Our primary PBM services consist of the automated online processing of prescription claims on behalf of our clients. When a member of one of our clients presents a prescription or health plan identification card to a retail pharmacist in our network, our system provides the pharmacist with accesses to online information regarding eligibility, patient history, health plan formulary listings, and contractual reimbursement rates. The member generally pays a co-payment to the retail pharmacy and the pharmacist fills the prescription. On behalf of our clients, we electronically aggregate pharmacy benefit claims, which include prescription costs plus our claims processing fees for consolidated billing and payment. We receive payments from clients and remit the amounts owed to the retail pharmacies pursuant to our negotiated rates and retaining the difference, including claims processing fees.
We have established a nationwide network of over 50,000 retail pharmacies. In general, self-insured employers and managed-care organizations contract with us to access our negotiated retail pharmacy network rates, participate in certain rebate arrangements with manufacturers based on formulary design and benefit from the other care enhancement protocols in our system. Under these contracts, we have an independent obligation to pay network retail pharmacies for the drugs dispensed and accordingly, have assumed that risk independent of our clients. When the Company administers pharmacy reimbursement contracts and does not assume a credit risk, the Company records only its administrative or dispensing fees as revenue. Pharmacy benefit claim payments from our clients are recorded as revenues, and prescription costs to be paid to pharmacies are recorded as direct expenses. Member co-payments are not recorded as revenue. Rebates earned under arrangements with manufacturers are recorded as a reduction of direct expenses. The portion of manufacturer rebates due to plan sponsors is recorded as a reduction of revenue.
On December 1, 2002, the Company acquired 100% of the common stock of PNNC. Total consideration for PNNC stock was $20.2 million. Total acquisition cost included transaction costs of approximately $1.4 million. Funding for the $21.6 million cash transaction was derived from the Company's working capital. The acquisition of PNNC was accounted for using the purchase method of accounting. The acquisition resulted in goodwill of approximately $10.6 million.
During the first quarter of 2002, the Company purchased the outstanding 20% minority interest in Catalyst for 319,033 shares of the Company's stock valued at $1.1 million and notes payable of $4.2 million. The stock was transferred to the seller on April 1, 2002, and the $3.1 million in cash was paid in 2002, with the final installment of $1.1 million paid on March 1, 2003.
Effective November 1, 2000, the Company completed the acquisition of IPM for an aggregate purchase price of approximately $9.2 million. Consideration for the transaction consisted of approximately 95% cash and the remainder in common stock. The acquisition of IPM was accounted for using the purchase method of accounting. Goodwill recorded at acquisition was $9.2 million.
HealthExtras has successfully integrated IPM and Catalyst into the Company's financial, organizational, management and technology structure. Our acquisitions have provided the Company with a more diverse and complete set of products and services to sell to a larger customer base. For example, Catalyst's previously developed demand management, generic substitution and other clinical programs have significantly enhanced the Company's ability to serve larger and more sophisticated customers. The acquisitions have also allowed us to better capture efficiencies in corporate overhead and information technology investments. The Company has achieved cost savings from the consolidation of certain corporate activities and the elimination of certain duplicated components of the Company's corporate operations.
The Company's supplemental benefits segment generates revenue from the sale of membership programs which provide insurance and other benefits. The Company has distribution agreements with many of the nation's largest financial institutions (the "distributors"), along with leading affinity groups and associations. Additionally, HealthExtras has a relationship with actor and advocate Christopher Reeve to promote these benefits programs.
Revenue is generated by payments for program benefits and payments from certain distributors. In general, program revenue is recognized based on the number of members enrolled in each reporting period multiplied by the applicable fee collected from the member or paid by the distributor for their specific membership program. The program revenue recognized by HealthExtras includes the cost of the membership benefits, which are supplied by others, including the insurance components. Payments from the distributors related to new member enrollments are recorded as revenue to the extent of the related direct expenses, which to date have exceeded payments from the distributors.
Direct expenses consist principally of the cost of benefits provided to program members, distributors' compensation, and transaction processing fees. Direct expenses are a function of the level of membership during the period and the specific set of program features selected by members. The coverage obligations of our benefit suppliers and the related expense are determined monthly, as are the remaining direct expenses.
Selling and general administrative expenses for the year ended 2001, were approximately $38.5 million or 30.5% of total operating expenses, $3.7 million which related to the Company's PBM segment, while the remaining $34.8 million related to the supplemental benefits segment. These expenses included $5.8 million for creative development, product endorsements and market research, $21.4 million in direct marketing, $6.1 million in compensation and benefits, $1.1 million in professional fees, insurance and taxes, $1.0 million in other expenses, $843,000 in facility costs, $466,000 in travel expenses, and $1.8 million in depreciation and amortization.
MINORITY INTEREST. The minority interest charge for the years ended December 31, 2002 and 2001, was approximately $45,000 and $96,000, respectively. The charges represent the net income attributable to the 20% minority interest holder of Catalyst for the months of January and February 2002, and November and December 2001, respectively. As the Company purchased the remaining minority interest on March 1, 2002, no additional minority interest charge for Catalyst will appear on the Company's future financial statements.
Operating expenses of the segments exclude $11.9 million and $2.4 million in corporate overhead that was not allocated by management in assessing segment performance for the years ended December 31, 2002 and 2001, respectively.
REVENUE. Revenue from operations for the year ended December 31, 2001 was $118.2 million, compared to $43.9 million for the year ended December 31, 2000. PBM segment revenue was $46.9 million, while revenue for the supplemental benefits segment was $71.3 million. As the Company had increased its strategic focus on pharmacy services during 2001, the majority of its revenue and revenue growth were derived from such services at the end of 2001. Much of the growth in the PBM segment was attributable to the acquisitions IPM and Catalyst during the fourth quarters of 2000 and 2001, respectively. The 2001 increase in revenue due to the IPM acquisition was approximately $28.9 million. Catalyst revenue accounted for $13.0 million in 2001. Due to the Company's adoption of EITF 01-9, revenue of previously reported 2001 and 2000 revenue has been reduced by $6.2 million and $255,000,
respectively, in the comparative financial statements. For more information about the adoption of EITF 01-9, see Note 2 of the Notes to Consolidated Financial Statements.
DIRECT EXPENSES. Direct expense for the year ended December 31, 2001 of $87.5 million consisted of $43.6 million in direct costs associated with the PBM segment and $43.9 million attributable to benefit costs and compensation to our distributors for supplemental benefits products. Direct expenses for the year ended 2000 were $24.0 million, consisting of approximately $4.5 million and $19.5 million attributable to the pharmacy benefit management services and supplemental benefits segments, respectively. Much of the growth in the PBM segment was attributable to the acquisitions of IPM and Catalyst during the fourth quarters of 2000 and 2001, respectively. The 2001 increase in direct expenses due to the IPM acquisition was approximately $22.7 million. Catalyst direct expenses accounted for $12.2 million in 2001. The direct expenses of $87.5 million and $24.0 million for the years ended 2001 and 2000, represent 69.5% and 37.7% of operating expenses for the respective periods. Due to the Company's adoption of EITF 01-9, revenue of previously reported 2001 and 2000 direct expenses have been reduced by $6.2 million and $255,000, respectively, in the comparative financial statements. For more information about the adoption of EITF 01-9, see Note 2 of the Notes to Consolidated Financial Statements.
Selling and general administrative expenses for the year ended 2000, were approximately $39.7 million or 62.3% of total operating expenses, $448,000 which related to the Company's PBM segment, which $39.2 million related to the supplemental benefits segment. These expenses included $5.1 million for creative development, product endorsements and market research, $26.1 million in direct marketing, $4.6 million in compensation and benefits, $2.5 million in other fees and insurance and taxes, $467,000 in facility costs, $274,000 in travel expenses, and $702,000 in depreciation and amortization.
INTEREST INCOME (EXPENSE) NET. Interest income, net for the year ended December 31, 2001, was $1.1 million compared to interest income of $2.1 million for the year ended December 31, 2000, a decrease of 48% principally due to lower invested balances, interest rates and interest on borrowings initiated in 2001.
MINORITY INTEREST. The minority interest charge for the year ended December 31, 2001 was approximately $96,000. There was no minority interest charge for the year ended December 31, 2000. The 2001 charge represents the net income attributable due to the 20% minority interest holder of Catalyst for the months November and December 2001.
Cash and cash equivalents at December 31, 2002, totaled $17.5 million compared to $33.0 million at December 31, 2001. During 2002, the Company received $30.5 million in cash from borrowings, repaid $12.5 million on borrowings, paid $31.6 million for business acquisitions and related costs, paid $2.0 million in capital expenditures, and used $6.9 million of the borrowed funds and $1.4 million of the Company's cash to reduce outstanding payables and accrued expenses in order to negotiate more favorable rates with specific vendors.
CASH USED IN OPERATING ACTIVITIES. Cash used for operating activities during 2002 was $22,000 compared to $2.0 million during 2001. The variance is primarily due to a $10 million increase in income before taxes offset by a large reduction in accounts payable and, accrued expenses, and an increase in deferred charges.
By managing accounts receivable to conform more closely to our payment obligations to suppliers, the Company should be able to generate positive operating cash flow which combined with available cash resources will be sufficient to met our planned working capital, capital expenditures and business expense requirements. However, there can be no assurance that we will not require additional capital. Even if such funds are not required, we may seek additional equity or debt financing. We cannot be assume that such financing will be available on acceptable terms, if at all, of that such financing will not be dilutive to our stockholders.
The Company has no off balance sheet transactions. The following table reflects our current contractual commitments as of December 31, 2002.
Rebates earned under arrangements with manufacturers are recorded as a reduction of direct expenses. The portion of such rebates due to plan sponsors is recorded as a reduction of revenue. Manufacturers rebates are based on estimates, which are subject to final settlement with the contracted party. Member co-payments are not recorded as revenue.
The Company estimates reserves for doubtful PBM accounts receivable as of each balance sheet date. The Company has historically had very limited exposure to bad debts due to the nature of the employee benefits involved, the necessity of maintaining benefit continuity for its customers employees, and the general financial strength of its customer base. With respect to supplemental benefits, substantially all revenues are collected in advance via credit card and as such generate no accounts receivable exposure.
In October 2001, the FASB issued SFAS No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets", which addresses financial accounting and reporting for the impairment or disposal of long-lived assets. SFAS No. 144 supersedes SFAS No. 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of"; however, it retains many of the fundamental provisions of that Statement. SFAS No. 144 also supersedes the accounting and reporting provisions of APB Opinion No. 30, "Reporting the Results of Operations--Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions", for the disposal of a segment of a business. However, it retains the requirement in APB No. 30 to report separately discontinued operations and extends that reporting to a component of an entity that either has been disposed of (by sale, abandonment, or in a distribution to owners) or is classified as held for sale. By broadening the presentation of discontinued operations to include more disposal transactions, the FASB has enhanced management's ability to provide information that helps financial statement users to assess the effects of a disposal transaction on the ongoing operations of an entity. SFAS No. 144 is effective for fiscal years beginning after December 15, 2001 and interim periods within those fiscal years. Early application is encouraged. The provisions of SFAS No. 144 generally are to be applied prospectively. The Company recognized an impairment loss on fixed assets of $2.6 million for the year ended December 31, 2002. See footnote financial statement disclosure for additional detail.
If we do not manage our growth effectively, we may not be able to maintain profitability - -----------------------------------------------------------------------------
We may not be successful in managing or expanding our operations or maintaining adequate management, financial and operating systems and controls.
Our recent acquisition of PNNC is important to achieving the scale and operating leverage necessary to compete in this segment. Should we fail to integrate these operations and realize the expected opportunities our prospects could be damaged.
Our pharmacy benefit management business relies on real-time management information systems - -----------------------------------------------------------------------------
A significant majority of all of our supplemental benefits program sales is attributable to two distribution relationships. The relationships with Aegon and American Express provide us with access to customer leads resulting in sales to individual consumers. If we lose one or more of these marketing relationships and are unable to replace them with other marketing outlets, our access to potential customers would decline and sales and revenue would suffer.
If the providers of the benefits included in the programs fail to provide those benefits, or the extent of those benefits is deemed to be greater than the providers are obligated to pay, we could become subject to liability claims by program members - -------------------------------------------------------------------------------
We arrange for the provision by others of the benefits included in the member programs. If the firms with which we have contracted to provide those benefits fail to provide them as required, or are negligent or otherwise culpable in providing them, or if it is determined that the level of benefits to which members are entitled exceeds the obligations of the providers, we could become involved in any resulting claim or litigation.
- levels of pharmacy claims expenditures, seasonal fluctuations in demand and enrollment levels;
- changes in acceptance levels for our supplemental benefits program by consumers;
We believe that quarter-to-quarter comparisons of our operating results are not necessarily meaningful and not good indicators of our future performance. Due to the above-mentioned and other factors, it is possible that in one or more future quarters our operating results will fall below the expectations of securities analysts and investors. If this happens, the trading price of our common stock would likely decrease.
One of the means by which distributors market the program is telemarketing, which the distributors may out source to third parties. Telemarketing has become subject to an increasing amount of Federal and state regulation as well as general public scrutiny in the past several years. For example such regulation limits the hours during which telemarketers may call consumers and prohibits the use of automated telephone dialing equipment to call certain telephone numbers. The Federal Telemarketing and Consumer Fraud and Abuse Prevention Act of 1994 and Federal Trade Commission ("FTC") regulations prohibit deceptive, unfair or abusive practices in telemarketing sales. Both the FTC and state attorneys general have authority to prevent certain telemarketing activities deemed by them to violate consumer protection. On January 29, 2003, the FTC published a final rule on telemarketing sales that, among other things, provides for a national "do-not-call" registry. While the registry will require additional federal funding to become effective, and additional time to be implemented, it is anticipated that as of October 2003 it
will be illegal for most telemarketers to call anyone who has elected to be listed on the registry. Implementation of the registry could have an adverse effect on the sale of the Company's programs. In addition, some states have enacted laws and others are considering enacting laws targeted directly at regulating telemarketing practices, and there can be no assurance that any such laws, if enacted, will not adversely affect or limit the Company's current or future operations. While compliance with these regulations is generally the responsibility of the distributors and subcontractors, there can be no assurance that the Company would have no exposure to liability.
We could be subject to legal liability based upon the information on our website - ----------------------------------------------------------------------------
Our members may rely upon the information published on our website regarding insurance coverage, exclusions, limitations and ratings, and the other benefits included in our programs. To the extent that the information we provide is not accurate, we could be liable for damages. These types of claims could be time-consuming and expensive to defend, divert management's attention, and could cause consumers to lose confidence in our service. As a result, these types of claims, whether or not successful, could harm our business.
Network Access Legislation. A majority of states now have some form of legislation affecting our ability to limit access to a pharmacy provider network or removal of a network provider. Such legislation may require us or our clients to admit any retail pharmacy willing to meet the plan's price and other terms for network participation ("any willing provider" legislation); or may provide that a provider may not be removed from a network except in compliance with certain procedures ("due process" legislation).
Anti-Remuneration Legislation. "Anti-kickback" statutes at the federal and state level prohibit an entity from paying or receiving any compensation to induce the referral of healthcare plan beneficiaries or the purchase of items or services for which payment may be made under such healthcare plans. Additionally, state and federal regulations have been the basis for investigations and multi-state settlements relating to financial incentives provided by pharmaceutical manufacturers to retail pharmacies in connection with pharmaceutical "switching" or "product conversion" programs. To our knowledge, these laws have not been applied to prohibit pharmacy benefit management companies from receiving amounts from pharmaceutical manufacturers in connection with pharmaceutical purchasing and formulary management programs, to prohibit therapeutic substitution programs conducted by independent pharmacy benefit management companies, or to prohibit contractual relationships such as we have regarding these types of programs.
ERISA Regulation. ERISA regulates certain aspects of employee pension and health benefit plans, including self-funded corporate health plans with which we have agreements to provide PBM services. We believe that the conduct of our business generally is not subject to the fiduciary obligations of ERISA. However, other PBMs, including Caremark and AdvancePCS, have disclosed publicly that they are defending private litigant lawsuits alleging that they are ERISA fiduciaries. There can be no assurance that the U.S. Department of Labor, which is the agency that enforces ERISA, or a private litigant would not assert that the fiduciary obligations imposed by the statute apply to certain aspects of our operations.
In addition to its fiduciary provisions, ERISA imposes civil and criminal liability on service providers to health plans and certain other persons if certain forms of illegal remuneration are made or received. These provisions of ERISA are similar, but not identical, to the health care anti-remuneration statutes discussed in the immediately preceding section; in particular, ERISA does not provide for any "safe harbor" exceptions. Like the health care anti-remuneration laws, the corresponding provisions of ERISA are written broadly and their application to particular cases is often uncertain. The Company has implemented policies, which include disclosure to health plan sponsors with respect to any commissions paid by or to us that might fall within the scope of such provisions, and accordingly believe we are in substantial compliance with these provisions of ERISA. However, we can provide no assurance that our policies in this regard would be found by the appropriate enforcement authorities and potential private litigants to meet the requirements of ERISA.
Patient Choice and Benefit Design. Some states have enacted legislation that prohibits the plan sponsor from implementing certain restrictive design features, and many states have introduced legislation to regulate various aspects of managed-care plans, including provisions relating to the pharmacy benefit. Legislation has been introduced in some states to prohibit or restrict therapeutic substitution, or to require coverage of all FDA approved drugs. Other states mandate coverage of certain benefits or conditions. Such legislation does not generally apply to us, but it may apply to certain of our customers, such as HMOs and health insurers. If such legislation were to become widespread and broad in scope, it could have the effect of limiting the economic benefits achievable through pharmacy benefit management and consequently make our services less attractive.
Legislation Affecting Drug Prices. Some states have adopted so-called "most favored nation" legislation providing that a pharmacy participating in the state Medicaid program must give the state the best price that the pharmacy makes available to any third-party plan. Such legislation may adversely affect our ability to negotiate discounts in the future from network pharmacies. In addition, various Federal and state medicate agencies, as well as legislators and private litigants have raised the issue of how average wholesale price ("AWP") is determined.
Licensure. Many states have licensure or registration laws governing certain types of ancillary healthcare organizations, including preferred provider organizations, third party administrators and utilization review organizations. Laws requiring registration and regulating the operations of PBMs meeting certain criteria have also begun to appear. These laws differ significantly from state to state, and the application of such laws to the activities of pharmacy benefit managers is often unclear. We have registered under such laws in those states in which we have concluded such registration is required.
If we experience failures of, or capacity constraints in, our systems or the systems of third parties on which we rely, sales of our programs likely would be reduced and our reputation could be damaged - ------------------------------------------------------------------------------
depends on the efficient and uninterrupted operation of our computer and communications hardware systems. Our service has experienced periodic system interruptions, and it is likely that these interruptions will continue to occur from time to time. Additionally, our systems and operations are vulnerable to damage or interruption from human error, natural disasters, power loss, telecommunication failures, break-ins, sabotage, computer viruses, acts of vandalism and similar events. We may not carry sufficient business interruption insurance to compensate for losses that could occur. Any system failure that causes an interruption in service or decreases the responsiveness of our service would impair our revenue-generating capabilities, and could damage our reputation and our brand name.