** **

**U.S. SECURITIES ANDEXCHANGE COMMISSION**

**WASHINGTON, DC 20549**

** **

**FORM10-Q/A**

**AMENDMENTNO. 1**

** **
| **(Mark  One)**                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     |   |                                                                                           |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|------------------------------------------------------------------------------------------------|
| ** **                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          |   |                                                                                           |
| ý                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              |   | **QUARTERLY REPORT PURSUANT TO  SECTION 13 or 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934.**  |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                |   |                                                                                           |   |   |
| **For  the quarterly period ended December 31, 2005**                                                                                                                                                                                                                                                                                                                                                                                                                                                               |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                |   |                                                                                           |   |   |
| **OR**                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                |   |                                                                                           |   |   |
| o                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   |   | **TRANSITION REPORT PURSUANT TO  SECTION 13 or 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934.** |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                |   |                                                                                           |   |   |
| **For  the transition period from                                          to                                        ** |

 

**Commission file number 000-26749**

 

**NATIONALMEDICAL HEALTH CARD SYSTEMS, INC.**

(Exact Name of Registrant as Specified in Its Charter)

 

| **Delaware**                                                               |   | **11-2581812**                    |
|----------------------------------------------------------------------------|--------|-----------------------------------|
| (State or Other Jurisdiction of Incorporation or Organization)             |   | (IRS Employer Identification No.) |
|                                                                       |   |                              |
| **26 Harbor Park Drive, Port Washington, NY**                              |   | **11050**                         |
| (Address of Principal Executive Offices)                                   |   | (Zip Code)                        |
|                                                                       |   |                              |
| Registrant’s Telephone Number, Including Area Code **(516) 626-0007** |

 

**Not Applicable**

Former Name, Former Address and Former Fiscal Year, if Changed SinceLast Report.

 

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    ý               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):

Largeaccelerated filer o                      Acceleratedfiler ý                      Non-acceleratedfiler o

 

Indicateby check mark whether the registrant is a shell company (as defined in Rule12b-2 of the Exchange Act.)

Yes  o               No  ý

 

**APPLICABLE ONLY TO CORPORATE ISSUERS:**

** **

The number of sharesoutstanding of the issuer’s common stock, as of February 7, 2006 was 5,185,685shares.

 

 

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NATIONAL MEDICAL HEALTHCARD SYSTEMS, INC. AND SUBSIDIARIES

 

**Explanatory Note**

 

National Medical Health Card Systems, Inc. (“NMHC”) received a review letter from the Staff of the  Securities  and Exchange Commission (“SEC”) as part of its periodic examination of public company disclosure.   In  connection with the review by the SEC, this Amendment No. 1  to the quarterly report on Form 10-Q/A of NMHC hereby amends the information in its Form 10-Q for the second fiscal quarter ended December 31, 2005,  as filed with the SEC on February 9, 2006, by amending the information contained in Items 1 and 2 of Part I to (i) remove certain non-GAAP performance measures and (ii) revise the disclosure to provide the total cost related to nonvested awards and clarify certain other information contained therein. For the convenience of the reader, this Form 10-Q/A sets  forth the original Form 10-Q in its entirety.

 

In addition, as previously disclosed in NMHC’s Form 8-K filed with the SEC on September 12, 2006, on September 11, 2006, in connection with the preparation of its annual report on Form 10-K for the year ended June 30, 2006, NMHC concluded that it should restate its previously issued financial statements for its second fiscal quarter ended December 31, 2005 to reflect the correction of two rebate cash receipts from one pharmaceutical manufacturer which resulted in NMHC recognizing additional rebate revenue during the quarter ended December 31, 2005 (the “Restatement”).  The Restatement reflects adjustments to NMHC’s revenue and cost of claims for the three and six month periods ended December 31, 2005.  The impact of error realized in the estimation of rebates receivable and payable at December 31, 2005 on NMHC’s income statement was an overstatement of operating income of $662,000 ($380,000 net of tax) for the quarter ended December 31, 2005.  The Restatement has been incorporated in Items 1 and 2 of Part I of this Form 10-Q/A to revise the disclosure impacted by such restatement.  There was no impact on the results for the full year ended June 30, 2006.  For a more detailed description of the Restatement, see Note 2, “Restatement of Financial Statements,” to the accompanying consolidated financial statements and the section entitled “Restatement” in Management’s Discussion and Analysis of Financial Condition and Results of Operations contained in this Form 10-Q/A.

 

This amendment continues to speak as of the filingdate of our original Form 10-Q for the quarter ended December  31, 2005. We have not restated, amended, modified, supplementedor updated the disclosures contained in this amendment to reflect events thathave occurred since the filing of the original Form 10-Q, nor have we restated, amended, modified, supplementedor updated these disclosures in any way other than as described above.Accordingly, this amendment should be read in conjunction with our filings madewith the SEC after February 9, 2006, the filing date of the original Form 10-Q.

 

2

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NATIONAL MEDICAL HEALTHCARD SYSTEMS, 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 December 31, 2005 (unaudited) and June 30, 2005                                   | 5          |
|       |       |                                                                                                                |       |
|       |       | CONSOLIDATED  STATEMENT OF INCOME (unaudited) for the three months and six months ended  December 31, 2005 and 2004 | 6          |
|       |       |                                                                                                                |       |
|       |       | CONSOLIDATED  STATEMENT OF CASH FLOWS (unaudited) for the six months ended December 31,  2005 and 2004              | 7          |
|       |       |                                                                                                                |       |
|       |       | CONDENSED  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS                                                               | 8          |
|       |       |                                                                                                                |       |
| ITEM 2     | -          | MANAGEMENT’S DISCUSSION AND  ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS                         | 21         |
|       |       |                                                                                                                |       |
| ITEM  3    | -          | QUANTITATIVE  AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK                                                         | 34         |
|       |       |                                                                                                                |       |
| ITEM 4     | -          | CONTROLS AND  PROCEDURES                                                                                            | 34         |
|       |       |                                                                                                                |       |
| PART II    | -          | OTHER INFORMATION                                                                                                   | 36         |
|       |       |                                                                                                                |       |
| ITEM 1     | -          | LEGAL  PROCEEDINGS                                                                                                  | 36         |
|       |       |                                                                                                                |       |
| ITEM 1A    | -          | RISK FACTORS                                                                                                        | 36         |
|       |       |                                                                                                                |       |
| ITEM 2     | -          | UNREGISTERED  SALES OF EQUITY SECURITIES AND USE OF PROCEEDS                                                        | 36         |
|       |       |                                                                                                                |       |
| ITEM 3     | -          | DEFAULTS  UPON SENIOR SECURITIES                                                                                    | 36         |
|       |       |                                                                                                                |       |
| ITEM  4    | -          | SUBMISSION  OF MATTERS TO A VOTE OF SECURITY HOLDERS                                                                | 36         |
|       |       |                                                                                                                |       |
| ITEM 5     | -          | OTHER INFORMATION                                                                                                   | 37         |
|       |       |                                                                                                                |       |
| ITEM 6     | -          | EXHIBITS                                                                                                            | 37         |

 

3

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**Forward-Looking Statements**

 

When used herein, the words “may,”“could,” “estimate,” “believe,” “anticipate,” “think,” “intend,” “expect” andsimilar expressions identify forward-looking statements within the meaning ofthe Private Securities Litigation Reform Act of 1995. Such statements are notguarantees of future performance and involve known and unknown risks anduncertainties, and other factors, which could cause actual results to differmaterially from those in the forward-looking statements. Readers are cautionednot to place undue reliance on such statements, which speak only as of the datehereof.  Forward-looking statements madeby National Medical Health Card Systems, Inc. (“NMHC” 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 variousdisclosures made by the Company which attempt to advise investors of thefactors which affect NMHC’s business, including, without limitation, thedisclosures made under the caption “Description of Business – Risk FactorsAffecting NMHC’s Business” in Item 1 and “Management’s Discussion and Analysisof Financial Condition and Results of Operations” in Item 7 of NMHC’s AnnualReport on Form 10-K, for the fiscal year ended June 30, 2005, filed with theU.S. Securities and Exchange Commission on September 22, 2005, as amended.

 

4

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** **

**PART I –FINANCIAL INFORMATION**

 

**ITEM 1**– CONDENSED FINANCIAL STATEMENTS

  NATIONAL MEDICAL HEALTH CARD SYSTEMS,INC. AND SUBSIDIARIES

 

**CONSOLIDATEDBALANCE SHEET**

**($ inthousands)**

** **
| ** **                                                                                                                                              | ** ** | **December 31,  2005** | ** ** | **June 30,  2005** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------|------------|--------------------|------------|
| ** **                                                                                                                                              | ** ** | **(Restated)**         | ** ** | ** **         | ** ** |
| ** **                                                                                                                                              | ** ** | **(Unaudited)**        | ** ** | ** **         | ** ** |
| **Assets**                                                                                                                                              |       |                   |       |               |       |
| **Current:**                                                                                                                                            |       |                   |       |               |       |
|                                                                                                                                                    |       |                   |       |               |       |
| Cash and cash  equivalents (including cash equivalent investments of $289 and $193,  respectively)                                                      |       | $                      | 9,271      |               | $          | 7,272 |   |
| Restricted cash                                                                                                                                         |       | 3,855                  |       | 3,994              |       |
| Accounts  receivable, less allowance for doubtful accounts of $2,505 and $1,953,  respectively                                                          |       | 111,345                |       | 103,129            |       |
| Rebates  receivable                                                                                                                                     |       | 58,533                 |       | 40,377             |       |
| Inventory                                                                                                                                               |       | 6,520                  |       | 4,119              |       |
| Due from  affiliates                                                                                                                                    |       | ––           |       | 31                 |       |
| Deferred tax  assets                                                                                                                                    |       | 2,051                  |       | 2,117              |       |
| Other current  assets                                                                                                                                   |       | 1,778                  |       | 5,759              |       |
| **Total  current assets**                                                                                                                               |       | 193,353                |       | 166,798            |       |
|                                                                                                                                                    |       |                   |       |               |       |
| Property,  equipment and software development costs, net                                                                                                |       | 13,492                 |       | 12,177             |       |
| Intangible  assets, net of accumulated amortization of $3,811 and $3,273, respectively                                                                  |       | 3,463                  |       | 3,951              |       |
| Goodwill                                                                                                                                                |       | 99,842                 |       | 99,710             |       |
| Other assets                                                                                                                                            |       | 1,241                  |       | 1,295              |       |
| **Total  Assets**                                                                                                                                       |       | $                      | 311,391    |               | $          | 283,931 |   |
|                                                                                                                                                    |       |                   |       |               |       |
| **Liabilities, Redeemable Preferred Equity, and  Common Stockholders’ Equity**                                                                     |       |                   |       |               |       |
| **Current Liabilities:**                                                                                                                                |       |                   |       |               |       |
|                                                                                                                                                    |       |                   |       |               |       |
| Claims payable  to pharmacies                                                                                                                           |       | $                      | 124,607    |               | $          | 118,660 |   |
| Rebates payable  to sponsors                                                                                                                            |       | 65,385                 |       | 45,436             |       |
| Trade and other  payables and accrued expenses                                                                                                          |       | 18,213                 |       | 24,747             |       |
| Revolving credit  facility and loans payable-current                                                                                                    |       | —                 |       | 1,860              |       |
| Current portion  of capital lease obligations                                                                                                           |       | 30                     |       | 29                 |       |
| Income taxes  payable                                                                                                                                   |       | 1,311                  |       | —             |       |
| Other current  liabilities                                                                                                                              |       | 276                    |       | 503                |       |
| **Total  current liabilities**                                                                                                                          |       | 209,822                |       | 191,235            |       |
|                                                                                                                                                    |       |                   |       |               |       |
| Capital lease  obligations, less current portion                                                                                                        |       | 1                      |       | 16                 |       |
| Long term loans  payable and other liabilities                                                                                                          |       | 997                    |       | 998                |       |
| Deferred tax  liability                                                                                                                                 |       | 6,368                  |       | 5,964              |       |
| **Total  liabilities**                                                                                                                                  |       | 217,188                |       | 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                                 |       | 76,103                 |       | 75,864             |       |
|                                                                                                                                                    |       |                   |       |               |       |
| **Common Stockholders’ Equity:**                                                                                                                   |       |                   |       |               |       |
| ** **                                                                                                                                              |       |                   |       |               |       |
| Common stock,  $.001 par value, 35,000,000 shares authorized, 9,715,329 and 9,461,826 shares  issued, 5,075,429 and 4,821,926 outstanding, respectively |       | 10                     |       | 9                  |       |
| Additional  paid-in-capital                                                                                                                             |       | 120,603                |       | 115,061            |       |
| Accumulated  deficit                                                                                                                                    |       | (50,634                | )          | (53,337            | )          |
| Treasury stock  at cost, 4,639,900 shares                                                                                                               |       | (51,879                | )          | (51,879            | )          |
| **Total  common stockholders’ equity**                                                                                                             |       | 18,100                 |       | 9,854              |       |
| **Total  Liabilities, Redeemable Preferred Equity, and Common Stockholders’ Equity**                                                               |       | $                      | 311,391    |               | $          | 283,931 |   |

* *

*See accompanying condensed notes to consolidatedfinancial statements*

 

5

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NATIONAL MEDICAL HEALTH CARD SYSTEMS, INC. AND SUBSIDIARIES

 

**CONSOLIDATEDSTATEMENT OF INCOME**

**(Amountsin thousands, except per share amounts)**

**(Unaudited)**

 
| ** **                                                                                                                                                                                                        | ** ** | **Three months ended  December 31,** | ** ** | **Six months ended  December 31,** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------|------------|------------------------------------|------------|
| ** **                                                                                                                                                                                                        | ** ** | **2005**                             | ** ** | **2004**                           | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                                                                                                                                                                                        | ** ** | **(Restated)**                       | ** ** | ** **                         | ** ** | **(Restated)** | ** ** | ** ** | ** ** |
|                                                                                                                                                                                                              |       |                                 |       |                               |       |   |   |   |   |
| Revenue  (includes co-payments collected of $4,319, $4,173, $9,118 and $6,450,  respectively; and excludes co-payments retained by the pharmacies of  $83,046, $74,770, $160,499 and $128,691, respectively) |       | $                                    | 219,909    |                               | $          | 200,550 |   | $ | 434,601 |   | $ | 385,392 |   |
|                                                                                                                                                                                                              |       |                                 |       |                               |       |   |   |   |   |
| Cost of claims  (excludes co-payments retained by the pharmacies of $83,046, $74,770,  $160,499 and $128,691, respectively)                                                                                       |       | 196,232                              |       | 178,618                            |       | 387,362 |   | 343,783 |   |
|                                                                                                                                                                                                              |       |                                 |       |                               |       |   |   |   |   |
| Gross profit                                                                                                                                                                                                      |       | 23,677                               |       | 21,932                             |       | 47,239 |   | 41,609 |   |
|                                                                                                                                                                                                              |       |                                 |       |                               |       |   |   |   |   |
| Selling, general and administrative expenses                                                                                                                                                                      |       | 18,950                               |       | 17,001                             |       | 37,588 |   | 32,080 |   |
|                                                                                                                                                                                                              |       |                                 |       |                               |       |   |   |   |   |
| Operating income                                                                                                                                                                                                  |       | 4,727                                |       | 4,931                              |       | 9,651 |   | 9,529 |   |
|                                                                                                                                                                                                              |       |                                 |       |                               |       |   |   |   |   |
| Other income (expense):                                                                                                                                                                                           |       |                                 |       |                               |       |   |   |   |   |
| Interest expense                                                                                                                                                                                                  |       | (78                                  | )          | (228                               | )          | (182 | ) | (367 | ) |
| Interest income                                                                                                                                                                                                   |       | 446                                  |       | 28                                 |       | 620 |   | 38 |   |
| Other (expense) income, net                                                                                                                                                                                       |       | (52                                  | )          | 1,711                              |       | (40 | ) | 1,761 |   |
|                                                                                                                                                                                                              |       | 316                                  |       | 1,511                              |       | 398 |   | 1,432 |   |
|                                                                                                                                                                                                              |       |                                 |       |                               |       |   |   |   |   |
| Income before provision for income taxes                                                                                                                                                                          |       | 5,043                                |       | 6,442                              |       | 10,049 |   | 10,961 |   |
| Provision for income taxes                                                                                                                                                                                        |       | 2,145                                |       | 2,641                              |       | 4,284 |   | 4,494 |   |
|                                                                                                                                                                                                              |       |                                 |       |                               |       |   |   |   |   |
| Net income                                                                                                                                                                                                        |       | 2,898                                |       | 3,801                              |       | 5,765 |   | 6,467 |   |
| Redeemable convertible preferred stock cash  dividends                                                                                                                                                            |       | 1,411                                |       | 1,411                              |       | 2,823 |   | 2,823 |   |
| Accretion of transaction expenses                                                                                                                                                                                 |       | 119                                  |       | 120                                |       | 239 |   | 239 |   |
| Net income available to common stockholders                                                                                                                                                                       |       | $                                    | 1,368      |                               | $          | 2,270 |   | $ | 2,703 |   | $ | 3,405 |   |
|                                                                                                                                                                                                              |       |                                 |       |                               |       |   |   |   |   |
| Earnings per common share:                                                                                                                                                                                        |       |                                 |       |                               |       |   |   |   |   |
| Basic                                                                                                                                                                                                             |       | $                                    | 0.27       |                               | $          | 0.51 |   | $ | 0.55 |   | $ | 0.77 |   |
| Diluted *                                                                                                                                                                                                         |       | $                                    | 0.24       |                               | $          | 0.32 |   | $ | 0.48 |   | $ | 0.54 |   |
|                                                                                                                                                                                                              |       |                                 |       |                               |       |   |   |   |   |
| Weighted average number of common shares  outstanding:                                                                                                                                                            |       |                                 |       |                               |       |   |   |   |   |
| Basic                                                                                                                                                                                                             |       | 5,025                                |       | 4,424                              |       | 4,943 |   | 4,412 |   |
| Diluted *                                                                                                                                                                                                         |       | 12,146                               |       | 12,046                             |       | 12,133 |   | 12,074 |   |

* *

*See accompanying condensednotes to consolidated financial statements*

 

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* = The number ofweighted average diluted shares was calculated using the “as if converted”method for the redeemable convertible preferred stock.

 

6

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NATIONAL MEDICAL HEALTH CARD SYSTEMS, INC. AND SUBSIDIARIES

 

**CONSOLIDATEDSTATEMENT OF CASH FLOWS**

**(Amountsin thousands, except per share amounts)**

**(Unaudited)**

 
| ** **                                                                                   | ** ** | **Six months ended  December 31,** | ** ** |
|----------------------------------------------------------------------------------------------|------------|------------------------------------|------------|
|                                                                                         |       | **2005**                           | ** ** | **2004** |   |
|                                                                                         |       | **(Restated)**                     | ** ** | ** ** |   |
| **Cash flows from operating activities:**                                                    |       |                               |       |   |   |
| Net income                                                                                   |       | $                                  | 5,765      |   | $ | 6,467 |   |
| Adjustments to  reconcile net income to net cash provided by (used in) operating activities: |       |                               |       |   |   |
|                                                                                         |       |                               |       |   |   |
| Depreciation and  amortization                                                               |       | 3,592                              |       | 3,101 |   |
| Employee stock  option expense                                                               |       | 1,264                              |       | — |   |
| Amortization of  deferred gain                                                               |       | (12                                | )          | (76 | ) |
| Amortization of  deferred financing costs                                                    |       | 56                                 |       | — |   |
| Loss on disposal  of capital assets                                                          |       | 64                                 |       | — |   |
| Provision for  doubtful accounts                                                             |       | 552                                |       | 374 |   |
| Deferred income  taxes                                                                       |       | 491                                |       | 902 |   |
| Excess tax  benefits from exercise of stock options                                          |       | (1,021                             | )          | — |   |
| Changes in  assets and liabilities:                                                          |       |                               |       |   |   |
| Restricted cash                                                                              |       | 139                                |       | 50 |   |
| Accounts  receivable                                                                         |       | (8,768                             | )          | (11,362 | ) |
| Rebates  receivable                                                                          |       | (18,156                            | )          | (5,688 | ) |
| Inventory                                                                                    |       | (2,401                             | )          | (3,709 | ) |
| Other current  assets                                                                        |       | 2,005                              |       | (1,529 | ) |
| Due from  affiliates                                                                         |       | 31                                 |       | (9 | ) |
| Other assets                                                                                 |       | (2                                 | )          | 2,398 |   |
| Claims payable  to pharmacies                                                                |       | 5,947                              |       | 2,601 |   |
| Rebates payable  to sponsors                                                                 |       | 19,949                             |       | 4,780 |   |
| Trade and other  payables and accrued expenses                                               |       | (6,740                             | )          | (3,290 | ) |
| Income taxes  payable and other current liabilities                                          |       | 2,594                              |       | 4,976 |   |
| Other long term  liabilities                                                                 |       | 11                                 |       | (1,063 | ) |
| Net cash provided by (used in) operating activities                                          |       | 5,360                              |       | (1,077 | ) |
|                                                                                         |       |                               |       |   |   |
| **Cash flows from investing activities:**                                                    |       |                               |       |   |   |
| Capital  expenditures                                                                        |       | (3,680                             | )          | (1,712 | ) |
| Proceeds from  sale of capital assets                                                        |       | 100                                |       | — |   |
| Acquisition of  Inteq, net of cash acquired                                                  |       | 116                                |       | (9 | ) |
| Acquisition of  PPP, net of cash acquired                                                    |       | (425                               | )          | (358 | ) |
| Net cash (used in) investing activities                                                      |       | (3,889                             | )          | (2,079 | ) |
|                                                                                         |       |                               |       |   |   |
| **Cash flows from financing activities:**                                                    |       |                               |       |   |   |
| Proceeds from  exercise of stock options                                                     |       | 2,344                              |       | 1,054 |   |
| Proceeds from  revolving credit facility                                                     |       | 65,575                             |       | 560,458 |   |
| Repayment of  revolving credit facility                                                      |       | (65,575                            | )          | (554,686 | ) |
| Payment of  redeemable convertible preferred stock cash dividends                            |       | (2,823                             | )          | (2,823 | ) |
| Deferred financing  costs                                                                    |       | —                             |       | 95 |   |
| Excess tax  benefits from exercise of stock options                                          |       | 1,021                              |       | — |   |
| Repayment of  debt and capital lease obligations                                             |       | (14                                | )          | (340 | ) |
| Net cash provided by financing activities                                                    |       | 528                                |       | 3,758 |   |
|                                                                                         |       |                               |       |   |   |
| Net increase in cash and cash equivalents                                                    |       | 1,999                              |       | 602 |   |
| Cash and cash equivalents at beginning of period                                             |       | 7,272                              |       | 3,388 |   |
| Cash and cash equivalents at end of period                                                   |       | $                                  | 9,271      |   | $ | 3,990 |   |

* *

*See accompanying condensed notes to consolidatedfinancial statements*

 

7

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NATIONAL MEDICAL HEALTH CARD SYSTEMS, INC. AND SUBSIDIARIES

 

**CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

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

**(Unaudited)**

 

 

1.             NATURE OF BUSINESS

 

NationalMedical Health Card Systems, Inc. and its wholly owned subsidiaries(collectively the “Company” or “NMHC”) provides comprehensive pharmacy benefitmanagement (“PBM”) services to plan sponsors, which include managed careorganizations, local governments, unions, corporations and third party healthcare plan administrators through its network of licensed pharmacies throughoutthe United States.  The Company’s PBMservices include electronic point-of-sale pharmacy claims management, retailpharmacy network management, mail service pharmacy claims management, specialtypharmacy claims management, benefit design consultation, preferred drugmanagement programs, drug review and analysis, consulting services, diseaseinformation services, data access, reporting and information analysis andphysician profiling.  In addition, theCompany operates a mail service pharmacy, a specialty pharmacy and a healthinformatics company.

 

Theunaudited consolidated financial statements include the accounts of theCompany.  The Company does not have anysubsidiaries in which 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.

 

Theunaudited consolidated financial statements have been prepared by the Companyin accordance with United States generally accepted accounting principles forinterim financial information and substantially in the form prescribed by theU.S. Securities and Exchange Commission (the “SEC”) in instructions to Form10-Q and in Article 10 of Regulation S-X. Accordingly, the interim financial information does not include all ofthe information and footnotes required by such accounting principles for completefinancial statements.  In the opinion ofthe Company’s management, the December 31, 2005 and 2004 unaudited interimfinancial statements include all adjustments consisting of normal recurringadjustments, necessary for a fair presentation of results for these interimperiods.  In the opinion of the Company’smanagement, the disclosures contained in this Form 10-Q/A are adequate to makethe information presented not misleading when read in conjunction with theNotes to Consolidated Financial Statements included in the Company’s Form 10-Kfor the year ended June 30, 2005, asamended.  The results ofoperations for the three and six months ended December 31, 2005 are notnecessarily indicative of the operating results to be expected for the fullyear.

 

Certainamounts in the prior period have been reclassified to conform to the currentperiod presentation.  For informationconcerning the Company’s significant accounting policies, reference is made tothe Company’s Annual Report on Form 10-K for the year ended June 30, 2005 (the “AnnualReport”) filed with the SEC, as amended.

 

2.            RESTATEMENT OF FINANCIALSTATEMENTS

 

Weare restating the Company's previously issued financial statements for thesecond fiscal quarter ended December 31, 2005 to reflect the correction oftwo rebate cash receipts from one pharmaceutical manufacturer which resulted inthe Company recognizing additional rebate revenue during the quarter endedDecember 31, 2005. The restatement reflects adjustments to the Company'srevenue and cost of claims for the three and six month periods endedDecember 31, 2005. The tax effects on the corrections have also beenreflected in these restatements. The impact of the corrections on theconsolidated balance sheets and consolidated statements of income is shown inthe accompanying tables. Adjustments to the statement of income for the threeand six months ended December 31, 2005 primarily represent adjustments tocorrect the overstatement of the Company's revenue, cost of claims andresultant gross profit. Income tax expense was adjusted to reflect the incometax effects of the adjustments noted for overstating gross profit.

 

8

----

 

NATIONAL MEDICAL HEALTH CARD SYSTEMS, INC. AND SUBSIDIARIES

 

**CONDENSED NOTES TO CONSOLIDATEDFINANCIAL STATEMENTS (Continued)**

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

**(Unaudited)**

 

Inaddition, balance sheet adjustments forDecember 31, 2005 primarily represent adjustments to rebates receivable,rebates payable to sponsors, income taxes payable and accumulated deficit tocorrect the balance sheet for overstating revenues, cost of claims, provisionfor income taxes and net income. However,there was no impact on the results for the full year ended June 30, 2006.

 

Thefollowing table presents the effect of the Restatement on the consolidatedstatement of operations for the three months ended December 31, 2005:

 
| ** **                                             | ** ** | **Three Months Ended December 31, 2005  (In Thousands)** | ** ** |
|--------------------------------------------------------|------------|---------------------------------------------------------------|------------|
| ** **                                             | ** ** | **As Previously  Reported**                                   | ** ** | **Adjustments** | ** ** | **As Restated** | ** ** |
| Revenue:                                               |       | $                                                             | 220,993    |   | $ | (1,084 | ) | $ | 219,909 |   |
|                                                   |       |                                                          |       |   |   |   |   |
| Cost of Claims:                                        |       | 196,654                                                       |       | (422 | ) | 196,232 |   |
|                                                   |       |                                                          |       |   |   |   |   |
| Gross Profit:                                          |       | 24,339                                                        |       | (662 | ) | 23,677 |   |
|                                                   |       |                                                          |       |   |   |   |   |
| Selling, general and administrative expenses:          |       | 18,950                                                        |       | — |   | 18,950 |   |
|                                                   |       |                                                          |       |   |   |   |   |
| Operating Income:                                      |       | 5,389                                                         |       | (662 | ) | 4,727 |   |
|                                                   |       |                                                          |       |   |   |   |   |
| Other Income/(expense), net:                           |       | 316                                                           |       | — |   | 316 |   |
|                                                   |       |                                                          |       |   |   |   |   |
| Income before provision for income taxes:              |       | 5,705                                                         |       | (662 | ) | 5,043 |   |
|                                                   |       |                                                          |       |   |   |   |   |
| Provision for income taxes:                            |       | 2,427                                                         |       | (282 | ) | 2,145 |   |
|                                                   |       |                                                          |       |   |   |   |   |
| Net Income:                                            |       | $                                                             | 3,278      |   | $ | (380 | ) | $ | 2,898 |   |
|                                                   |       |                                                          |       |   |   |   |   |
| Redeemable convertible preferred stock cash  dividends |       | 1,411                                                         |       | — |   | 1,411 |   |
|                                                   |       |                                                          |       |   |   |   |   |
| Accretion of transaction expenses                      |       | 119                                                           |       | — |   | 119 |   |
|                                                   |       |                                                          |       |   |   |   |   |
| Net income available to common stockholders            |       | $                                                             | 1,748      |   | $ | (380 | ) | $ | 1,368 |   |
|                                                   |       |                                                          |       |   |   |   |   |
| Earnings per common share:                             |       |                                                          |       |   |   |   |   |
| Basic                                                  |       | $                                                             | 0.35       |   | $ | (0.08 | ) | $ | 0.27 |   |
| Diluted                                                |       | $                                                             | 0.27       |   | $ | (0.03 | ) | $ | 0.24 |   |
|                                                   |       |                                                          |       |   |   |   |   |
| Weighted average number of common shares  outstanding: |       |                                                          |       |   |   |   |   |
| Basic                                                  |       | 5,025                                                         |       |   |   | 5,025 |   |
| Diluted                                                |       | 12,146                                                        |       |   |   | 12,146 |   |

 

 

9

----

 

NATIONAL MEDICAL HEALTH CARD SYSTEMS, INC. AND SUBSIDIARIES

 

**CONDENSED NOTES TO CONSOLIDATEDFINANCIAL STATEMENTS (Continued)**

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

**(Unaudited)**

 

Thefollowing table presents the effect of the Restatement on the consolidatedstatement of operations for the six months ended December 31, 2005:

 
| ** **                                             | ** ** | **Six Months Ended December 31, 2005  (In Thousands)** | ** ** |
|--------------------------------------------------------|------------|-------------------------------------------------------------|------------|
| ** **                                             | ** ** | **As Previously  Reported**                                 | ** ** | **Adjustments** | ** ** | **As Restated** | ** ** |
| Revenue:                                               |       | $                                                           | 435,685    |   | $ | (1,084 | ) | $ | 434,601 |   |
|                                                   |       |                                                        |       |   |   |   |   |
| Cost of Claims:                                        |       | 387,784                                                     |       | (422 | ) | 387,362 |   |
|                                                   |       |                                                        |       |   |   |   |   |
| Gross Profit:                                          |       | 47,901                                                      |       | (662 | ) | 47,239 |   |
|                                                   |       |                                                        |       |   |   |   |   |
| Selling, general and administrative expenses:          |       | 37,588                                                      |       | — |   | 37,588 |   |
|                                                   |       |                                                        |       |   |   |   |   |
| Operating Income:                                      |       | 10,313                                                      |       | (662 | ) | 9,651 |   |
|                                                   |       |                                                        |       |   |   |   |   |
| Other income/(expense), net:                           |       | 398                                                         |       | — |   | 398 |   |
|                                                   |       |                                                        |       |   |   |   |   |
| Income before provision for income taxes:              |       | 10,711                                                      |       | (662 | ) | 10,049 |   |
|                                                   |       |                                                        |       |   |   |   |   |
| Provision for income taxes:                            |       | 4,566                                                       |       | (282 | ) | 4,284 |   |
|                                                   |       |                                                        |       |   |   |   |   |
| Net Income:                                            |       | $                                                           | 6,145      |   | $ | (380 | ) | $ | 5,765 |   |
|                                                   |       |                                                        |       |   |   |   |   |
| Redeemable convertible preferred stock cash  dividends |       | 2,823                                                       |       | — |   | 2,823 |   |
|                                                   |       |                                                        |       |   |   |   |   |
| Accretion of transaction expenses                      |       | 239                                                         |       | — |   | 239 |   |
|                                                   |       |                                                        |       |   |   |   |   |
| Net income available to common stockholders            |       | $                                                           | 3,083      |   | $ | (380 | ) | $ | 2,703 |   |
|                                                   |       |                                                        |       |   |   |   |   |
| Earnings per common share:                             |       |                                                        |       |   |   |   |   |
| Basic                                                  |       | $                                                           | 0.62       |   | $ | (0.07 | ) | $ | 0.55 |   |
| Diluted                                                |       | $                                                           | 0.51       |   | $ | (0.03 | ) | $ | 0.48 |   |
|                                                   |       |                                                        |       |   |   |   |   |
| Weighted average number of common shares  outstanding: |       |                                                        |       |   |   |   |   |
| Basic                                                  |       | 4,943                                                       |       |   |   | 4,943 |   |
| Diluted                                                |       | 12,133                                                      |       |   |   | 12,133 |   |
|                                                        |            |                                                             |            |  |  |  |  |  |  |  |  |  |

 

 

10

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NATIONAL MEDICAL HEALTH CARD SYSTEMS, INC. AND SUBSIDIARIES

 

**CONDENSED NOTES TO CONSOLIDATEDFINANCIAL STATEMENTS (Continued)**

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

**(Unaudited)**

 

The following table represents the effect of theRestatement on the consolidated balance sheet as of December 31, 2005:

 
| ** **                                                                                                                            | ** ** | **As of December 31,  2005** | ** **  |
|---------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------|-------------|
| ** **                                                                                                                            | ** ** | **(In Thousands)**                | ** **  |
| ** **                                                                                                                            | ** ** | **As Previously**                 | ** **  | ** ** | ** ** | ** ** | ** ** |
| ** **                                                                                                                            | ** ** | **Reported**                      | ** **  | **Adjustments** | ** ** | **As Restated** | ** ** |
| **Assets**                                                                                                                            |       |                              |        |   |   |   |   |
|                                                                                                                                  |       |                              |        |   |   |   |   |
| **Current:**                                                                                                                          |       |                              |        |   |   |   |   |
| Cash and cash  equivalents (including cash equivalent investments of $289)                                                            |       | $                                 | 9,271       |   | — |   | $ | 9,271 |   |
| Restricted cash                                                                                                                       |       | 3,855                             |        | — |   | 3,855 |   |
| Accounts receivable,  less allowance for doubtful accounts of $2,505                                                                  |       | 111,345                           |        | — |   | 111,345 |   |
| Rebates receivable                                                                                                                    |       | 59,617                            |        | (1,084 | ) | 58,533 |   |
| Inventory                                                                                                                             |       | 6,520                             |        | — |   | 6,520 |   |
| Due from affiliates                                                                                                                   |       | —                            |        | — |   | — |   |
| Deferred tax assets                                                                                                                   |       | 2,051                             |        | — |   | 2,051 |   |
| Other current assets                                                                                                                  |       | 1,778                             |        | — |   | 1,778 |   |
| **Total current assets**                                                                                                              | ** ** | **194,437**                       | ** **  | **(1,084** | **)** | **193,353** | ** ** |
|                                                                                                                                  |       |                              |        |   |   |   |   |
| Property, equipment and  software development costs, net                                                                              |       | 13,492                            |        | — |   | 13,492 |   |
| Intangible assets, net  of accumulated amortization of $3,811                                                                         |       | 3,463                             |        | — |   | 3,463 |   |
| Goodwill                                                                                                                              |       | 99,842                            |        | — |   | 99,842 |   |
| Other assets                                                                                                                          |       | 1,241                             |        | — |   | 1,241 |   |
| **Total Assets**                                                                                                                      | ** ** | **$**                             | **312,475** | ** ** | **$** | **(1,084** | **)** | **$** | **311,391** | ** ** |
| ** **                                                                                                                            | ** ** | ** **                        | ** **  | ** ** | ** ** | ** ** | ** ** |
| **Liabilities, Redeemable  Preferred Equity, and Common Stockholders' Equity**                                                        | ** ** | ** **                        | ** **  | ** ** | ** ** | ** ** | ** ** |
| **Current Liabilities:**                                                                                                              | ** ** | ** **                        | ** **  | ** ** | ** ** | ** ** | ** ** |
| ** **                                                                                                                            | ** ** | ** **                        | ** **  | ** ** | ** ** | ** ** | ** ** |
| Claims payable to  pharmacies                                                                                                         |       | $                                 | 124,607     |   | — |   | $ | 124,607 |   |
| Rebates payable to  sponsors                                                                                                          |       | 65,807                            |        | (422 | ) | $ | 65,385 |   |
| Trade and other  payables and accrued expenses                                                                                        |       | 18,213                            |        | — |   | 18,213 |   |
| Revolving credit  facility and loans payable-current                                                                                  |       | —                            |        | — |   | — |   |
| Current portion of  capital lease obligations                                                                                         |       | 30                                |        | — |   | 30 |   |
| Income taxes payable                                                                                                                  |       | 1,593                             |        | (282 | ) | 1,311 |   |
| Other current  liabilities                                                                                                            |       | 276                               |        | — |   | 276 |   |
| **Total current liabilities**                                                                                                         | ** ** | **210,526**                       | ** **  | **(704** | **)** | **209,822** | ** ** |
|                                                                                                                                  |       |                              |        |   |   |   |   |
| Capital lease  obligations, less current portion                                                                                      |       | 1                                 |        | — |   | 1 |   |
| Long term loans payable  and other liabilities                                                                                        |       | 997                               |        | — |   | 997 |   |
| Deferred tax liability                                                                                                                |       | 6,368                             |        | — |   | 6,368 |   |
| **Total liabilities**                                                                                                                 | ** ** | **217,892**                       | ** **  | **(704** | **)** | **217,188** | ** ** |
| ** **                                                                                                                            | ** ** | ** **                        | ** **  | ** ** | ** ** | ** ** | ** ** |
| **Commitments and Contingencies**                                                                                                     | ** ** | ** **                        | ** **  | ** ** | ** ** | ** ** | ** ** |
| **Redeemable Preferred Equity:**                                                                                                      | ** ** | ** **                        | ** **  | ** ** | ** ** | ** ** | ** ** |
| Series A  redeemable convertible preferred stock $.10 par value; 15,000,000 shares  authorized, 6,956,522 issued and outstanding |       | 76,103                            |        | — |   | 76,103 |   |
|                                                                                                                                  |       |                              |        |   |   |   |   |
| **Common Stockholders Equity:**                                                                                                       |       |                              |        |   |   |   |   |
| Common stock, $0.01 par  value, 35,000,000 shares authorized, 9,715,329 shares issued, 5,075,429  outstanding, respectively           |       | 10                                |        | — |   | 10 |   |
| Additional  paid-in-capital                                                                                                           |       | 120,603                           |        | — |   | 120,603 |   |
| Accumulated deficit                                                                                                                   |       | (50,254                           | )           | (380 | ) | (50,634 | ) |
| Treasury stock at cost,  4,639,900 shares                                                                                             |       | (51,879                           | )           | — |   | (51,879 | ) |
| **Total common stockholders’  equity**                                                                                           |       | 18,480                            |        | (380 | ) | 18,100 |   |
| **Total Liabilities, Redeemable  Preferred Equity, and Common Stockholders’ Equity**                                             | ** ** | **$**                             | **312,475** | ** ** | **$** | **(1,084** | **)** | **$** | **311,391** | ** ** |
|                                                                                                                                       |            |                                   |             |  |  |  |  |  |  |  |  |

 

 

3.            STOCK-BASED COMPENSATION

 

AtDecember 31, 2005, the Company had one stock-based employee compensation plan,which is more fully described in Note 6. Prior to July 1, 2005, the Company accounted for this plan under therecognition and measurement provisions of APB Opinion No. 25, *Accounting for Stock*

 

 

11

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NATIONAL MEDICAL HEALTH CARD SYSTEMS, INC. AND SUBSIDIARIES

 

**CONDENSED NOTES TO CONSOLIDATEDFINANCIAL STATEMENTS (Continued)**

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

**(Unaudited)**

 

*Issued to Employees*, and relatedInterpretations, 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 six monthsended December 31, 2004, as all options granted under this plan had an exerciseprice at least equal to the market value of the underlying common stock on thedate of grant.  Effective July 1, 2005,the Company adopted the fair value recognition provisions of FASB Statement No.123(R), *Share-Based Payment*,using the modified-prospective-transition method.  Under that transition method, compensationcost recognized in the three and six months ended December 31, 2005 includes:(a) compensation cost for all share-based payments granted prior to, but notyet vested 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 theprovisions of FASB Statement No. 123(R). Results for prior periods have not been restated.

 

Forthe six months ended December 31, 2005, 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 63.6% and 69.5%, post-vesting terminations of 1% and asub-optimal exercise factor of 4.1.  Theweighted-average value of options granted was $17.72 during the six monthsended December 31, 2005.

 

Asa result of adopting FASB Statement No. 123(R) on July 1, 2005, the Company’sincome before income taxes for the three and six months ended December 31, 2005are $596 and $1,264 lower, respectively,  than if it had continued to account forshare-based compensation under APB Opinion No. 25. The after-tax effect of thischarge was $484, or $0.10 per basic earningsper share, or EPS, and $0.04 per diluted EPS using the "as if converted" method for the three months endedDecember 31, 2005 and $1,020,or $0.20 per basic EPSand $0.08 per diluted EPS using the "as if converted" method for the six months endedDecember 31, 2005, respectively. As of December 31, 2005, the totalunrecognized compensation cost related to nonvested stock awards was $8,613 andthe related weighted-average period over which it is expected to be recognizedis approximately 3.2 years.

 

Priorto the adoption of FASB Statement No. 123(R), the Company presented all taxbenefits of deductions resulting from the exercise of stock options asoperating cash flows in the Consolidated Statement of Cash Flows.  FASB Statement No. 123(R) requires the cashflows resulting from the tax benefits resulting from tax deductions in excessof the compensation cost recognized for those options (excess tax benefits) tobe classified as financing cash flows.

 

Thefollowing table illustrates the effect on net income and earnings per share ifthe Company had applied the fair value recognition provisions of FASB StatementNo. 123 to options granted

 

 

12

----

 

NATIONAL MEDICAL HEALTH CARD SYSTEMS, INC. AND SUBSIDIARIES

 

**CONDENSED NOTES TO CONSOLIDATEDFINANCIAL STATEMENTS (Continued)**

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

**(Unaudited)**

 

underthe Company’s stock option plan in the three and six months ended December 31,2004.  For purposes of this pro formadisclosure, the value of the options is estimated using the Black-Scholesoption-pricing model with the following weighted-average assumptions used forall grants in the six months ended December 31, 2004: no dividend yield,weighted-average expected life of the option of between 3 and 6 years,risk-free interest rate of between 3.40% and 4.46%, and volatility of between74.7% and 75% for all grants.  Theweighted-average value of options granted was $14.72 for the six months endedDecember 31, 2004.

 
| ** **                                                                                                                                                                           | ** ** | **Three Months Ended December 31, 2004** | ** ** | **Six Months Ended December 31, 2004** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------------------|------------|----------------------------------------|------------|
| Net income  available to common stockholders, as reported                                                                                                                            |       | $                                        | 2,270      |                                   | $          |  3,405 |   |
| 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 |       | (495                                     | )          | (953                                   | )          |
| Pro forma net  income available to common stockholders                                                                                                                               |       | $                                        | 1,775      |                                   | $          | 2,452 |   |
| Pro forma  earnings per share:                                                                                                                                                       |       |                                     |       |                                   |       |
| Basic – as  reported                                                                                                                                                            |       | $                                        | 0.51       |                                   | $          | 0.77 |   |
| Basic – pro  forma                                                                                                                                                              |       | $                                        | 0.40       |                                   | $          | 0.56 |   |
|                                                                                                                                                                                 |       |                                     |       |                                   |       |
| Diluted – as  reported                                                                                                                                                          |       | $                                        | 0.32       |                                   | $          | 0.54 |   |
| Diluted – pro  forma                                                                                                                                                            |       | $                                        | 0.27       |                                   | $          | 0.46 |   |

 

4.             NEW MOUNTAIN TRANSACTION

 

The Company entered into an amended and restated preferred stockpurchase agreement, dated as of November 26, 2003, with New Mountain Partners,L.P. (the “purchase agreement”). Pursuant to the purchase agreement, the Company agreed, subject tovarious conditions, to issue to New Mountain Partners a total of 6,956,522shares of series A 7% redeemable convertible preferred stock (the “seriesA preferred stock”) at a purchase price of $11.50 per share, for aggregateproceeds of approximately $80,000.  OnMarch 19, 2004, the Company completed the sale of the series A preferredstock to New Mountain Partners and used approximately $49,000 of theproceeds of the sale of the series A preferred stock to purchase, pursuantto a tender offer, 4,448,900 shares of the Company’s issued and outstandingcommon stock (the “common stock”) at $11.00 per share (collectively, the “NewMountain Transaction”).  Prior to theclosing of the New Mountain Transaction, Bert E. Brodsky, the former chairmanof the board of directors, and certain stockholders related to him, held(assuming the exercise of 330,000 options and warrants held by Mr. Brodsky,which occurred in April 2004), in the aggregate, approximately 59% of thecommon stock and had agreed to tender 4,448,900 shares, or approximately 54% ofthe common stock, held by them, into the tender offer.  No other stockholders tendered shares in theoffer.

 

 

13

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NATIONAL MEDICAL HEALTH CARD SYSTEMS, INC. AND SUBSIDIARIES

 

**CONDENSED NOTES TO CONSOLIDATEDFINANCIAL STATEMENTS (Continued)**

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

**(Unaudited)**

 

Following the completion of the tender offer, and assuming the exerciseof 330,000 options and warrants held by Mr. Brodsky, which occurred in April2004, New Mountain Partners owned securities at March 19, 2004 that wereinitially convertible into approximately 64% of the common stock and prior toconversion of the series A preferred stock were entitled to cast thatnumber of votes that is equal to approximately 60% of the Company’s aggregatevoting power.  Following the closing ofthe New Mountain Transaction, New Mountain Partners was entitled to and didnominate and elect 60% of the members of the Company’s board of directors.

 

The Company used the remaining proceeds from the issuance and sale ofthe series A preferred stock of approximately $24,000, excluding expensesrelated to the closing of the New Mountain Transaction, for the InteqAcquisition described in Note 4 – Business Acquisitions and for working capitalpurposes.

 

The series A preferred stock provides for an initial annual cashdividend equal to 7% of the investment amount, which decreases to 3.5% afterthe fifth anniversary of issuance.  Theseries A preferred stock is convertible into the Company’s common stock at aprice of $11.50 per share of common stock, or an aggregate of approximately7,000,000 shares of the Company’s common stock.

 

The series A preferred stock may be redeemed at the Company’soption subsequent to the fourth anniversary of its issuance, subject to certainconditions.  After the tenth anniversaryof the issuance of the series A preferred stock, each holder of shares ofseries A preferred stock may require the Company to redeem all or a partof that holder’s shares of series A preferred stock.

 

5.             BUSINESS ACQUISITIONS

 

On March 7, 2005, the Company acquired all of the outstanding stock ofPharmaceutical Care Network, a California corporation, from the CaliforniaPharmacists Association (the “PCN Acquisition”).  The aggregate purchase price of the PCNAcquisition was $13,000 in cash.  Inaddition, the Company has agreed to pay the California Pharmacists Association(“CphA”) earn-outs, as additional purchase price, up to $30,000 over a periodof three years if certain financial and performance targets are achieved.  As of December 31, 2005, the financial andperformance targets have not been achieved. The funds for the payment of the purchase price in connection with thePCN Acquisition were obtained out of the Company’s working capital and theJPMorgan credit facility (See Note 5). The PCN operations complement the Company’s business while strengtheningthe Company’s presence in the California marketplace as well as in the Medicaidmanaged care market.

 

In addition to the $13,000 purchase price for the PCN Acquisition,there were $561 of acquisition related expenses incurred by the Company.  Of the $13,000, $10,500 was paid to CPhA andcertain of PCN’s current and former employees who participated in its Long TermIncentive Plan, and $2,500 was deposited into escrow to secure CPhA’sobligations under the purchase agreement. At the time of the acquisition, PCN had approximately $30,942 of assetswhich included $16,711 of cash, $2,734 of restricted cash, $3,204 of accountsreceivable, $6,090 of rebates receivable, $1,139 of other assets, and $1,064 ofproperty and equipment.  They also

 

 

14

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NATIONAL MEDICAL HEALTH CARD SYSTEMS, INC. AND SUBSIDIARIES

 

**CONDENSED NOTES TO CONSOLIDATEDFINANCIAL STATEMENTS (Continued)**

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

**(Unaudited)**

 

had approximately $27,040 of liabilities which included $26,848 ofclaims and accounts payable, $97 of other current liabilities and $95 of otherlong-term liabilities.  As a result ofthe PCN Acquisition, $2,842 of severance and exit costs have been accrued as ofDecember 31, 2005, with $1,223 recorded as a deferred tax asset and $1,619recorded as additional goodwill.  Of thisamount, $1,024 was paid as of December 31, 2005.  The acquisition was accounted for under thepurchase method of accounting and the results of PCN’s operations were includedin the consolidated financial statements commencing as of the closing date ofthe PCN Acquisition.  The excess of theacquisition costs over the fair value of identifiable net assets acquired was$11,957, which consists of the following components: “know how” and computersoftware valued at $870, which will be amortized over ten (10) years, customerrelationships valued at $380, which will be amortized over ten (10) years, andgoodwill of $10,707, which will not be amortized for book purposes per SFAS142.

 

On April 1, 2004, the Company entered into an Asset Purchase Agreementwith Inteq PBM, LP, a Texas limited partnership (the “Purchaser”), The INTEQ-RXGroup, LLP and certain other owners named therein (together with The INTEQ-RXGroup, LLP, the “The Inteq Group”), pursuant to which the Company agreed toacquire certain assets of The Inteq Group relating to their PBM business (the “InteqAcquisition”).  The aggregate purchaseprice of the Inteq Acquisition was $31,500 in cash.  In addition, the Company agreed to pay TheInteq Group, as additional purchase price, up to $4,200 over a period of oneyear if the acquired PBM business achieved certain financial performancetargets during the one-year period following the closing.

 

In addition, $3,000, out of the $4,200 potential to be paid to TheInteq Group, was placed in escrow to secure the Company’s obligations to payThe Inteq Group additional purchase price if certain targets were achievedduring the first year. Of this amount, $1,024 of additional consideration wasearned and released from escrow, with the balance of $1,976 being returned tothe Company.

 

On July 31, 2003, theCompany entered into a Stock Purchase Agreement with Portland ProfessionalPharmacy (“PPRX”), Portland Professional Pharmacy Associates (“PRXA”, andtogether with PPRX, “PPP” or “NMHC Ascend”) and the individual shareholders(the “PPP Shareholders”) to purchase all of the shares of PPP for $3,150 (the “PPPAcquisition”).   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 of theCompany’s common stock (17,127 shares at $24.84 per share).  For the third year, through December 31,2005, $373 has been earned and will be settled in September 2006.

 

 

15

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NATIONAL MEDICAL HEALTH CARD SYSTEMS, INC. AND SUBSIDIARIES

 

**CONDENSED NOTES TO CONSOLIDATEDFINANCIAL STATEMENTS (Continued)**

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

**(Unaudited)**

 

Each of PRXA and PPRXcontinues to operate under their respective names, and also does business underthe name NMHC Ascend.

 

TheCompany entered into an Asset Purchase Agreement (the “Asset Purchase Agreement”),dated as of January 29, 2002, with HSL, HSL Acquisition Corp., a Delawarecorporation and a wholly-owned subsidiary of the Company (“Sub”), and thesecurity holders of HSL named therein, pursuant to which the Company agreed toacquire certain assets of HSL relating to the PBM business conducted by HSLunder the name “Centrus” (the “Centrus Acquisition”).  The aggregate purchase price of the CentrusAcquisition was $40,000 in cash.  Inaddition, the Company has agreed to pay HSL as additional purchase price up to$4,000 over a period of three (3) years if the acquired Centrus businessachieves certain financial performance targets during the two-year periodfollowing the Centrus closing.  Thefinancial performance targets were achieved during the first two years and$4,000 was earned.  Of this amount,$1,000 was paid in May 2003, $2,000 was paid in May 2004, and another $1,000was paid in May 2005.

 

Thesummarized unaudited pro forma results of operations set forth below for thethree and six months ended December 31, 2004 assumes the PCN Acquisition hadoccurred as of the beginning of these periods.

 

| ** **                                                       | ** ** | **Three Months Ended  December 31, 2004**                   | ** ** |
|------------------------------------------------------------------|------------|-------------------------------------------------------------|------------|
| Revenue                                                          |       | $                                                           | 219,521    |   |
| Net income                                                       |       | $                                                           | 3,194      |   |
| Net income available to common Stockholders                      |       | $                                                           | 1,663      |   |
| Earnings per common share:                                       |       |                                                        |       |
| Basic                                                            |       | $                                                           | 0.38       |   |
| Diluted                                                          |       | $                                                           | 0.14       |   |
| Pro forma weighted-average number of common shares  outstanding: |       |                                                        |       |
| Basic                                                            |       | 4,424                                                       |       |
| Diluted                                                          |       | 12,046                                                      |       |
|                                                             |       |                                                        |       |
| ** **                                                       | ** ** | **Six Months Ended  December 31, 2004** | ** ** |
| Revenue                                                          |       | $                                                           | 426,801    |   |
| Net income                                                       |       | $                                                           | 5,432      |   |
| Net income available to common Stockholders                      |       | $                                                           | 2,370      |   |
| Earnings per common share:                                       |       |                                                        |       |
| Basic                                                            |       | $                                                           | 0.54       |   |
| Diluted                                                          |       | $                                                           | 0.45       |   |
| Pro forma weighted-average number of common shares  outstanding: |       |                                                        |       |
| Basic                                                            |       | 4,412                                                       |       |
| Diluted                                                          |       | 12,074                                                      |       |

 

 

16

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NATIONAL MEDICAL HEALTH CARD SYSTEMS, INC. AND SUBSIDIARIES

 

**CONDENSED NOTES TO CONSOLIDATEDFINANCIAL STATEMENTS (Continued)**

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

**(Unaudited)**

 

Thispro forma financial information is presented for information purposesonly.  Pro forma adjusted net income percommon share, including acquisitions, may not be indicative of actual results,primarily because pro forma earnings include historical results of operationsof the acquired entity and do not reflect any cost savings or potential saleserosion that may result from the Company’s integration efforts.  In addition, while PCN has traditionallyrecorded all revenue on a gross basis, the Company has adjusted the historicalamounts to reflect certain contracts on a revenue basis consistent with NMHC’spolicies.

 

Thechange in the carrying amount of goodwill for the six months ended December 31,2005 is as follows:

 
| Balance as of  June 30, 2005        |   | $      | 99,710 |   |
|-------------------------------------|--------|--------|--------|--------|
| PCN acquisition                     |   | (61    | )      |
| PCN additional consideration earned |   | (236   | )      |
| PPP additional consideration earned |   | 429    |   |
|                                |   |   |   |
| Balance as of December 31, 2005     |   | $      | 99,842 |   |

 

Approximately$81,464 of the Company’s December 31, 2005 goodwill is deductible for incometax purposes on a straight-line basis over 15 years.

 

Acquiredintangible assets subject to amortization consisted of the following:

 
| ** **             | ** ** | **December 31, 2005**       | ** ** | **June 30, 2005**            | ** ** |
|------------------------|------------|-----------------------------|------------|------------------------------|------------|
| **Asset Class**        | ** ** | **Gross  Carrying  Amount** | ** ** | **Accumulated Amortization** | ** ** | **Gross  Carrying  Amount** | ** ** | **Accumulated Amortization** | ** ** |
| Customer relationships |       | $                           | 5,326      |                         | $          | 2,782 |   | $ | 5,296 |   | $ | 2,410 |   |
| Non-compete agreements |       | 220                         |       | 179                          |       | 220 |   | 156 |   |
| Employment agreements  |       | 186                         |       | 146                          |       | 186 |   | 133 |   |
| Trade name             |       | 100                         |       | 60                           |       | 100 |   | 37 |   |
| Company know how       |       | 1,442                       |       | 644                          |       | 1,422 |   | 537 |   |
|                   |       | $                           | 7,274      |                         | $          | 3,811 |   | $ | 7,224 |   | $ | 3,273 |   |

 

6.             DEBT

 

On January 28, 2005, the Company and certain of itssubsidiaries entered into a five-year $65,000 cash flow based line of creditwith a syndicate of commercial banks led by JPMorgan

 

 

17

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NATIONAL MEDICAL HEALTH CARD SYSTEMS, INC. AND SUBSIDIARIES

 

**CONDENSED NOTES TO CONSOLIDATEDFINANCIAL STATEMENTS (Continued)**

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

**(Unaudited)**

 

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 the timing and dollar amount of each loanrequest, the Company will either borrow at a spread above LIBOR, the overnightFederal Funds rate or JPMorgan’s prime rate. The initial spread was 1.75% for LIBOR and Federal Funds loans and 0.75%for prime rate loans.  After receipt ofthe Company’s consolidated financial statements for the fiscal year ended June30, 2005, the spreads decreased due to a favorable ratio of debt to annualEBITDA.  The current spread is 1.50% forLIBOR and Federal Funds loans and 0.50% for prime rate loans.

 

The JPMorgan credit facility is secured by the Company’sconsolidated assets.  The JPMorgan creditfacility requires the Company to be in compliance with financial and othercovenants.  The three defined financialcovenants include:  consolidated networth; consolidated fixed charge ratio; and consolidated debt to EBITDAratio.  The Company was in compliancewith all covenants at December 31, 2005.

 

7.             STOCK OPTIONS

 

Duringthe six months ended December 31, 2005, the Company granted stock options underthe 1999 Stock Option Plan, as amended (the “Plan”).  The options granted during this period areexercisable at prices ranging from $24.01 to $27.90 and terminate seven or tenyears from the grant date.  The totalnumber of shares of common stock of the Company reserved by the Company forissuance under the Plan is 4,850,000 plus an indeterminable number of shares ofcommon stock of the Company issuable pursuant to the anti-dilution provisionsof the Plan or upon the exercise of “reload options.”  There are no options outstanding that containthe “reload” provision.  There are1,252,783 options issuable under the Plan as of December 31, 2005.  The following table summarizes informationabout stock option activity for the six months ended December 31, 2005:

 
| ** **                               | ** ** | **Number of   Options** | ** ** | **Weighted-Average   Exercise Price  Per Share** | ** ** |
|------------------------------------------|------------|-----------------------------------|------------|-----------------------------------------------------------------|------------|
| Outstanding options at June 30, 2005     |       | 1,441,213                         |       | $                                                               | 16.52      |   |
| Canceled                                 |       | (73,677                           | )          | 23.77                                                           |       |
| Granted                                  |       | 320,637                           |       | 26.88                                                           |       |
| Exercised                                |       | (236,376                          | )          | 9.51                                                            |       |
|                                     |       |                              |       |                                                            |       |
| Outstanding options at December 31, 2005 |       | 1,451,797                         |       | 19.53                                                           |       |
|                                          |            |                                   |            |                                                                 |            |  |

 

 

18

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NATIONAL MEDICAL HEALTH CARD SYSTEMS, INC. AND SUBSIDIARIES

 

**CONDENSED NOTES TO CONSOLIDATEDFINANCIAL STATEMENTS (Continued)**

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

**(Unaudited)**

 

Thefollowing table summarizes information about stock options outstanding atDecember 31, 2005:

 
| ** **             | ** ** | **Outstanding**      | ** ** | **Exercisable**                         | ** ** |
|------------------------|------------|----------------------|------------|-----------------------------------------|------------|
| **Option Price Range** | ** ** | **Number of Shares** | ** ** | **Weighted-  average  Remaining  Life** | ** ** | **Weighted-  average  Exercise  Price** | ** ** | **Number  of  Shares** | ** ** | **Weighted-  average  Exercise  Price** | ** ** |
| $ 1.67 to $2.51   |       | 7,000                |       | 0.14 years                              |       | $ | 1.67 |   | 7,000 |   | $ | 1.67 |   |
| $ 2.52 to $3.78   |       | 4,105                |       | 0.55 years                              |       | $ | 3.14 |   | 4,105 |   | $ | 3.14 |   |
| $ 3.79 to $5.69   |       | 900                  |       | 0.75 years                              |       | $ | 4.20 |   | 900 |   | $ | 4.20 |   |
| $ 5.70 to $8.55   |       | 45,146               |       | 1.72 years                              |       | $ | 7.69 |   | 43,727 |   | $ | 7.67 |   |
| $ 8.56 to $12.84  |       | 391,917              |       | 1.96 years                              |       | $ | 10.05 |   | 365,167 |   | $ | 9.92 |   |
| $ 12.85 to $19.28 |       | 140,332              |       | 5.38 years                              |       | $ | 13.87 |   | 86,047 |   | $ | 13.61 |   |
| $ 19.29 to $28.94 |       | 759,604              |       | 8.41 years                              |       | $ | 24.80 |   | 78,722 |   | $ | 23.88 |   |
| $ 28.95 to $36.66 |       | 102,793              |       | 3.40 years                              |       | $ | 31.63 |   | 67,719 |   | $ | 32.39 |   |
|                   |       |                 |       |                                    |       |   |   |   |   |   |   |
| $ 1.67 to $36.66  |       | 1,451,797            |       | 5.74 years                              |       | $ | 19.53 |   | 653,387 |   | $ | 14.13 |   |

 

8.             EARNINGS PER SHARE

 

Areconciliation of shares used in calculating basic and diluted earnings pershare follows:

 
| ** **                                                              | ** ** | **Three Months Ended  December 31,** | ** ** |
|-------------------------------------------------------------------------|------------|--------------------------------------|------------|
| ** **                                                              | ** ** | **2005**                             | ** ** | **2004** | ** ** |
| Basic                                                                   |       | 5,024,701                            |       | 4,423,757 |   |
| Effect of assumed exercise of employee stock options                    |       | 164,620                              |       | 665,985 |   |
| Effect of assumed conversion of redeemable  convertible preferred stock |       | 6,956,522                            |       | 6,956,522 |   |
| Diluted weighted average number of shares  outstanding                  |       | 12,145,843                           |       | 12,046,264 |   |
| ** **                                                              | ** ** | ** **                           | ** ** |
| ** **                                                              | ** ** | **Six Months Ended  December 31,**   | ** ** |
| ** **                                                              | ** ** | **2005**                             | ** ** | **2004** | ** ** |
|                                                                    |       |                                 |       |   |   |
| Basic                                                                   |       | 4,943,274                            |       | 4,411,709 |   |
| Effect of assumed exercise of employee stock options                    |       | 233,588                              |       | 705,808 |   |
| Effect of assumed conversion of redeemable  convertible preferred stock |       | 6,956,522                            |       | 6,956,522 |   |
| Diluted weighted average number of shares  outstanding                  |       | 12,133,384                           |       | 12,074,039 |   |

 

Basicnet income per common share is computed by dividing the net income available tocommon stockholders by the weighted-average number of common shares outstandingduring the period.  For the three and sixmonths ended December 31, 2005 and 2004, diluted net income

 

 

19

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NATIONAL MEDICAL HEALTH CARD SYSTEMS, INC. AND SUBSIDIARIES

 

**CONDENSED NOTES TO CONSOLIDATEDFINANCIAL STATEMENTS (Continued)**

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

**(Unaudited)**

 

pershare is computed by dividing the net income by the weighted-average number ofcommon and dilutive common equivalent shares (consisting of employee stockoptions and redeemable preferred stock as if converted) outstanding during theperiod.

 

9.               RELATED PARTYTRANSACTIONS

 

TheCompany receives certain services from the Chairman of the Board as per aconsulting agreement signed at the end of his employment with the Company.  During the three months ended December 31,2005 and 2004, $33 and $31, respectively, were paid under this agreement.  During the six months ended December 31, 2005and 2004, $64 and $42, respectively, were paid under this agreement.

 

Inaddition, the Company rents two houses from Living in Style, LLC, an entity ownedpartially by an executive officer and the current Chairman of the Board.  During the three months ended December 31,2005 and 2004, $36 and $35, respectively, were paid for the rent of these twohouses.  During the six months endedDecember 31, 2005 and 2004, $72 and $70, respectively, were paid for the rentof these two houses.

 

10.             MAJOR SPONSORS AND PHARMACIES

 

Forthe three and six months ended December 31, 2005, approximately 28% and 25% ofthe consolidated revenue of the Company was from two sponsors administeringmultiple plans. For the three and six months ended December 31, 2004,approximately 19% and 20%, respectively, of the consolidated revenue of theCompany was from one sponsor.  Amountsdue from these sponsors as of December 31, 2005 approximated $18,321.

 

Forthe three and six months ended December 31, 2005, no pharmacy chain accountedfor more than 10% of the total cost of claims. For the three and six months ended December 31, 2004, approximately 11%of the cost of claims was from one pharmacy chain.

 

11.            SUPPLEMENTALCASH FLOW INFORMATION

 

Duringthe six months ended December 31, 2005 and 2004, the Company paid $237 and $343in interest, and $47 and $1,247 in income taxes, respectively.  During the six months ended December 31,2005, the Company financed $853 of capital expenditures through its tradepayables.

 

12.            LITIGATION

 

Neitherthe Company nor any of its subsidiaries are involved in any material pendinglegal proceeding.  However, 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. Although the results oflitigation and claims cannot be predicted with certainty, the Company believesthat it does not have any material

 

 

20

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NATIONAL MEDICAL HEALTH CARD SYSTEMS, INC. AND SUBSIDIARIES

 

**CONDENSED NOTES TO CONSOLIDATEDFINANCIAL STATEMENTS (Continued)**

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

**(Unaudited)**

 

pendinglegal proceedings that will have a material adverse effect on itsbusiness.  Regardless of the outcome, litigation can have an adverseimpact on the Company because of defense costs, diversion of managementresources and other factors.

 

 

21

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**ITEM 2 – **MANAGEMENT’S DISCUSSION AND ANALYSIS OFFINANCIAL CONDITION AND RESULTS OF OPERATIONS 

** **

OPERATING INCOME($ in thousands)Three months ended December 31,

 
| ** **                                   | ** ** | **2005** | ** ** | **Increase/  (Decrease)** | ** ** | **2004** | ** ** |
|----------------------------------------------|------------|----------|------------|---------------------------|------------|----------|------------|
| Revenue                                      |       | $        | 219,909    |                      | 9.7        | %        | $          | 200,550 |   |
| Cost of claims                               |       | 196,232  |       | 9.9                       | %          | 178,618  |       |
| Gross profit                                 |       | 23,677   |       | 8.0                       | %          | 21,932   |       |
| Selling, general and administrative expenses |       | 18,950   |       | 11.5                      | %          | 17,001   |       |
| Operating Income                             |       | $        | 4,727      |                      | (4.1       | )%       | $          | 4,931 |   |

** **

OPERATING INCOME($ in thousands)Six months ended December 31,

 
| ** **                                   | ** ** | **2005** | ** ** | **Increase/  (Decrease)** | ** ** | **2004** | ** ** |
|----------------------------------------------|------------|----------|------------|---------------------------|------------|----------|------------|
| Revenue                                      |       | $        | 434,601    |                      | 12.8       | %        | $          | 385,392 |   |
| Cost of claims                               |       | 387,362  |       | 12.7                      | %          | 343,783  |       |
| Gross profit                                 |       | 47,239   |       | 13.5                      | %          | 41,609   |       |
| Selling, general and administrative expenses |       | 37,588   |       | 17.2                      | %          | 32,080   |       |
| Operating Income                             |       | $        | 9,651      |                      | 1.3        | %        | $          | 9,529 |   |

** **

**Results of Operations**

 

***Three Months Ended December 31, 2005Compared to Three Months Ended December 31, 2004***

*** ***

Revenueincreased $19.4 million, or 9.7%, from $200.6 million for the three months endedDecember 31, 2004, to $219.9 million for the three months ended December31, 2005.  Revenue recognized forcontracts recorded on a gross revenue basis was $199.0 million for the threemonths ended December 31, 2004 and $217.5 million for the three months endedDecember 31, 2005.  Revenue recognizedfor contracts recorded on a net revenue basis was $1.6 million for the three monthsended December 31, 2004 and $2.4 million for the three months ended December31, 2005. The specific terms of the contracts that we enter into with oursponsors will determine whether we recognize the gross revenue related to thecost of the prescriptions filled (see Critical Accounting Policies andEstimates – Revenue Recognition).  Forthose contracts on which we recognize net revenue, gross profit is equal to thenet revenue since neither the prescription revenue nor the related costs of theprescriptions are recorded. Whether revenues are recorded on either a gross ornet basis, we record the gross amount billed in accounts receivable and the

 

 

22

----

 

relatedclaims payable to the pharmacies on the balance sheet.  We include in revenue only those co-paymentscollected in our mail service facility in Miramar, Florida.  For the three months ended December 31, 2005,there was $4.3 million of co-payments included in revenue versus $4.2 millionfor the three months ended December 31, 2004. Co-payments retained by pharmacies on prescriptions filled for ourmembers and not included in our revenue were $83.0 million and $74.8 million,for the three months ended December 31, 2005 and 2004, respectively.

 

Ofthe $19.4 million increase in revenue during the three months ended December31, 2005, $20.0 million was attributable to the inclusion of revenue generatedby PCN that was not included in the three months ended December 31, 2004. Theincrease attributable to PCN was partially offset by the net of $20.2 millionof revenue related to new sponsors or new services offered by us, excludingcontracts recorded on a net revenue basis, and $5.3 million of revenue fromexisting sponsors related to, among other things, higher costs forpharmaceuticals, availability of new drugs, plan participant growth and anincrease in the average number of claims per plan participant, as well aschanges in other miscellaneous revenue items. These revenue increases werepartially offset by a $26.1 million reduction in revenue related to thetermination of existing sponsor contracts.

 

Costof claims increased $17.6 million, or 9.9%, from $178.6 million for the threemonths ended December 31, 2004 to $196.2 million for the three months ended December31, 2005.  PCN accounted for $17.5million of this increase.  The remainderof the increase was attributable to costs of claims totaling $19.8 millionrelated to the activity of new sponsors, and $5.4 million related to the growthin existing sponsors, partially offset by a $25.1 million reduction in costsrelated to the termination of existing sponsor contracts.  As a percentage of revenue, cost of claims increasedfrom 89.1% to 89.2% for the three months ended December 31, 2004 and December31, 2005, respectively.

 

Gross profit increased $1.7million, or 8.0%, from $21.9 million for the three months ended December 31,2004 to $23.7 million for the three months ended December 31, 2005. PCNaccounted for $2.5 million of this increase, the increase in gross profitattributable to PCN of $2.5 million was partially offset by the net ofanother $0.2 million of incremental gross profit was generated by our expandingmail service and specialty operations and competitive pressures which have ledto a decline in some prices that we charge to our sponsors have had the effectof partially offsetting the increases in gross profit described above by $1.0million.  Gross profit, as a percentageof revenue, decreased from 10.9% to 10.8% for the three months ended December31, 2004 and December 31, 2005.

 

Selling, general andadministrative expenses increased $2.0 million, or 11.8%, from $17.0 millionfor the three months ended December 31, 2004 to $19.0 million for the threemonths ended December 31, 2005.  Theacquisition of PCN and compensation expense related to the expensing ofemployee stock options accounted for $2.1 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. These increases were offset bya $0.7 million decrease in various other selling, general and administrativeexpenses.

 

Selling, general andadministrative expenses as a percent of revenue increased from 8.5% for thethree months ended December 31, 2004 to 8.6% for the three months endedDecember 31, 2005.  Selling, general andadministrative expenses as a percent of revenue for the three months ended

 

23

----

 

December 31,2005 would have been 8.3% excluding the compensation expense relating toemployee stock options.

 

Other income, net decreased $1.2 million, or 80%,from $1.5 million for the three months ended December 31, 2004 to $0.3million for the three months ended December 31, 2005. The primary reasonfor the net decrease in other income was the recognition of a non-recurringgain of $1.7 million from an insurance claim which represented the excess ofthe insurance proceeds over the carrying value of the assets covered by theclaim during the three months ended December 31, 2004. This item waspartially offset by higher cash balances due to increased cash flow fromoperations which resulted in an increase in interest income during the threemonths ended December 31, 2005. In addition, we aggregate rebates for anunrelated third party and charge them interest on advances we make to them fortheir rebates. For the three months ended December 31, 2005, we earned$0.3 million in interest income from this third party.

 

Incomebefore the provision for income taxes decreased $1.4 million, or 21.7%, from$6.4 million for the three months ended December 31, 2004, to $5.0 millionfor the three months ended December 31, 2005. The primary factor leadingto this decrease in income before the provision for income taxes was thedecrease in other income, net which represented the aforementioned recognitionof a non-recurring gain of $1.7 million related to an insurance claim duringthe three months ended December 31, 2004. The increase in selling, generaland administrative expenses, primarily related to the PCN acquisition and theinitial expensing of employee stock options also contributed to the decrease inincome before the provision for income taxes. This decrease was partiallyoffset by the increase in our gross profit.

 

Theeffective tax rate was 42.5% for the three months ended December 31, 2005,as compared to 41.0% for the three months ended December 31, 2004. Theincrease in the effective tax rate for the three months ended December 31,2005 was the result of the expensing of employee incentive stock options inaccordance with FASB Statement No. 123(R). This compensation expense forincentive stock options, which is not deductible for tax purposes, increasedour effective tax rate by 2.2%. The current estimated tax rate for the full2006 fiscal year is 42.6%.

 

Netincome decreased $0.9 million, or 23.8%, from $3.8 million for the three monthsended December 31, 2004, to $2.9 million for the three months ended December 31,2005. The decrease in net income was primarily attributable to theaforementioned non-recurring after-tax gain of $1.0 million related to aninsurance claim during the three months ended December 31, 2004, as wellas a $0.5 million compensation charge, net of its income tax benefit, relatedto the expensing of employee incentive stock options, beginning July 1,2005, in accordance with FASB Statement No. 123(R). The remainder ofdecrease was caused by the increase in our selling, general and administrativeexpenses, net of the increase in our gross profit.

 

Inaddition, there were two charges against income available to commonstockholders related to the New Mountain Transaction (See Note 3 of Part 1,Item 1). The first of these charges relates to the series A redeemableconvertible preferred stock cash dividends, which amounted to $1.4 million forboth the three months ended December 31, 2005 and December 31, 2004.The series A redeemable convertible preferred stock 

 

 

24

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providesfor an initial cash dividend equal to 7% of the investment amount (currently$80 million), which decreases to 3.5% after the fifth anniversary of issuance. Thedividends of $1.4 million represent the amount accrued and paid for both thethree months ended December 31, 2005 and December 31, 2004. Thesecond charge is for the accretion of transaction expenses which was $0.1million for both the three months ended December 31, 2005 and December 31,2004.

 

Afterdeducting these two charges from net income, there remained net incomeavailable to common stockholders of $1.4 million for the three months ended December 31,2005, as compared to $2.3 million for the three months ended December 31,2004.

 

25

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***Six Months Ended December 31, 2005 Compared to Six Months Ended December 31,2004***

 

Revenueincreased $49.2 million, or 12.8%, from $385.4 million for the six months endedDecember 31, 2004, to $434.6 million for the six months ended December 31,2005. Revenue recognized for contracts recorded on a gross revenue basis was$382.8 million for the six months ended December 31, 2004 and $429.9million for the six months ended December 31, 2005. Revenue recognized forcontracts recorded on a net revenue basis was $2.6 million for the six monthsended December 31, 2004 and $4.7 million for the six months ended December 31,2005. The specific terms of the contracts that we enter into with our sponsorswill determine whether we recognize the gross revenue related to the cost ofthe prescriptions filled (see Critical Accounting Policies and Estimates –Revenue Recognition). For those contracts on which we recognize net revenue,gross profit is equal to net revenue since neither the prescription revenue northe related costs of the prescriptions are recorded. Whether revenues arerecorded on either a gross or net basis, we record the gross amount billed inaccounts receivable and the related claims payable to the pharmacies on thebalance sheet. We include in revenue only those co-payments collected in ourmail service facility in Miramar, Florida. For the six months ended December 31,2005, there was $9.1 million of co-payments included in revenue versus $6.5million for the six months ended December 31, 2004. Co-payments retainedby pharmacies on prescriptions filled for our members and not included in ourrevenue were $160.5 million and $128.7 million, for the six months ended December 31,2005 and 2004, respectively.

 

Ofthe $49.2 million increase in revenue during the six months ended December 31,2005, $38.9 million was attributable to the inclusion of revenue generated byPCN that was not included in the six months ended December 31, 2004. Theremainder of the increase was attributable to $34.0 million of revenue relatedto new sponsors or new services offered by us, excluding contracts recorded ona net revenue basis, and $19.1 million of revenue from existing sponsors 

 

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relatedto, among other things, higher costs for pharmaceuticals, availability of newdrugs, plan participant growth and an increase in the average number of claimsper plan participant, as well as changes in other miscellaneous revenue items.These revenue increases were partially offset by a $42.8 million reduction inrevenue related to the termination of existing sponsor contracts.

 

Costof claims increased $43.6 million, or 12.7%, from $343.8 million for the sixmonths ended December 31, 2004 to $387.4 million for the six months ended December 31,2005. PCN accounted for $33.8 million of this increase. The remainder of theincrease was attributable to costs of claims totaling $33.1 million related tothe activity of new sponsors, and $8.6 million related to the growth in existingsponsors. These cost increases were partially offset by a $31.9 millionreduction in costs related to the termination of existing sponsor contracts. Asa percentage of revenue, cost of claims decreased from 89.2% to 89.1% for thesix months ended December 31, 2004 and December 31, 2005,respectively.

 

Grossprofit increased $5.6 million, or 13.5%, from $41.6 million for the six monthsended December 31, 2004 to $47.2 million for the six months ended December 31,2005. PCN accounted for $5.1 million of this increase, while another $1.8million of incremental gross profit was generated by our expanding mail serviceand specialty operations. These increases were partially offset by a $1.3 milliondecrease in the amount of rebates we retained during the six months ended December 31,2005 as compared to the six months ended December 31, 2004. Gross profit,as a percentage of revenue, increased from 10.8% to 10.9% for the six monthsended December 31, 2004 and December 31, 2005, respectively.

 

Selling,general and administrative expenses increased $5.5 million, or 17.1%, from$32.1 million for the six months ended December 31, 2004 to $37.6 millionfor the six months ended December 31, 2005. The acquisition of PCN andcompensation expense related to the expensing of employee stock optionsaccounted for $4.2 million and $1.3 million of this increase, respectively. Theexpensing of employee stock options was required to be included in our selling,general and administrative expenses beginning July 1, 2005.

 

Selling, general and administrative expenses as apercent of revenue increased from 8.3% for the six months ended December 31,2004 to 8.6% for the six months ended December 31, 2005. Selling, generaland administrative expenses as a percent of revenue for the six months ended December 31,2005 would have been 8.4% excluding the compensation expense relating toemployee stock options.

 

Other income, net decreased $1.0 million, or 71.4%,from $1.4 million for the six months ended December 31, 2004 to $0.4million for the six months ended December 31, 2005. The primary componentof the $1.0 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 six months ended December 31, 2004. Thisitem was partially offset by higher cash balances due to increased cash flowfrom operations which resulted in an increase in interest income during the sixmonths ended December 31, 2005. In addition, we aggregate rebates for anunrelated third party and charge them interest on advances we make to them fortheir rebates. For the six months ended December 31, 2005, we earned $0.3million in interest income from this third party.

 

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Incomebefore the provision for income taxes decreased $0.9 million, or 8.3%, from$11.0 million, for the six months ended December 31, 2004, to $10.0million for the six months ended December 31, 2005. The primary factorleading to this decrease in income before the provision for income taxes wasthe decrease in other income, net which included the aforementioned recognitionof a non-recurring gain of $1.7 million related to an insurance claim duringthe six months ended December 31, 2004. The increase in selling, generaland administrative expenses, primarily related to the PCN acquisition and theinitial expensing of employee stock options also contributed to the decrease inincome before the provision for income taxes. This decrease was partiallyoffset by the increase in our gross profit.

 

Theeffective tax rate was 42.6% for the six months ended December 31, 2005,as compared to 41.0% for the six months ended December 31, 2004. Theincrease in the effective tax rate for the six months ended December 31,2005 was the result of the expensing of employee incentive stock options inaccordance with FASB Statement No. 123(R). This compensation expense forincentive stock options, which is not deductible for tax purposes, increasedour effective tax rate by 2.4%. The tax rate of 42.6% represents our currentestimated tax rate for the full 2006 fiscal year.

 

Netincome decreased $0.7 million, or 10.9%, from $6.5 million for the six monthsended December 31, 2004 to $5.8 million for the six months ended December 31,2005. The decrease in net income was primarily attributable to theaforementioned non-recurring after-tax gain of $1.0 million related to aninsurance claim during the six months ended December 31, 2004, as well asa $1.0 million compensation charge, net of its income tax benefit, related tothe expensing of employee incentive stock options, beginning July 1, 2005,in accordance with FASB Statement No. 123(R). The remainder of thedecrease was caused by the increase in our selling, general and administrativeexpenses, net of the increase in our gross profit.

 

Inaddition, there were two charges against income available to commonstockholders related to the New Mountain Transaction (See Note 3 of Part 1,Item 1). The first of these charges relates to the series A preferredstock cash dividends, which amounted to $2.8 million for both the six monthsended December 31, 2005 and December 31, 2004. The series Apreferred stock provides for an initial cash dividend equal to 7% of theinvestment amount (currently $80 million), which decreases to 3.5% after thefifth anniversary of issuance. The dividend of $2.8 million represents theamount accrued and paid for both the six months ended December 31, 2005and December 31, 2004. The second charge is for the accretion oftransaction expenses which were $239,000 for both the six months ended December 31,2005 and December 31, 2004.

 

Afterdeducting these two charges from net income, there remained net incomeavailable to common stockholders of $2.7 million for the six months ended December 31,2005, as compared to $3.4 million for the six months ended December 31,2004.

 

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# **Liquidity and Capital Resources**

 

Ourprimary cash requirements are for capital expenditures and operating expenses,including cost of pharmaceuticals, software and hardware upgrades and thefunding of accounts receivable and inventory in our mail service and specialtypharmacy facilities. Also, we require cash to execute our strategy of pursuingacquisitions of other PBM companies or of companies providing related services.We have now acquired seven companies since July 2000 utilizing primarilycash. This has had the effect of increasing our working capital deficits untilsufficient profitability is earned to offset these deficits. As of December 31,2005, we had a working capital deficit of $16.5 million as compared to aworking capital deficit of $24.4 million as of June 30, 2005. The primaryreason for the improvement in working capital was the profits we generatedduring the six months ended December 31, 2005.

 

Wehave a banking structure resulting in certain disbursement accounts carryingnegative book balances of $27.1 million and $8.3 million at December 31,2005 and June 30, 2005, respectively, which are reclassified to claimspayable and accounts payable. This reclassification restores balances to cashand current liabilities for liabilities to our vendors which have not yet beensatisfied. No bank overdraft or unsecured short-term loan exists in relation tothese negative balances.

 

Netcash provided by operating activities was $5.4 million for the six months endedDecember 31, 2005, as compared to net cash used in operating activities of$1.1 million for the six months ended December 31, 2004. This increase of$6.5 million in net cash provided by operating activities was the result of a$3.3 million increase in claims payable to pharmacies and a $2.8 millionreduction in accounts receivable through our improved collection efforts duringthe six months ended December 31, 2005. The increase was further caused by$0.4 million of net cash provided by operating activities from variousoperating assets and liabilities.

 

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

 

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Our accounts receivable have increased at arate faster than revenue because there are certain contracts, such as ourPreferred Partnership Program, in which, in general, we bill these pass-throughsponsors on a gross revenue basis but only recognize their revenue on a netbasis. The primary factor that leads to recognizing net revenue on thesePreferred Partnership Program contracts is that the amount that we earn isfixed. Under the Preferred Partnership Program contracts, which, in general,are full pass-through contracts, we receive a fixed charge per claim and asmall fixed percentage of the rebates subject to minimums; and all otherpharmacy costs are charged to the plan sponsor. The entire amount paid to thepharmacy is billed to the plan sponsor, and there is no margin retained by us. Forthe six months ended December 31, 2005, billings from pass-throughcontracts increased 126% ($187 million) which was the primary reason for the23% increase in accounts receivable.

 

Netcash used in investing activities was $3.9 million for the six months ended December 31,2005, as compared to $2.1 million for the six months ended December 31,2004. This increase of $1.8 million in net cash used in investing activitieswas the result of a $2.0 million increase in capital expenditures along with a$0.1 million increase in the cash paid for the PPP Acquisition. The cashpayments of $426,000 during the six months ended December 31, 2005 and$358,000 for the six months ended December 31, 2004 for the PPP Acquisitionare for additional payments due under the earn-out provision (See Note 4 of Part 1,Item 1). We have accrued $373,000 through December 31, 2005 as additionalpurchase price related to the earn-out provision, which will be paid in September 2006.These increases were partially offset by $1.9 million paid in connection withthe Inteq Acquisition netted against $2.0 million released from the Inteqearnout escrow and returned to us.

 

Netcash provided by financing activities was $0.5 million for the six months endedDecember 31, 2005, as compared to $3.8 million for the six months ended December 31,2004. This decrease of $3.3 million was the result of additional net borrowingsof $5.8 million from our credit facility during the six months ended December 31,2004. This item was offset by a $1.3 million increase in proceeds from theexercise of employee stock options and a reduction of $0.3 million in therepayment of capital lease obligations during the six months ended December 31,2005 as all but two of our capital leases have ended. The decrease was furtheroffset by a $1.0 million cash inflow during the six months ended December 31,2005, which represented the excess tax benefit from the exercise of employeestock options in accordance with FASB Statement No. 123(R).

 

OnJanuary 28, 2005, we entered into a five-year $65.0 million cash flow based,line of credit with a syndicate of commercial banks led by JPMorgan Chase Bank,N.A. (“JPMorgan”). Subject to certain conditions, including the consent ofexisting lenders, the new line of credit may be increased by an aggregate of$35.0 million. The JPMorgan credit facility contains various covenants that,among other things, require us to maintain certain financial ratios, which areconsolidated net worth, consolidated fixed charge ratio and consolidated debtto EBITDA (earnings before interest, taxes, depreciation and amortization)ratio. As of December 31, 2005 there was no principal balance outstanding underthe JPMorgan credit facility, and we were in compliance with our financialcovenants.

 

Twoof these financial covenants are based upon the EBITDA generated by us overspecified periods of time. These covenants, consolidated fixed charge ratio andconsolidated debt to EBITDA ratio, are evaluated by 

 

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JPMorganas a measure of our liquidity and our ability to meet all of our obligationsunder the credit facility. EBITDA is presented as cash flow from operationsplus or minus the net changes in assets and liabilities and the changes incertain non-cash reconciling items from net cash from operations to net incomeover the reported periods. While EBITDA is not a measure of financialperformance or liquidity under United States generally accepted accountingprinciples, it is provided as information for investors for analytical purposesin light of the financial covenants referred to above. EBITDA is not meant tobe considered a substitute or replacement for net income as prepared inaccordance with United States generally accepted accounting principles. EBITDA,which decreased by $1.2 million or 8.3%, from $14.4 million for the sixmonths ended December 31, 2004 to $13.2 million for the six months ended December 31,2005, is calculated as follows (see Consolidated Statement of Cash Flowscomprising Item 1 hereof for more details):

 

| ** **                                                          | ** ** | **Six Months Ended December 31,** | ** ** |
|---------------------------------------------------------------------|------------|----------------------------------------|------------|
| ** **                                                          | ** ** | **2005**                               | ** ** | **2004** | ** ** |
| Cash flow from operations                                           |       | $                                      | 5,360      |   | $ | (1,077 | ) |
| Provision for income taxes                                          |       | 4,284                                  |       | 4,494 |   |
| Interest (income) expense, net                                      |       | (438                                   | )          | 329 |   |
| Net change in assets and Liabilities                                |       | 5,391                                  |       | 11,845 |   |
| Non-cash items to reconcile net cash from operations  to net income |       | (1,394                                 | )          | (1,200 | ) |
| EBITDA                                                              |       | $                                      | 13,203     |   | $ | 14,391 |   |

 

Wehave entered into various capital lease transactions for hardware and software.We have also assumed various capital leases through our acquisitions. As of December 31,2005, there are two capital leases remaining in effect.

 

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

 

The total future payments under thesecontractual obligations as of December 31, 2005, are as follows:

 

**Payments Due by Period**

**($in thousands)**

 

**Contractual Obligations**

 
| ** **                         | ** ** | **Total** | ** ** | **Less than  1 Year** | ** ** | **1-3 Years** | ** ** | **4-5  Years** | ** ** | **More   than  5 Years** | ** ** |
|------------------------------------|------------|-----------|------------|-----------------------|------------|---------------|------------|----------------|------------|--------------------------|------------|
| Capital Lease Obligations          | ** ** | $         | 31         |                  | $          | 30            |       | $              | 1          |                     | $          | — |   | $ | — | ** ** |
| Operating Leases                   | ** ** | 21,701    |       | 7,026                 |       | 8,388         |       | 3,942          |       | 2,345                    | ** ** |
| Sale-leaseback                     |       | 140       |       | 140                   |       | —        |       | —         |       | —                   |       |
| Total Contractual Cash Obligations |       | $         | 21,872     |                  | $          | 7,196         |       | $              | 8,389      |                     | $          | 3,942 |   | $ | 2,345 |   |

 

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The shareholders of PCN are eligible toreceive additional consideration of up to $30.0 million, if certain financialand performance targets are met over the three year period beginning March 1,2005. As of December 31, 2005, the financial and performance targets havenot been achieved.

 

Theshareholders of the Inteq Group were eligible to receive additionalconsideration of up to $4.2 million, if certain financial targets were metduring the year ended April 1, 2005. Of this potential amount, $3.0million was deposited in escrow at the time of closing. As of December 31,2005, $1.0 million was earned and released from escrow, with the balance of$2.0 million being returned to us.

 

Theshareholders of PPP are eligible to receive additional consideration of up to$7.0 million, if certain financial targets are met over the three year periodbeginning August 1, 2003. Such amounts earned are payable within 45 daysafter the first, second, and third anniversary of the date of acquisition. Inthe sole discretion of NMHC, up to 50% of any amounts earned can be paid in theform of our stock in lieu of cash. For the year ended July 31, 2004,$716,000 has been earned and was paid on September 15, 2004. Of thisamount, $358,000 was paid in cash and $358,000 was satisfied by the issuance of12,650 shares of our common stock. For the year ended July 31, 2005,$851,000 has been earned and was paid on September 15, 2005. Of thisamount, $426,000 was paid in cash and $425,000 was satisfied by the issuance of17,127 shares of our common stock. As of December 31, 2005, $373,000 hasbeen accrued as additional purchase price and will be paid in September 2006.

 

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

 

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

 

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

 

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Theseries A redeemable convertible preferred stock provides for an initialannual cash dividend equal to 7% of the investment amount, which decreases to3.5% after the fifth anniversary of issuance. The series A redeemableconvertible preferred stock is convertible into common stock at a price of$11.50 per share of common stock, or an aggregate of approximately 7 millionshares of our common stock.

 

Theseries A redeemable convertible preferred stock may be redeemed atour option subsequent to the fourth anniversary of its issuance, subject tocertain conditions. After the tenth anniversary of the issuance of the series Aredeemable convertible preferred stock, each holder of shares of series Apreferred stock may require us to redeem all or a part of that holder’sshares of series A redeemable convertible preferred stock.

 

Weanticipate that current cash positions and available credit facilities, afterour seven acquisitions together with anticipated cash flow from operations,will be sufficient to satisfy our contemplated cash requirements for at least24 months. This is based upon current levels of capital expenditures andanticipated operating results for the next 24 months. However, it is one of ourstated goals to acquire other pharmacy benefit management companies andcompanies providing related services. Depending on our evaluation of futureacquisitions, additional cash may be required to complete theseacquisitions. In addition, we will require cash to acquire additional inventoryfor our mail service and specialty distribution divisions to service ourexpanding operations. In the event that our plans change or our assumptionsprove to be inaccurate, or the proceeds from the new revolving credit facilityand the New Mountain Transaction prove to be insufficient to fund operationsand acquisitions, we could be required to seek additional financing sooner thananticipated. There can be no assurance that such financing could be obtained atrates or on terms acceptable to us, if at all.

 

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**OtherMatters**

 

***Inflation***

 

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

 

**Critical Accounting Policies and Estimates**

 

***General***

 

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

 

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

 

***Revenue Recognition***

 

(a)                             Since January 1, 2000, all servicesprovided by NMHC have been on a fee for service basis. Under the fee 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 isrecognized when the claims are adjudicated. Included as revenue are ouradministrative fees and charges relating to pharmaceuticals dispensed by ournetwork of pharmacies. Revenue is reduced by the amount of rebates paid to oursponsors.

 

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

 

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

 

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

 

 (d)                              Rebates are recognized when we are entitled to them in accordance withthe terms of our arrangements with drug manufacturers, third party rebateadministrators, and sponsors, and when the amount of the rebates isdeterminable. We record the gross rebate receivable and the appropriate payableto the sponsors based on estimates, which are subject to final settlement. Theestimates are based upon the claims submitted and our rebate experience, andare adjusted as additional information becomes available.

 

***Bad Debt***

 

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

 

***Goodwill and Intangible AssetImpairment***

 

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

 

***Cash***

 

Wehave a banking structure resulting in certain disbursement accounts carryingnegative book balances of $27.1 million and $8.3 million at December 31,2005 and June 30, 2005, respectively, which are reclassified to claimspayable and accounts payable. This reclassification restores balances to cashand current liabilities for liabilities to our vendors which have not yet beensatisfied. No bank overdraft or unsecured short-term loan exists in relation tothese negative balances.

 

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***Deferred Taxes***

 

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

 

***Capitalized Software***

 

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

 

***Share-Based Payments***

 

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

 

**ITEM 3 -**QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK 

 

NotApplicable.

 

**ITEM 4 –**CONTROLS AND PROCEDURES 

 

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

 

Underthe supervision and with the participation of management, chiefly our principalexecutive officer and our principal financial officer, we evaluated theeffectiveness of the design and operation of our disclosure controls andprocedures (as defined in Rules 13a-15(e) and 15d-15(e) underthe Exchange Act), as of December 31, 2005. Based on that evaluation, ourprincipal 

 

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executiveofficer and our principal financial officer have concluded that these controlsand procedures are effective in alerting them to material information, on atimely basis, required to be included in our periodic Securities and ExchangeCommission filings. There have been no changes in our internal controls overfinancial reporting (as defined in Rules 13a-15(f) and 15d-15(f) underthe Exchange Act) that occurred in this period that have materially affected,or are reasonably likely to materially affect, our internal controls overfinancial reporting.

 

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### **PART II– OTHER INFORMATION**

 

**ITEM 1**–****LEGAL PROCEEDINGS 

 

None.

 

**ITEM 1A** – RISK FACTORS

 

None.

 

**ITEM 2**–****UNREGISTERED SALES OF EQUITY SECURITIES ANDUSE OF PROCEEDS

 

None.

 

**ITEM 3 –**DEFAULTS UPON SENIOR SECURITIES  

 

None.

 

**ITEM 4 -**SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS 

 

NMHCheld its annual meeting of stockholders on December 7, 2005. Each of thematters described below were voted upon and approved at the annual meeting.

 

1)                                      The election of 11 directors to serve untilthe next annual meeting of stockholders:

 
| **Name**             | ** ** | **For**   | ** ** | **Withheld** |
|----------------------|------------|-----------|------------|--------------|
|                 |       |      |       |         |
| James J. Bigl        |       | 3,814,115 |       | 669,774      |
| James Smith          |       | 3,881,523 |       | 602,366      |
| Paul J. Konigsberg   |       | 4,270,363 |       | 213,526      |
| Gerald Angowitz      |       | 4,271,363 |       | 212,526      |
| Steven B. Klinsky    |       | 3,740,463 |       | 743,426      |
| Micheal B. Ajouz     |       | 3,813,520 |       | 670,369      |
| G. Harry Durity      |       | 3,813,470 |       | 670,419      |
| Michael T. Flaherman |       | 3,812,620 |       | 671,269      |
| Robert R. Grusky     |       | 3,813,520 |       | 670,369      |
| David E. Shaw        |       | 3,813,520 |       | 670,369      |
| Daniel B. Hebert     |       | 3,793,520 |       | 690,369      |

 

2)                                      To approve and ratify the engagement of Ernst &Young LLP as NMHC’s independent registered public accounting firm for thefiscal year ending June 30, 2006.

 
| **For**   | ** ** | **Against** | ** ** | **Abstain** |
|-----------|------------|-------------|------------|-------------|
| 4,481,939 |       | 450         |       | 1,500       |

 

Adetailed description of the matters voted upon at the Registrant’s 2005 AnnualMeeting of Stockholders has been previously reported in NMHC’s Definitive ProxyStatement filed with the SEC on October 28, 2005.

 

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**ITEM 5 –**OTHER INFORMATION 

 

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                                                                                                       |
| 3.6         |       | Nominating  and Corporate Governance Committee Charter (6)                                                                                                          |
| 4.1         |       | Form of  Warrant Agreement, including form of Representatives’ Warrants (1)                                                                          |
| 4.2         |       | Certificate  of Designation, Preferences and Rights of Series A 7% Convertible  Preferred Stock of NMHC (5)                                                    |
| 10.1        |       | Credit  Agreement dated January 28, 2005 among NMHC, the Lenders party thereto  and JPMorgan Chase, as Administrative Agent (7)                                |
| 10.2        |       | Lease  Expansion and Modification Agreement dated July 31, 2003 between Sunbeam  Development Corporation and NMHCRx Mail Order, Inc. (3)                  |
| 10.3        |       | AmerisourceBergen  Prime Vendor Agreement, dated July 21, 2003 between NMHCRx Mail Order, Inc.  d/b/a NMHCmail and AmerisourceBergen Drug Corporation (3) |
| 10.4        |       | Amendment  to Lease Agreement, dated as of October 23, 2003, by and among BFS  Realty, LLC and National Medical Health Card Systems, Inc. (4)             |
| 10.5        |       | 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) Denotes document filed as an Exhibit toNMHC’s Registration Statement on Form S-1 (Registration Number:  333-72209) and incorporated herein byreference.

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

 

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

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

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

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

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

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

(9) Denotes documents filed as an Exhibit toNMHC’s Form 10-Q for the quarter ended September 30, 2005 andincorporated herein by reference.

(10) Denotes documents filed as an Exhibit toNMHC’s Form 8-K filed on January 26, 2006 and incorporated herein byreference.

(11) Denotes document filed as an Exhibit toNMHC’s Form 10-Q for the quarter ended December 31, 2005 andincorporated herein by reference.

 

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# SIGNATURES

 

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

 

 

NATIONAL MEDICAL HEALTH CARDSYSTEMS, INC.

(Registrant)

 

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

 

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