We lease twenty-two facilities throughout the United Sates and Puerto Rico. Our corporate headquarters office, containing 72,000 square feet, is located in Rockville, Maryland and accommodates our executive and corporate functions. We also have satellite offices in Arizona, California, Florida, Georgia, Hawaii, Iowa, Louisiana, Mississippi, Nevada, New Mexico, North Carolina, Ohio, Pennsylvania, Puerto Rico and Texas. We believe all of our facilities are well-maintained and in good operating condition and have adequate capacity to meet our current business needs.
Nineteen of our twenty-one satellite offices, with a total of 80,000 square feet, are under leases that expire over terms through 2013 and the other offices are under a month-to-month lease. We believe that suitable space on commercially reasonable terms will be available as required.
Member co-payments are not recorded as revenue or direct expenses. We incur no obligations for co-payments to pharmacies and have never made such payments. Under our pharmacy agreements, the pharmacy is solely obligated to collect the co-payments from the members.
The following table illustrates the effects on the reported PBM revenue and direct expenses if we had included the actual member co-payments as indicated by our claims processing system (in millions):
On November 3, 2006, we purchased all of the outstanding common stock of R/xx Pharmacy Solutions, Inc. (“R/xx”), an Arizona corporation, for $16.0 million in cash and $0.7 million in related transaction costs. As provided for in the acquisition agreement, additional cash consideration of $2.1 million was earned and paid based on successful achievement of certain client retention criteria during the period ended March 31, 2007. R/xx is a provider of pharmacy benefit management services with a strategic focus on clients in the Arizona, Nevada and Hawaii markets. We have also established a business development marketing relationship with an R/xx affiliate, Pharmacy Benefit Consultants, Inc. (“PBC”), and have agreed to purchase PBC if requested by its shareholder on terms determined by PBC’s success in generating new business in 2007. There was no new business generated by PBC through December 31, 2007.
Based on management’s best estimate, including our valuation report of the allocation of the purchase price to the net assets acquired, the acquisition of R/xx resulted in goodwill of $15.3 million and customer relationship intangibles of $5.8 million. The customer relationship intangibles are being amortized on a straight-line basis over a 12-year life.
On February 6, 2007, under the terms of the transaction, we acquired the remaining 20% minority ownership interest in the parent of EBRx through the acquisition of a separate entity and transferred the shares in the operating subsidiary to HCEM Corp., our wholly owned subsidiary. The transaction resulted in a cash payment of $30.3 million, of which $29.0 million was recorded as additional goodwill, prior to the repayment of related transaction debt and accrued interest. On May 16, 2007, the related transaction debt of $1.0 million plus accrued interest of $0.1 million was repaid.
The acquisition also provided for an additional contingent consideration payment of up to $3.0 million subject to performance based standards including certain specified client retention and gross profit criteria for the twelve months ended December 31, 2006. The contingent consideration earned and paid was approximately $2.9 million and recorded as additional goodwill.
In June 2004, we acquired 100% of the common stock of MHS. The purchase price of this acquisition included, among other things, warrants to purchase an aggregate of 300,000 shares of our common stock at a purchase price of $15.45 per share, subject to the provisions in the warrant, including performance-based standards. Based on achievement of various revenue and performance requirements, we issued 100,000 warrants in July 2005 and 100,000 warrants in July 2006. Each of these two warrant issuances were valued at $1.0 million and were recognized as additional goodwill as a component of the acquisition accounting. The remaining 100,000 warrants remained potentially issuable subject to future revenue and gross profit performance based requirements.
We have successfully integrated R/xx, EBRx and MHS into our financial, organizational, management and technology structure. As a result, we achieved cost savings from the consolidation of certain corporate activities and the elimination of certain duplicate components of our corporate operations.
the extent and timing of marketing campaigns funded by these companies and the success they achieve. Correspondingly, these companies are compensated with an increasing percentage of total program revenue, which is accounted for as direct expenses by us. All of the insurance and service features included in our programs are supplied by third-party insurance companies or other vendors, and the programs are distributed through an independent, licensed and non-affiliated insurance agency.
In December 2007, our marketing agreement with American Express Travel Related Services Company, Inc. (“Amex”) was terminated and, effective January 1, 2008, we transferred the Amex cardholder portion of our supplemental benefits business to Amex. Additionally, as we previously disclosed on November 5, 2007, we entered into an agreement in principle with Alliance HealthCard (“Alliance”). Under the proposed terms, Alliance would acquire a portion of our supplemental benefits business and HealthExtras would be the pharmacy benefit management provider for health care products offered to Alliance’s members. Financial terms of the agreement will be based on business volumes and the persistency of the supplemental benefits membership base.
Direct Expenses. Direct expenses for the year ended December 31, 2007 were $1.7 billion, consisting of approximately $1.7 billion in direct expenses from the PBM segment and $17.1 million in direct expenses from the supplemental benefits segment. PBM segment direct expenses increased over the comparable period in 2006 by $581.0 million, while the supplemental benefits segment direct expenses decreased by approximately $10.6 million. The PBM segment’s increase in direct expenses is primarily related to the $601.0 million increase in PBM revenue. Also included in the PBM segment’s direct expenses for 2007 are charges of approximately $1.9 million reflective of the resolution of a previously disclosed arbitration proceeding which stems from a prior acquisition, and related adjustments. The decrease in direct expenses in the supplemental benefits segment was largely a result of a decrease in membership and the negotiation of lower costs for certain of the benefits in our programs.
Direct expenses for year ended December 31, 2006 were $1.2 billion, consisting of approximately $1.1 billion million and $27.6 million attributable to the PBM and supplemental benefit segments, respectively. The direct expenses of $1.7 billion and $1.2 billion for the years ended December 31, 2007 and 2006 represented 97.0% and 96.2% of total operating expenses for the respective periods.
Gross margins, calculated as segment revenue less segment direct expense, in the PBM segment are generally predictable based on client contract terms and vendor/supplier contracts. Other factors that can result in changes in gross margins include generic substitution rates, changes in the utilization of preferred drugs with higher discounts and changes in the volume of prescription dispensing at lower cost network pharmacies. None of the foregoing factors have materially changed in 2007 in a manner that would meaningfully affect current results. In 2007, composite gross margin percentages were reduced by the addition of several new large contracts including Wellmark Blue Cross Blue Shield of Iowa and the State of Maryland, which are more competitively priced due to their size. These decreases were somewhat offset by gross margin improvements resulting from an increased level of generic substitution and higher network discount rates.
Selling, general and administrative expenses of $54.0 million for the year ended December 31, 2007, consisted of $27.7 million in compensation and benefits, which includes $4.9 million in non-cash compensation, $5.5 million in professional fees and technology services, $5.6 million in facility costs, $2.7 million in travel expenses, $2.3 in insurance and other corporate expenses, $0.3 million in product endorsement and marketing, $3.7 million in other, which includes $1.7 million in recruitment and temporary help, and $6.2 million in depreciation and amortization. Included in the $27.7 million of compensation and benefits is approximately $0.9 million of costs related to changes in employment relationships previously disclosed.
Net Income. Net income for year ended December 31, 2007 increased by approximately $7.7 million over the same period in 2006 to $39.3 million. The increase in net income was primarily a function of increased gross margin dollars in the PBM segment and an increase in interest income, reduced by an increase in selling, general and administrative expenses. PBM segment gross margins increased to $100.0 million in 2007 from $79.9 million in 2006, largely attributable to new clients. Segment operating information for 2007 and 2006 is as follows (in millions):
Gross margins, calculated as segment revenue less segment direct expense, in the PBM segment are generally predictable based on client contract terms and vendor/supplier contracts. Other factors that can result in changes in gross margins include generic substitution rates, changes in the utilization of preferred drugs with higher discounts
Selling, general and administrative expenses of $46.4 million for the year ended December 31, 2006, included $25.1 million in compensation and benefits, which includes $3.6 million in non-cash compensation, $4.1 million in professional fees and technology services, $4.2 million in facility costs, $2.2 million in travel expenses, $2.0 in insurance and other corporate expenses, $0.3 million in product endorsement and marketing, $3.7 million in other, which includes $2.2 million in recruitment and temporary help, and $4.8 million in depreciation and amortization.
Interest Expense. Interest expense decreased to $0.8 million in the year ended December 31, 2006 from $1.1 million in the year ended December 31, 2005. This decrease reflects a decrease in the average outstanding amount of debt during the current year. In particular, in April 2005, we repaid $8.0 million outstanding on our line of credit and have not borrowed against it since, and in September 2006 we fully repaid the balance outstanding on our term loan facility.
As of December 31, 2007, we had $43.6 million in marketable securities consisting of Auction Rate Securities (“ARSs”). Subsequent to year end, all of these ARSs were reset at their par values, which was consistent with their values recorded at December 31, 2007. As of February 20, 2008, we had liquidated all but $14.4 million of our ARSs. The remaining ARSs continue to carry AAA/Aaa credit ratings and are either federally guaranteed or required to maintain a minimum collateralization of 200% in accordance with the Investment Company Act of 1940. Due to current credit market conditions, the Company recently was unable to liquidate $3.25 million in ARSs, of which $1.8 million are federally guaranteed. We believe that based on the Company’s cash, cash equivalents and marketable securities balances of $124.6 million at December 31, 2007 and our expected continued increase in operating cash flows, the current lack of liquidity in the ARS market will not have a material impact on the Company’s liquidity, financial condition, results of operations or cash flows.
treasury stock, received proceeds of $7.1 million from the exercise of options and $0.5 million in proceeds from issuance of common stock pursuant to the Employee Stock Purchase Plan. In addition, we received an income tax payable benefit of $9.1 million from the exercise of stock options and restricted stock vesting. In 2006, we repaid $12.5 million in notes payable and received proceeds of $8.8 million from the exercise of options and Employee Stock Purchase Plan purchases. In addition, we received an income tax payable benefit of $10.5 million from the exercise of stock options and restricted stock awards and incurred $1.1 million from all other financing activities.
We recognize revenues from PBM services, which include sales of prescription drugs by pharmacies in our nationwide network and related claims processing fees, provided to our clients. Revenue is recognized when the claims are adjudicated. Pharmacy claims are adjudicated at the point-of-sale using an on-line claims processing system. When we have a contractual obligation to pay a network pharmacy provider for benefits provided to our clients’ members, total payments from these clients are recorded as revenue and payments to the network pharmacy provider and the claim adjudication service costs are recorded as direct expenses. Generally, these contracts require us to assume the credit risk of our clients’ abilities to pay. In addition, under the vast majority of our client contracts, we are at risk for the difference between the payments we receive from our clients and the negotiated reimbursements we pay to the pharmacies. When we administer pharmacy reimbursement contracts and do not assume credit risk, we record only the net revenue and the administrative or processing fees. Rebates earned under arrangements with manufacturers are recorded as a reduction to direct expenses. The portion of such rebates due to our clients is recorded as a reduction of revenue. Manufacturers’ rebates are based on estimates, which are subject to final settlement with the contracted party.
The primary determinant of revenue recognition for the supplemental benefits segment is monthly program enrollment. In general, program revenue is recognized based on the number of members enrolled in each reporting period multiplied by the applicable monthly fee for their specific membership program. The program revenue we recognize includes the cost of membership features supplied by others, including the insurance components. Direct program expenses consist of the costs that are a direct function of a period of membership and a specific set of program features. The coverage obligations of our benefit suppliers and the related expense are determined monthly, as are the remaining direct expenses.
Trade accounts receivable are recorded at the invoiced amount and do not bear interest. The allowance for accounts receivable is our best estimate of the amount of probable credit losses in our existing accounts receivable. We determine the allowance based on historical write-off experience by industry and regional economic data. We review our allowance for accounts receivable monthly. All past due balances over 120 days are fully reserved. All other balances are reviewed on a pooled basis by type of receivable. Account balances are charged off against the allowance when we feel it is probable the receivable will not be recovered. We do not have any off-balance-sheet credit exposure related to our customers.
capitalization at the date of valuation. For the purposes of performing this impairment test, our business segments are our reporting units. If the carrying amount exceeds the fair value, the second step of the goodwill impairment test is performed to measure the amount of the impairment loss, if any. In the second step the implied fair value of the goodwill is estimated as the fair value of the reporting unit used in the first step less the fair values of all other net tangible and intangible assets of the reporting unit. If the carrying amount of the goodwill exceeds its implied fair market value, an impairment loss is recognized in an amount equal to that excess, not to exceed the carrying amount of the goodwill. In addition, goodwill of a reporting unit is tested for impairment between annual tests if an event occurs or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying value.