 |   |
| Trade name             |       | 100                       |       | 60                           |       | 100 |   | 37 |   |
| Company know how       |       | 1,422                     |       | 666                          |       | 1,422 |   | 537 |   |
|                   |       | $7,274                    |       | $4,034                       |       | $7,224 |   | $3,273 |   |

 

6.           DEBT

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

Depending on thetiming and dollar amount of each loan request, the Company will either borrowat a spread above LIBOR, the overnight Federal Funds rate or JPMorgan’s primerate. The initial spread was 1.75% for LIBOR and Federal Funds loans and 0.75%for prime rate 

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loans.  After receipt of the Company’s consolidatedfinancial statements for the fiscal year ended June 30, 2005, the spreadsdecreased due to a favorable ratio of debt to annual EBITDA.  The current spread is 1.50% for LIBOR andFederal Funds loans and 0.50% for prime rate loans.

The JPMorgan creditfacility is secured by the Company’s consolidated assets.  The JPMorgan credit facility requires theCompany to be in compliance with financial and other covenants.  The three defined financial covenantsinclude:  consolidated net worth;consolidated fixed charge ratio; and consolidated debt to EBITDA ratio.  The Company was in compliance with allcovenants at March 31, 2006 as set forth in the credit agreement in connectionwith the credit facility.

7.           STOCKOPTIONS

During the nine monthsended March 31, 2006, the Company granted stock options under the 1999 StockOption Plan, as amended (the “Plan”). The options granted during this period are exercisable at prices rangingfrom $24.01 to $32.22 and terminate seven or ten years from the grantdate.  The total number of shares ofcommon stock of the Company reserved by the Company for issuance under the Planis 4,850,000 plus an indeterminable number of shares of common stock of theCompany issuable pursuant to the anti-dilution provisions of the Plan or uponthe exercise of “reload options.”  Thereare no options outstanding that contain the “reload” provision.  There are 1,057,751 options issuable underthe Plan as of March 31, 2006.  Thefollowing table summarizes information about stock option activity for the ninemonths ended March 31, 2006:
| ** **                             | ** ** | ** **         | ** ** | **Weighted-Average**    | ** ** |
|----------------------------------------|------------|--------------------|------------|-------------------------|------------|
| ** **                             | ** ** | **Number of** | ** ** | **Exercise Price** | ** ** |
| ** **                             | ** ** | **Options**        | ** ** | **Per Share**      | ** ** |
| Outstanding  options at June 30, 2005  |       | 1,441,213          |       | $                       | 16.52      |   |
| Canceled                               |       | (180,546           | )          | 22.18                   |       |
| Granted                                |       | 621,938            |       | 27.92                   |       |
| Exercised                              |       | (440,909           | )          | 10.62                   |       |
| Outstanding options at March  31, 2006 |       | 1,441,696          |       | $                       | 22.68      |   |

 

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The following tablesummarizes information about stock options outstanding at March 31, 2006:
| ** **                       | ** ** | **Outstanding**            | ** ** | **Exercisable**                         | ** ** |
|----------------------------------|------------|----------------------------|------------|-----------------------------------------|------------|
| **Option Price Range** | ** ** | **Number of  Shares** | ** ** | **Weighted-  average  Remaining  Life** | ** ** | **Weighted-  average  Exercise  Price** | ** ** | **Number  of Shares** | ** ** | **Weighted-  average  Exercise  Price** | ** ** |
| $7.19 to $10.78                  |       | 231,127                    |       | 1.63 years                              |       | $ | 9.19 |   | 226,744 |   | $ | 1.62 |   |
| $10.79 to $16.20                 |       | 126,464                    |       | 2.76 years                              |       | $ | 12.80 |   | 87,285 |   | $ | 2.86 |   |
| $16.21 to $24.30                 |       | 249,532                    |       | 7.89 years                              |       | $ | 21.88 |   | 39,243 |   | $ | 6.59 |   |
| $24.31 to $36.50                 |       | 834,347                    |       | 8.20 years                              |       | $ | 28.15 |   | 110,053 |   | $ | 4.84 |   |
| $36.51 to $36.66                 |       | 226                        |       | 3.14 years                              |       | $ | 36.66 |   | 76 |   | $ | 3.14 |   |
| $7.19 to $36.66                  |       | 1,441,696                  |       | 6.62 years                              |       | $ | 22.68 |   | 463,401 |   | $ | 3.04 |   |

 

8.             EARNINGS PER SHARE

A reconciliationof shares used in calculating basic and diluted earnings per share follows:
| ** **                                                             | ** ** | **Three Months Ended  March 31,** | ** ** |
|------------------------------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                                             | ** ** | **2006**                                         | ** ** | **2005** | ** ** |
| Basic                                                                  |       | 5,199,596                                        |       | 4,583,773 |   |
| Effect of assumed  exercise of employee stock options                  |       | 102,220                                          |       | 583,197 |   |
| Effect of assumed  conversion of redeemable convertiblepreferred stock |       | —                                           |       | 6,956,522 |   |
| Diluted weighted average number of shares outstanding                  |       | 5,301,816                                        |       | 12,123,492 |   |

 
| ** **                                                              | ** ** | **Nine Months Ended  March 31,** | ** ** |
|-------------------------------------------------------------------------|------------|-------------------------------------------------|------------|
| ** **                                                              | ** ** | **2006**                                        | ** ** | **2005** | ** ** |
| Basic                                                                   |       | 5,110,846                                       |       | 4,468,227 |   |
| Effect of assumed  exercise of employee stock options                   |       | 157,560                                         |       | 664,938 |   |
| Effect of assumed  conversion of redeemable convertible preferred stock |       | —                                          |       | 6,956,522 |   |
| Diluted weighted average number of shares outstanding                   |       | 5,268,406                                       |       | 12,089,687 |   |

 

Accountingprinciples generally accepted in the United States requires all anti-dilutivesecurities, including convertible preferred stock, to be excluded from thediluted earnings per share calculation. For the three and nine months ended March 31, 2006, all of the Company’sredeemable convertible preferred stock issued to New Mountain Partners, L.P.was excluded

17

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from the dilutedearnings per share calculation because its inclusion would have beenanti-dilutive.  If the Company was toinclude the assumed conversion of redeemable convertible preferred stock duringthe three and nine months ended March 31, 2006, the Company would have added6,956,522 equivalent shares of redeemable convertible preferred stock to thebasic weighted average shares outstanding to compute the diluted weightedaverage shares outstanding.

TheCompany also grants restricted stock awards to certain employees.  Restricted stock awards are valued at theclosing market value of the Company’s common stock on the date of grant, andthe total value of the award is expensed ratably over the service period of theemployees receiving the grants.  Duringthe nine months ended March 31, 2006, 17,730 shares of restricted stock weregranted to certain employees.  The sharesof the restricted stock have a 4-year cliff vesting feature.  Share-based compensation expense related toall restricted stock awards outstanding during the nine months ended March 31,2006 was approximately $46.  As of March31, 2006, the total amount of unrecognized compensation cost related tononvested restricted stock awards was approximately $424, and the relatedweighted-average period over which it is expected to be recognized isapproximately 3.61 years.   No restrictedshares vested during the nine months ended March 31, 2006.

9.             RELATED PARTYTRANSACTIONS

TheCompany receives certain services from a former Chairman of the Board, James Bigl,as per a consulting agreement signed at the end of his employment with theCompany.  Mr. Bigl resigned as Chairmanof the Board on March 13, 2006 but the consulting agreement will continue untilAugust 31, 2006.  During the three monthsended March 31, 2006 and 2005, $31 was paid under this agreement.  During the nine months ended March 31, 2006and 2005, $95 and $74, 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 a former Chairman of theBoard.  During the three months endedMarch 31, 2006 and 2005, $36 and $34, respectively, were paid for the rent ofthese two houses.  During the nine monthsended March 31, 2006 and 2005, $109 and $104, respectively, were paid for therent of these two houses.

10.           MAJORSPONSORS AND PHARMACIES

For the three andnine months ended March 31, 2006, approximately 15% of the Company’s grossdollar value of all prescriptions filled by the Company was from Mohawk ValleyPhysicians’ Health Plan, Inc. (“MVP”), a sponsor administering multipleplans.  For the nine months ended March31, 2006, approximately 11% of gross dollar value of all prescriptions filledby the Company was from another sponsor administering multiple plans. For thethree and nine months ended March 31, 2005, approximately 18% and 19%,respectively, of the gross dollar value of all prescriptions filled by theCompany was from MVP.  Amounts due from thesesponsors approximated $11,873 as of March 31, 2006.

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On May 4, 2006,MVP notified the Company of its intention to not renew its contract whichexpires December 31, 2006.

For the three andnine months ended March 31, 2006, no pharmacy chain accounted for more than 10%of the total cost of claims.

For the three andnine months ended March 31, 2005, approximately 11% of the cost of claims wasfrom one pharmacy chain.

11.           SUPPLEMENTAL CASH FLOW INFORMATION

During the ninemonths ended March 31, 2006 and 2005, the Company paid $340 and $492 in interest,and $1,079 and $1,543 in income taxes, respectively.  During the nine months ended March 31, 2006,the Company financed $569 of capital expenditures through its trade payables.

12.           LITIGATION

 From time to time, the Company has been andmay become defendant in, or a party to, pending or threatenedlegal actions, claims or proceedings incident to the ordinary course of ourbusiness which, in some cases, seek substantial monetary damages from, orother forms of relief, against the Company.  The Company hasestablished reserves to cover a current litigation andbelieves that the outcome of this matter, individually or in aggregate,will not have a material adverse effect on the results of operations orfinancial condition of the Company. Regardless of the outcome, litigation can have an adverse impact on theCompany because of defense costs, diversion of management resources and otherfactors.

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**ITEM 2—**MANAGEMENT’SDISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

OPERATING INCOME

($ in thousands)Three months ended March 31,
| ** **                                    | ** ** | **2006** | ** ** | **Increase/  (Decrease)** | ** ** | **2005** | ** ** |
|-----------------------------------------------|------------|----------|------------|---------------------------|------------|----------|------------|
| Revenue                                       |       | $        | 216,801    |                      | 8.8        | %        | $          | 199,342 |   |
| Cost of claims                                |       | 194,381  |       | 9.7                       | %          | 177,150  |       |
| Gross profit                                  |       | 22,420   |       | 1.0                       | %          | 22,192   |       |
| Selling, general  and administrative expenses |       | 19,308   |       | 16.1                      | %          | 16,629   |       |
| Operating Income                              |       | $        | 3,112      |                      | (44.1      | %)       | $          | 5,563 |   |

 

OPERATING INCOME($ in thousands)Nine months ended March 31,
| ** **                                    | ** ** | **2006** | ** ** | **Increase/  (Decrease)** | ** ** | **2005** | ** ** |
|-----------------------------------------------|------------|----------|------------|---------------------------|------------|----------|------------|
| Revenue                                       |       | $        | 651,402    |                      | 11.4       | %        | $          | 584,734 |   |
| Cost of claims                                |       | 581,742  |       | 11.7                      | %          | 520,940  |       |
| Gross profit                                  |       | 69,660   |       | 9.2                       | %          | 63,794   |       |
| Selling, general  and administrative expenses |       | 56,897   |       | 16.8                      | %          | 48,699   |       |
| Operating Income                              |       | $        | 12,763     |                      | (15.4      | %)       | $          | 15,095 |   |

 

**Results of Operations**

***ThreeMonths Ended March 31, 2006 Compared to Three Months Ended March 31, 2005***

Revenue increased$17.5 million, or 8.8%, from $199.3 million for the three months ended March31, 2005, to $216.8 million for the three months ended March 31, 2006.  Revenue recognized for contracts recorded ona gross revenue basis was $197.6 million for the three months ended March 31,2005 and $213.9 million for the three months ended March 31, 2006.  Revenue recognized for contracts recorded ona net revenue basis was $1.7 million for the three months ended March 31, 2005and $2.9 million for the three months ended March 31, 2006. The specific termsof the contracts that we enter into with our sponsors will determine whether werecognize the gross revenue related to the cost of the prescriptions filled(see Critical Accounting Policies and Estimates — Revenue Recognition).  For those contracts on which we recognize netrevenue, gross profit is equal to the net revenue since neither theprescription revenue nor the related costs of the prescriptions are recorded.  Regardless of whether revenues are recordedon either a gross or net basis, we record the gross amount billed in accountsreceivable and the related claims payable to the pharmacies on the balancesheet. We include in revenue only those 

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co-paymentscollected in our mail service facility in Miramar, Florida.  For the three months ended March 31, 2006,there was $4.7 million of co-payments included in revenue versus $4.3 millionfor the three months ended March 31, 2005. Co-payments retained by pharmacies on prescriptions filled for ourmembers and not included in our revenue were $74.9 million and $82.5 million,for the three months ended March 31, 2005 and 2006, respectively.

The $17.5 millionincrease in revenue during the three months ended March 31, 2006 was primarilyattributable to the inclusion of $17.5 million of revenue generated byPharmaceutical Care Network, or PCN, which we acquired during the quarter endedMarch 31, 2005.  In addition, there was$13.5 million reduction in revenue related to the termination of existingsponsor contracts, $0.7 million increase in credit memos issued to variouscustomers ($0.5 million of which was issued to one customer), substantiallyoffset by $13.2 million increase in revenue related to new sponsors or newservices offered by us, excluding contracts recorded on a net revenue basis,and $1.0 million increase in revenue from existing sponsors related to, amongother things, higher costs for pharmaceuticals, availability of new drugs, planparticipant growth and an increase in the average number of claims per plan participant.

The $17.2 millionincrease in cost of claims during the three months ended March 31, 2006 wasprimarily attributable to the inclusion of $15.9 million of costs of claimsincurred by PCN which we acquired during the quarter ended March 31, 2005 inaddition to an increase in costs of claims of $1.3 million from othersources.  This $1.3 million increase isprimarily comprised of a) $12.7 million reduction in costs of claims related tothe termination of existing sponsor contracts, b) $0.5 million write-down ofobsolete inventory from our mail service facility in Miramar, Florida, c) $13.0million increase in costs of claims related to the activity of new sponsors,and d) $0.5 million increase in costs of claims related to the growth inexisting sponsors.  Based on the abovementioned items as well as general competitive pricing pressures, cost ofclaims as a percentage of revenue, increased from 88.9% to 89.7% for the threemonths ended March 31, 2005 and March 31, 2006, respectively.

Gross profit increased $0.2 million, or 1.0%, from $22.2 million forthe three months ended March 31, 2005 to $22.4 million for the three monthsended March 31, 2006.  However, gross profit, as a percentage of revenue,decreased from 11.1% to 10.3% for the three months ended March 31, 2005 andMarch 31, 2006, respectively.  Thedecrease in gross profit as a percentage of revenue is primarily attributableto general competitive pricing pressures which have led to a decline insome prices that we charge our sponsors as well as the issuance of credit memosto certain customers and the write-down of obsolete inventory as noted above.

Selling, generaland administrative expenses increased $2.7 million, or 16.1%, from $16.6million for the three months ended March 31, 2005 to $19.3 million for thethree months ended March 31, 2006.  Theacquisition of PCN and compensation expense related to the expensing ofemployee stock options accounted for $0.8 million and $0.6 million of thisincrease, respectively.  The expensing ofemployee stock options was required to be included in our selling, general andadministrative expenses beginning July 1, 2005. The remainder of the increasewas primarily due to a $0.7 million reduction in internally developed softwareand the corresponding capitalized salaries which caused an increase in employeecompensation expense and $0.3 million for severance payments accrued to formeremployees.

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Selling, general and administrative expenses as a percent of revenueincreased from 8.3% for the three months ended March 31, 2005 to 8.9% forthe three months ended March 31, 2006.

Other income, net increased $0.4 million from an expense of $28,000 toother income of $0.4 million.  The netincrease in other income was primarily due to $0.2 million of interest incomeearned on overnight investments that began during June 2005 as well as $0.1million of interest earned on advances of rebates to an unrelated thirdparty.  The net increase in other incomewas also caused by a decrease in interest expense as well as our improved cashposition and higher interest rates.

Income before theprovision for income taxes decreased $2.0 million, or 36.7%, from $5.5 millionfor the three months ended March 31, 2005, to $3.5 million for the three monthsended March 31, 2006.  The primary factorleading to this decrease in income before the provision for income taxes wasthe $2.7 million increase in our selling, general and administrative expenses,primarily related to the PCN acquisition and the initial expensing of employeestock options.  This decrease waspartially offset by the $0.2 million increase in our gross profit and the $0.4million increase in other income, net.

The effective taxrate was 42.6% for the three months ended March 31, 2006, as compared to 41.0%for the three months ended March 31, 2005. The increase in the effective tax rate for the three months ended March31, 2006 was the result of the expensing of employee incentive stock options inaccordance with FASB Statement No. 123(R). This compensation expense for incentive stock options, which is notdeductible for tax purposes, increased our effective tax rate by 2.92%.  The current estimated tax rate for the full2006 fiscal year is 42.6%.

Net incomedecreased $1.3 million, or 38.5%, from $3.3 million for the three months endedMarch 31, 2005, to $2.0 million for the three months ended March 31, 2006.  The decrease in net income was primarilyattributable to the increase in our selling, general and administrativeexpenses, net of the increase in the gross profit and the increase in the otherincome, net.

In addition, therewere two charges against income available to common stockholders related to theNew Mountain Transaction (See Note 3 of Part 1, Item 1).  The first of these charges relates to theseries A preferred stock cash dividends, which amounted to $1.4 million forboth the three months ended March 31, 2006 and 2005. The series A preferredstock provides for an initial cash dividend equal to 7% of the investmentamount (currently $80 million), which decreases to 3.5% after the fifthanniversary of issuance.  The dividendsof $1.4 million represent the amount accrued and paid for both in the three monthsended March 31, 2006 and 2005.  Thesecond charge is for the accretion of transaction expenses which was $0.1million for both the three months ended March 31, 2006 and March 31, 2005.

After deductingthese two charges from net income, there remained net income available tocommon stockholders of $0.5 million for the three months ended March 31, 2006,as compared to $1.8 million for the three months ended March 31, 2005.

***NineMonths Ended March 31, 2006 Compared to Nine Months Ended March 31, 2005***

Revenue increased$66.7 million, or 11.4%, from $584.7 million for the nine months ended March31, 2005, to $651.4 million for the nine months ended March 31, 2006.  Revenue 

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recognized forcontracts recorded on a gross revenue basis was $580.5 million for the ninemonths ended March 31, 2005 and $643.7 million for the nine months ended March31, 2006.  Revenue recognized forcontracts recorded on a net revenue basis was $4.2 million for the nine monthsended March 31, 2005 and $7.7 million for the nine months ended March 31, 2006.The specific terms of the contracts that we enter into with our sponsors willdetermine whether we recognize the gross revenue related to the cost of theprescriptions filled (see Critical Accounting Policies and Estimates — Revenue Recognition).  For those contracts on which we recognize netrevenue, gross profit is equal to net revenue since neither the prescriptionrevenue nor the related costs of the prescriptions are recorded.  Whether revenues are recorded on either agross or net basis, we record the gross amount billed in accounts receivableand the related claims payable to the pharmacies on the balance sheet.    We include in revenue only thoseco-payments collected in our mail service facility in Miramar, Florida.  For the nine months ended March 31, 2006,there was $13.9 million of co-payments included in revenue versus $10.8 millionfor the nine months ended March 31, 2005. Co-payments retained by pharmacies onprescriptions filled for our members and not included in our revenue were$243.0 million and $203.6 million, for the nine months ended March 31, 2006 and2005, respectively.

The $66.7 millionincrease in revenue during the nine months ended March 31, 2006 was primarilyattributable to the inclusion of $56.4 million of revenue generated by PCNwhich we acquired during the quarter ended March 31, 2005 as well as anincrease in revenue of $10.3 million from other sources.  This $10.3 million increase is primarilycomprised of a) $49.3 million reduction in revenue related to the terminationof existing sponsor contracts, b) $0.8 million increase in credit memos issuedto various customers ($0.5 million of which was issued to one customer), c)$47.2 million increase in revenue related to new sponsors or new servicesoffered by us, excluding contracts recorded on a net revenue basis, and d)$13.2 million of revenue from existing sponsors related to, among other things,higher costs for pharmaceuticals, availability of new drugs, plan participantgrowth and an increase in the average number of claims per plan participant.

The $60.8 millionincrease in cost of claims during the nine months ended March 31, 2006 wasprimarily attributable to the inclusion of $49.7 million of costs of claimsincurred by PCN which we acquired during the quarter ended March 31, 2005 aswell as an increase in costs of claims of $11.1 million from othersources.  This $11.1 million increase isprimarily comprised of a) $46.4 million reduction in costs of claims related tothe termination of existing sponsor contracts, b) $0.5 million write-down ofobsolete inventory from our mail service facility in Miramar, Florida, c) $46.1million increase in costs of claims related to the activity of new sponsors,and d) $10.9 million increase in costs of claims related to the growth inexisting sponsors.  As a percentage ofrevenue, cost of claims increased from 89.1% to 89.3% for the nine months endedMarch 31, 2005 and 2006, respectively.

Gross profit increased $5.9 million, or 9.2%, from $63.8 million forthe nine months ended March 31, 2005 to $69.7 million for the nine months endedMarch 31, 2006. PCN accounted for $6.7 million of this increase, while another$3.0 million of incremental gross profit was generated by our expanding mailservice and specialty operations.  Theseincreases were partially offset by a $0.7 million decrease in the amount ofrebates we retained during the nine months ended March 31, 2006 as compared tothe nine months ended March 31, 2005.  Generalcompetitive pricing pressureswhich have led to a decline in some prices that we charge to our sponsors aswell as the issuance of credit memos to certain customers and the write-down of

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obsolete inventoryas noted above have hadthe effect of partially offsetting the increases in gross profit.  Gross profit, as a percentage of revenue,decreased from 10.9% to 10.7% for the nine months ended March 31, 2005 and2006, respectively.

Selling, general and administrative expenses increased $8.2 million, or16.8%, from $48.7 million for the nine months ended March 31, 2005 to $56.9million for the nine months ended March 31, 2006. The acquisition of PCN andcompensation expense related to the expensing of employee stock optionsaccounted for $5.0 million and $1.9 million of this increase, respectively.  The expensing of employee stock options wasrequired to be included in our selling, general and administrative expensesbeginning July 1, 2005.  The remainder ofthe increase was primarily due to $1.0 million incurred for new operatingleases as well as $0.3 million for severance payments accrued to formeremployees.

Selling, general and administrative expenses as a percent of revenueincreased from 8.3% for the nine months ended March 31, 2005 to 8.7% for thenine months ended March 31, 2006.

Other income, net decreased $0.6 million, or 44.0%, from $1.4 millionfor the nine months ended March 31, 2005 to $0.8 million for the nine monthsended March 31, 2006.  The primarycomponent of the $0.6 million decrease in other income was the recognition of anon-recurring gain of $1.7 million from an insurance claim which representedthe excess of the insurance proceeds over the carrying value of the assetscovered by the claim during the nine months ended March 31, 2005.  This item was partially offset by higher cashbalances due to increased cash flow from operations which resulted in anincrease in interest income during the nine months ended March 31, 2006.  In addition, we aggregate rebates for anunrelated third party and charge such third party interest on advances we maketo them for their rebates.  For the ninemonths ended March 31, 2006, we earned $0.5 million in interest income fromthis unrelated third party.

Income before theprovision for income taxes decreased $2.9 million, or 17.9%, from $16.5 millionfor the nine months ended March 31, 2005 to $13.5 million for the nine monthsended March 31, 2006.  The primary factorleading to this decrease in income before the provision for income taxes wasthe decrease in other income, net which included, as described above, therecognition of a non-recurring gain of $1.7 million related to an insuranceclaim during the nine months ended March 31, 2005.  The increase in selling, general andadministrative expenses, primarily related to the PCN acquisition and the initialexpensing of employee stock options also contributed to the decrease in incomebefore the provision for income taxes. This decrease was partially offset by the increase in our gross profit.

The effective taxrate was 42.7% for the nine months ended March 31, 2006, as compared to 41.0%for the nine months ended March 31, 2005. The increase in the effective taxrate for the nine months ended March 31, 2006 was the result of the expensingof employee incentive stock options in accordance with FASB Statement No.123(R).  This compensation expense forincentive stock options, which is not deductible for tax purposes, increasedour effective tax rate by 2.92%.  The taxrate of 42.7% represents our current estimated tax rate for the full 2006fiscal year.

Net incomedecreased $2.0 million, or 20.1%, from $9.7 million for the nine months endedMarch 31, 2005 to $7.8 million for the nine months ended March 31, 2006.  The decrease in net income was primarilyattributable to the non-recurring after-tax gain of $1.0 million described 

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above related toan insurance claim during the nine months ended March 31, 2005, as well as a$1.5 million compensation charge, net of its income tax benefit, related to theexpensing of employee incentive stock options, beginning July 1, 2005, inaccordance with FASB Statement No. 123(R). This decrease was further caused by the increase in our selling, generaland administrative expenses, net of the increase in our gross profit.

In addition, therewere two charges against income available to common stockholders related to theNew Mountain Transaction (See Note 3 of Part 1, Item 1).  The first of these charges relates to theseries A preferred stock cash dividends, which amounted to $4.2 million forboth the nine months ended March 31, 2006 and 2005.  The series A preferred stock provides for aninitial cash dividend equal to 7% of the investment amount (currently $80million), which decreases to 3.5% after the fifth anniversary of issuance.  The dividend of $4.2 million represents theamount accrued and paid for both the nine months ended March 31, 2006 and2005.  The second charge is for theaccretion of transaction expenses which were $0.4 million for both the ninemonths ended March 31, 2006 and 2005.

After deductingthese two charges from net income, there remained net income available tocommon stockholders of $3.2 million for the nine months ended March 31, 2006,as compared to $5.2 million for the nine months ended March 31, 2005.

# **Liquidity and Capital Resources**

Our primary cash requirementsare for capital expenditures and operating expenses, including cost ofpharmaceuticals, software and hardware upgrades and the funding of accountsreceivable and inventory in our mail service and specialty pharmacy facilities.Also, we require cash to execute our strategy of pursuing acquisitions of otherPBM companies or of companies providing related services.  We have now acquired seven companies sinceJuly 2000 utilizing primarily cash.  Thishas had the effect of increasing our working capital deficits until sufficientprofitability is earned to offset these deficits.  As of March 31, 2006, we had a workingcapital deficit of $11.7 million as compared to a working capital deficit of$24.4 million as of June 30, 2005. The primary reason for the improvement inworking capital was the profits we generated during the nine months ended March31, 2006.

We have a bankingstructure resulting in certain disbursement accounts carrying negative bookbalances of $29.2 million and $8.3 million at March 31, 2006 and June 30, 2005,respectively, which are reclassified to claims payable and accountspayable.  This reclassification restores balances to cash and currentliabilities for liabilities to our vendors which have not yet beensatisfied.  No bank overdraft or unsecured short-term loan exists inrelation to these negative balances.

Net cash providedby operating activities was $7.3 million for the nine months ended March 31,2006, as compared to net cash provided by operating activities of $4.5 million forthe nine months ended March 31, 2005. This increase of $2.8 million in net cash provided by operatingactivities was primarily the result of a $13.0 million increase in trade andother payables, a $27.3 million reduction in accounts receivable through ourimproved collection efforts during the nine months ended March 31, 2006 and$1.9 million relating to the expensing of employee stock options.  These increases were partially offset by an$11.8 million decrease in claims payable to pharmacies, a $15.4 millionincrease in rebates receivable from manufacturers, an $8.6 million 

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decrease in rebatepayable to sponsors and a $1.2 million increase relating to the excess taxbenefits from the exercising of stock options in accordance with FASB StatementNo. 123(R).  The increase was furtheroffset by $2.4 million of net cash used in operating activities from variousoperating assets and liabilities.

Historically, thetiming of our accounts receivable and accounts payable has generally been a netsource of cash from operating activities. This is the result of the terms oftrade in place with plan sponsors on the one hand, and our pharmacy network onthe 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 expect to operate on similar terms for the foreseeablefuture.  Further, the timing of ourrebates receivable and rebates payable has also been a net source of cash fromoperating activities.  This is the resultof the terms of trade in place with plan sponsors on the one hand, and drugmanufacturers on the other hand. These terms generally lead to our payments ofrebates to our sponsors being slower than its corresponding collections fromdrug manufacturers. We believe that this situation is not unusual in thepharmacy benefit management industry and expect to operate on similar terms forthe foreseeable future.  However, therecan be no assurance that such terms of trade will continue in the future and,if they were to change materially, we could require additional working capitalfinancing. Furthermore, if such terms of trade were to change materially,and/or if we were unable to obtain additional working capital financing, therecould be a material adverse effect on our business, financial condition, orresults of operations.

Historically, ouraccounts receivable have increased at a rate faster than revenue because thereare certain contracts, such as our Preferred Partnership Program, in which, ingeneral, we bill these pass-through sponsors on a gross revenue basis but onlyrecognize their revenue on a net basis. 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 PartnershipProgram contracts, which, in general, are full pass-through contracts, wereceive a fixed charge per claim and a small fixed percentage of the rebatessubject to minimums; and all other pharmacy costs are charged to the plansponsor.  The entire amount paid to the pharmacy isbilled to the plan sponsor, and there is no margin retained by us.

Net cash used ininvesting activities was $6.0 million for the nine months ended March 31, 2006,as compared to net cash used in investing activities of $1.6 million for thenine months ended March 31, 2005.  Thisincrease of $4.4 million in net cash used in investing activities was primarilythe result of a $1.6 million increase in capital expenditures along with $3.2million of cash generated from the PCN acquisition in March 2005.  The PCN cash balance at the closing date,March 7, 2005, was reported as a $3.2 million source of cash, or cash providedby investing activities, calculated by subtracting the $13.5 millionacquisition price and related costs from the $16.7 million of cashacquired.  These increases were partiallyoffset by a $0.4 million decrease in the cash provided by other investing activities.

Net cash providedby financing activities was $1.7 million for the nine months ended March 31,2006, as compared to net cash used in financing activities of $1.7 million forthe nine months ended March 31, 2005. This increase of $3.4 million was the result of a $1.4 million increasein proceeds from the exercise of employee stock options and a reduction of $0.3million in the repayment of capital lease obligations during the nine monthsended March 31, 2006 as all but 

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two of our capitalleases have expired.  The increase wasfurther caused by a $1.2 million cash inflow during the nine months ended March31, 2006, which represented the excess tax benefit from the exercise ofemployee stock options in accordance with FASB Statement No. 123(R).  The remainder of the increase wasattributable to $0.5 million of net cash provided by other financingactivities.

On January 28, 2005, we enteredinto a five-year $65.0 million cash flow based, line of credit with a syndicateof commercial banks led by JPMorgan Chase 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 JPMorgancredit facility contains various covenants that, among other things, require usto maintain certain financial ratios, which are consolidated net worth,consolidated fixed charge ratio and consolidated debt to EBITDA (earningsbefore interest, taxes, depreciation and amortization) ratio.  As of March31, 2006, there was no principal balance outstanding under the JPMorgancredit facility, and we were in compliance with all of our financial covenants as set forth in the credit agreement in connection with thecredit facility.

Two of thesefinancial covenants are based upon the EBITDA generated by us over specifiedperiods of time.  These covenants,consolidated fixed charge ratio and consolidated debt to EBITDA ratio, areevaluated by JPMorgan as a measure of our liquidity and our ability to meet allof our obligations under the credit facility. EBITDA is presented as cash flowfrom operations plus or minus the net changes in assets and liabilities and thechanges in certain non-cash reconciling items from net cash from operations tonet income over the reported periods. While EBITDA is not a measure of financial performance or liquidityunder United States generally accepted accounting principles, it is provided asinformation for investors for analytical purposes in light of the financialcovenants referred to above. EBITDA is not meant to be considered a substituteor replacement for net income as prepared in accordance with United Statesgenerally accepted accounting principles. EBITDA, which decreased by $3.4 million or 15.8%, from $21.5 million forthe nine months ended March 31, 2005 to $18.1 million for the nine months endedMarch 31, 2006, is calculated as follows (see Consolidated Statement of CashFlows comprising Item 1 hereof for more details):
| ** **                                                          | ** ** | **Nine Months  Ended March 31,** | ** ** |
|---------------------------------------------------------------------|------------|-------------------------------------------------|------------|
| ** **                                                          | ** ** | **2006**                                        | ** ** | **2005** | ** ** |
| Cash flow from operations                                           |       | $                                               | 7,289      |   | $ | 4,450 |   |
| Provision for  income taxes                                         |       | 5,777                                           |       | 6,765 |   |
| Interest  (income) expense, net                                     |       | (807                                            | )          | 373 |   |
| Net change in  assets and Liabilities                               |       | 8,461                                           |       | 11,531 |   |
| Non-cash items  to reconcile net cash from operations to net income |       | (2,578                                          | )          | (1,565 | ) |
| EBITDA                                                              |       | $                                               | 18,142     |   | $ | 21,554 |   |

 

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We have enteredinto various capital lease transactions for hardware and software.  We have also assumed various capital leasesthrough our acquisitions. As of March 31, 2006, there are two capital leasesremaining in effect.

We have enteredinto various real estate operating leases with both related and unrelatedparties.  We have entered into variousequipment operating leases and a sale-leaseback with unrelated third partiesfor office and mail service equipment. These leases have different payment terms and expiration dates.  See Note 11 to the Consolidated FinancialStatements comprising Item 8 of Form 10—K for the year ended June 30, 2005 fora further description of these various leases.

Thetotal future payments under these contractual obligations as of March 31, 2006,are as follows:

**ContractualObligations**

**PaymentsDue by Period($ in thousands)**
| ** **                         | ** ** | **Total** | ** ** | **Less than  1 Year** | ** ** | **1-3 Years** | ** ** | **4-5  Years** | ** ** | **More than  5 Years** | ** ** |
|------------------------------------|------------|-----------|------------|---------------------------------|------------|--------------------|------------|----------------|------------|----------------------------------|------------|
| Capital Lease  Obligations         |       | $         | 24         |                            | $          | 24                 |       | $              | —     |                             | $          | — |   | $ | — |   |
| Operating Leases                   |       | 20,200    |       | 6,988                           |       | 7,799              |       | 3,236          |       | 2,177                            |       |
| Sale-leaseback                     |       | 210       |       | 105                             |       | 105                |       | —         |       | —                           |       |
| Total Contractual Cash Obligations |       | $         | 20,434     |                            | $          | 7,117              |       | $              | 7,904      |                             | $          | 3,236 |   | $ | 2,177 |   |

 

The shareholders of PCN are eligible to receive additionalconsideration of up to $30.0 million, if certain financial and performancetargets are met over the three year period beginning March 1, 2005.  As of March 31, 2006, the financialand performance targets have not been achieved.

The shareholdersof the Inteq Group were eligible to receive additional consideration of up to$4.2 million, if certain financial targets were met during the year ended April1, 2005.  Of this potential amount, $3.0million was deposited in escrow at the time of closing.  As of March 31, 2006, $1.0 million was earnedand released from escrow, with the balance of $2.0 million being returned tous.

The shareholdersof PPP are eligible to receive additional consideration of up to $7.0 million,if certain financial targets are met over the three year period beginningAugust 1, 2003.  Such amounts earned arepayable within 45 days after the first, second, and third anniversary of thedate of acquisition.  In the solediscretion of NMHC, up to 50% of any amounts earned can be paid in the form ofour stock in lieu of cash. For the year ended July 31, 2004, $716,000 has beenearned and was paid on September 15, 2004. Of this amount, $358,000 was paid in cash and $358,000 was satisfied bythe issuance of 12,650 shares of our common stock.  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 17,127 shares of our commonstock.  As of March 31, 2006, $649,000has been accrued as additional purchase price and will be settled in September2006.

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We entered into anamended and restated preferred stock purchase agreement, dated as of November26, 2003, with New Mountain Partners, L.P. (the “purchase agreement”).  Pursuant to the purchase agreement, weagreed, subject to various conditions, to issue to New Mountain Partners atotal of 6,956,522 shares of series A preferred stock at a purchase priceof $11.50 per share, for aggregate proceeds of 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.

Following thecompletion of the tender offer, New Mountain Partners owned securities at March19, 2004 that were initially convertible into approximately 64% of our issuedand outstanding common stock and prior to conversion of the series Apreferred stock were entitled to cast that number of votes that is equal toapproximately 60% of our aggregate voting power.  Following the closing of the New MountainTransaction, New Mountain Partners was entitled to and did nominate and elect60% of the members of our board of directors.

We used theremaining proceeds from the issuance and sale of the series A preferredstock of approximately $24 million, excluding expenses related to theclosing of the New Mountain Transaction, for the Inteq Acquisition (See Note 4of Part 1, Item 1) and working capital purposes.

The series Apreferred 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 series A preferred stockis convertible into common stock at a price of $11.50 per share of commonstock, or an aggregate of 6,956,522 shares of our common stock.

The series Apreferred stock may be redeemed at our option subsequent to the fourthanniversary of its issuance, subject to certain conditions.  After the tenth anniversary of the issuanceof the series A preferred stock, each holder of shares of series Apreferred stock may require us to redeem all or a part of that holder’s sharesof series A preferred stock.

We anticipate thatcurrent cash positions and available credit facilities, after our sevenacquisitions together with anticipated cash flow from operations, will besufficient to satisfy our contemplated cash requirements for at least 24months.  This is based upon current levelsof capital expenditures and anticipated operating results for the next 24months.  However, it is one of our statedgoals to acquire other pharmacy benefit management companies and companiesproviding related services.  Depending onour evaluation of future acquisitions, additional cash may be required tocomplete these acquisitions.  Inaddition, we will require cash to acquire additional inventory for our mailservice and specialty distribution divisions to service our expandingoperations.  In the event that our planschange or our assumptions prove to be inaccurate, or our cash on hand togetherwith the proceeds from the new revolving credit facility prove to beinsufficient to fund operations and acquisitions, we could be required to seekadditional financing sooner than anticipated. There can be no assurance that such financing could be obtained at ratesor on terms acceptable to us, if at all.

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**Other Matters**

***Inflation***

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

**CriticalAccounting Policies and Estimates**

***General***

Our discussion andanalysis of NMHC’s financial condition and results of operations are based uponour unaudited consolidated financial statements, which have been prepared inaccordance with United States generally accepted accounting principles.   The preparation of these financialstatements requires us to make estimates and judgments that affect the reportedamounts of assets, liabilities, revenue and expenses; these estimates and judgmentsalso affect related disclosures of contingent assets and liabilities.  On an on-going basis, we evaluate ourestimates and judgments, including those related to revenue recognition, baddebt, intangible assets, cash, income taxes, software capitalization, andshare-based payments.  We base ourestimates on experience and on various other assumptions that are believed tobe reasonable under the circumstances, the results of which form the basis formaking judgments about the carrying values of assets and liabilities that arenot readily apparent from other sources. Actual results may differ from these estimates under differentassumptions or conditions.

We believe that ofour significant accounting policies (See Note 1 to the Consolidated FinancialStatements comprising Item 8 of Form 10-K for the year ended June 30, 2005),the following may involve a higher degree of judgment and complexity thanothers:

***RevenueRecognition***

(a)                                  SinceJanuary 1, 2000, primarily all services provided by NMHC have been on a fee forservice basis.  Under the fee for servicearrangement, we are paid by our sponsors for our contractually agreed uponrates based upon actual claims adjudicated, plus a fixed transaction fee.

Revenue under the fee for service arrangement is recognizedwhen the claims are adjudicated. Included as revenue are our administrative fees and charges relating topharmaceuticals dispensed by our network of pharmacies.  Revenue is reduced by the amount of rebatespaid to our sponsors.

(b)                                 Thespecific terms of the contracts that we enter into with our sponsors willdetermine whether we recognize the gross revenue related to the cost of theprescriptions filled.  There are several factors from EITF 99-19 that ledus to recognize the majority of our revenue on a gross basis.  These include: we act as a principal and notan agent and are the primary obligor in the relationship among the pharmacies,the sponsors and NMHC, we have credit risk, we have certain latitude in establishingprice, and we have discretion in supplier selection. In certain cases, primarily because the amount we earn is fixed,we have not recognized the gross revenue or cost related to prescriptionsfilled for a specific 

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sponsor.  Thishas no impact on our gross profit since neither the prescription revenue northe related cost of the prescriptions is recorded.  Whether revenues are recorded on either agross or net basis, we record the gross amount billed in accounts receivableand the related claims payable to the pharmacies on the balance sheet.

(c)                                  Weinclude in revenue only those co-payments collected from individual members byour mail service facility in Miramar, Florida. Co-payments retained bypharmacies on the remainder of the prescriptions filled for our members are notincluded in our reported revenue.  Wedisclose these amounts parenthetically on the face of our ConsolidatedStatement of Income.

(d)                                 We recognize revenue at the point ofshipment by our mail service facility in Miramar, Florida for the “sale” of theprescription to us at specified prices. Revenue from this intercompany sale iseliminated in consolidation.  Werecognize co-payment revenue from our mail service facility in Miramar, Floridaupon collection.

(e)                                  We recognize revenue and co-paymentrevenue at the point of shipment by our specialty facility in Portland, Maine.

(f)                                    Rebatesare recognized when we are entitled to them in accordance with the terms of ourarrangements with drug manufacturers, third party rebate administrators, andsponsors, and when the amount of the rebates is determinable.  We record the gross rebate receivable and theappropriate payable to the sponsors based on estimates, which are subject tofinal settlement.  We periodically reviewand revise the estimates of the rebate receivables and payables that are stilloutstanding to determine the reasonableness of the initial recording.  The estimates are based upon the claimssubmitted and our rebate experience, and are adjusted as additional informationbecomes available.

***BadDebt***

We maintain allowancesfor doubtful accounts for estimated losses resulting from the liability of oursponsors to make required payments.  Ifthe financial condition of our sponsors were to deteriorate, resulting in animpairment of their ability to make payments, additional allowances may berequired.

***Goodwilland Intangible Asset Impairment***

In assessing therecoverability of our goodwill and other intangibles, we must make assumptionsregarding estimated future cash flows and other factors to determine the fairvalue of the respective assets.  If theseestimates or their related assumptions change in the future, we may be requiredto record impairment charges for these assets not previously recorded.  On July 1, 2001 we adopted Statement ofFinancial Accounting Standards No. 142, “Goodwill and Other Intangible Assets,”and are required to analyze our goodwill for impairment issues on a periodicbasis thereafter.  To date, we have notrecorded any impairment losses related to goodwill and other intangible assets.

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***Cash***

We have a bankingstructure resulting in certain disbursement accounts carrying negative bookbalances of $29.2 million and $8.3 million at March 31, 2006 and June 30, 2005,respectively, which are reclassified to claims payable and accountspayable.  This reclassification restores balances to cash and currentliabilities for liabilities to our vendors which have not yet beensatisfied.  No bank overdraft or unsecured short-term loan exists inrelation to these negative balances.

***DeferredTaxes***

We periodically considerwhether or not to record a valuation allowance to reduce our deferred taxassets to the amount that is more likely than not to be realized.  While we have considered future taxableincome and ongoing tax planning strategies in assessing the need for thevaluation allowance, in the event we were to determine that we would be able torealize our deferred tax assets in the future in excess of its net recordedamount, an adjustment to the deferred tax asset would increase income in theperiod such determination was made. Likewise, should we determine that we would not be able to realize allor part 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.

***CapitalizedSoftware***

The costs ofsoftware developed for internal use incurred during the preliminary projectstage are expensed as incurred.  Directcosts incurred during the application development stage which provideadditional functionality are capitalized. Costs incurred during the post-implementation/operation stage areexpensed as incurred.  Capitalizedsoftware development costs are amortized on a straight-line basis over theirestimated useful lives, commencing on the date the software is placed into use,primarily three years.

***Share-BasedPayments***

Following theadoption of FASB Statement No. 123(R), *Share-Based Payment*,we now include in our consolidated statement of income an estimate of thecompensation cost resulting from the issuance of employee stock options.  The calculation of this compensation cost isdependent upon various valuation assumptions such as expected option life,volatility, risk-free interest rates, expected forfeiture rates, and post-vestingterminations.  While we believe that ouremployee stock option related assumptions are reasonable, actual vesting andexercise patterns may be significantly different.

**ITEM 3—**QUANTITATIVEAND QUALITATIVE DISCLOSURES ABOUT MARKET RISK 

Not Applicable.

**ITEM 4—**CONTROLSAND 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 

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1934, as amended (“ExchangeAct”) is recorded, processed, summarized and reported within the time periodsrequired.  They include, withoutlimitation, controls and procedures designed to ensure that information isaccumulated and communicated to management in order to allow timely decisions regardingrequired disclosure.  

Under thesupervision 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) under the ExchangeAct), as of March 31, 2006.  Based onthat evaluation, our principal executive officer and our principal financialofficer have concluded that these controls and procedures are effective inalerting them to material information, on a timely basis, required to beincluded in our periodic Securities and Exchange Commission filings.  There have been no changes in our internalcontrols over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f)under the Exchange Act) that occurred in this period that have materiallyaffected, or are reasonably likely to materially affect, our internal controlsover financial reporting.

 

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### **PART II—OTHERINFORMATION**

**ITEM 1—**LEGALPROCEEDINGS 

None.

**ITEM 1A**—RISK FACTORS

None.

**ITEM 2—**UNREGISTEREDSALES OF EQUITY SECURITIES AND USE OF PROCEEDS

None.

**ITEM 3—**DEFAULTSUPON SENIOR SECURITIES

None.

**ITEM 4—**SUBMISSIONOF MATTERS TO A VOTE OF SECURITY HOLDERS

None.

**ITEM 5—**OTHERINFORMATION

None.

**ITEM 6—**EXHIBITS

Exhibits
| 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(11)                                                                            |
| 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) |

 

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| 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            |   | Employment Agreement dated December 16, 2005 between  NMHC and Stuart Diamond(10)                                                                        |
| 10.6            |   | Form of Stock Option Agreement between NMHC and  Non-Employee Directors(11)                                                                              |
| 10.7            |   | Form of Stock Option Agreement between NMHC and  Senior Executive Officers(11)                                                                           |
| 10.8            |   | Form of Severance Agreement for Senior Executive  Officers(11)                                                                                           |
| 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)             Denotesdocument filed as an Exhibit to NMHC’s Registration Statement on Form S-1(Registration Number:  333-72209) andincorporated herein by reference.

(2)             Denotesdocument filed as an Exhibit to NMHC’s Definitive Proxy Statement on Schedule14-A filed on December 21, 2001 and incorporated herein by reference.

(3)             Denotesdocument filed as an Exhibit to NMHC’s Report on Form 10-K for the year endedJune 30, 2003 and incorporated herein by reference.

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

(5)             Denotesdocument filed as an Exhibit to NMHC’s Form 10-Q for the quarter ended March31, 2004 and incorporated herein by reference.

(6)             Denotesdocument filed as an appendix to NMHC’s Definitive Proxy Statement on Schedule14-A filed on October 28, 2005 and incorporated herein by reference.

(7)             Denotesdocument filed as an exhibit to NMHC’s Form 8-K filed on February 3, 2005 andincorporated herein by reference.

(8)             Denotesdocument filed on October 28, 2004 as an exhibit to NMHC’s Definitive ProxyStatement on Schedule 14-A and incorporated herein by reference.

(9)             Denotesdocuments filed as an Exhibit to NMHC’s Form 10-Q for the quarter endedSeptember 30, 2005 and incorporated herein by reference.

(10)       Denotesdocuments filed as an Exhibit to NMHC’s Form 8-K filed on January 26, 2006 andincorporated herein by reference.

(11)       Denotesdocuments filed as an Exhibit to NMHC’s Form 10-Q filed for the quarter endedDecember 31, 2005 and incorporated herein by reference.

 

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# SIGNATURES

Pursuantto the requirements of the Securities Exchange Act of 1934, as amended, theRegistrant has duly caused this report to be signed on its behalf by theundersigned thereunto duly authorized.

NATIONAL MEDICAL HEALTHCARD SYSTEMS, 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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