In June 2004, we entered into a ten-year lease in a new office building located in Rockville, Maryland for approximately 37,000 square feet of office space and moved our headquarters to the new location in the third quarter of 2004. Annual basic rent for the first year is approximately $1.0 million. The lease provides for annual escalations. We have clinical and sales offices in Florida, Georgia, Louisiana, Minnesota, Nevada, North Carolina, and Texas.
This Form 10-K may contain forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934, as amended. These forward-looking statements involve a number of risks and uncertainties. We undertake no obligation to revise any forward-looking statements in order to reflect events or circumstances that may arise after the date of this report. Readers are urged to carefully review and consider the various disclosures made in this report and in our other filings with the Securities and Exchange Commission that attempt to advise interested parties of the risks and factors that may affect our business.
Member co-payments are not recorded as revenue. The Company incurs no obligations for co-payments to pharmacies and has never made such payments. Under our pharmacy agreements, the pharmacy is solely obligated to collect the co-payments from the members.
Under our client contracts, we do not assume liability for member co-payments in pharmacy transactions. As such, we do not include member co-payments to pharmacies in revenue or operating expenses.
To provide additional information to investors, we have disclosed the specific amounts of member payments excluded from both revenue and operating expenses. If the Company had included co-payments in its reported revenue and operating expenses, it would have resulted in an increase in reported PBM revenue and operating expenses for years ended 2004, 2003 and 2002 of $213.0 million, $141.0 million and $71.6 million, respectively. Our operating and net income, consolidated balance sheets and statements of cash flows would not be affected.
The following tables illustrate the effects on the reported PBM revenue and operating expenses if Catalyst Rx had included the actual member co-payments as indicated by our claims processing system (in thousands):
On June 18, 2004, we acquired 100% of the common stock of MHS for a cash payment of $37.3 million and 100,739 shares of our common stock valued at $1.5 million. In addition, we agreed to issue $4.0 million principal amount of non-negotiable promissory notes, warrants to purchase up to 300,000 shares of our common stock at an exercise price of $15.45 per share, and to pay $2.0 million in cash, all subject to performance-based standards and certain revenue and gross profit criteria attributable to MHS. The acquisition of MHS was accounted for using the purchase method of accounting, and we have recorded goodwill of approximately $30.4 million and intangible assets of $8.4 million.
During the first quarter of 2002, we purchased the remaining 20% minority interest in Catalyst for $5.3 million, consisting of 319,033 shares of our common stock valued at $1.1 million and notes in the principal amount of $4.2 million. This minority interest purchase resulted in additional goodwill of $3.2 million and intangible assets of $1.7 million. The stock was transferred to the seller on April 1, 2002, $3.1 million in cash was paid in 2002, and the final cash installment of $1.1 million was paid on March 1, 2003.
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 recognized by the Company includes the cost of membership features supplied by others, including the insurance components. Revenue from program payments received, and related direct expenses, is deferred to the extent that they are applicable to future periods or to any refund guarantee we offer.
Year Ended December 31, 2004 Compared to Year Ended December 31, 2003
Direct Expenses. Direct expenses for year ended December 31, 2004 were $460.8 million, consisting of $427.0 million in direct expenses from the PBM segment and $33.8 million in direct expenses from the supplemental benefits segment. PBM segment direct expenses increased by $124.8 million, while the supplemental benefits segment direct expenses decreased by approximately $5.2 million. The PBM segment’s $124.8 million increase in direct expenses are a direct function of the $143.7 million increase in PBM revenue. The net $119.6 million increase is consistent with our anticipated gross margin contribution from increased prescription volume, the acquisition of MHS and
increased unit prices, offset by increased member co-payments. The decrease in direct expenses in the supplemental benefits segment was largely a result of a modest decrease in membership and the negotiation of lower costs for certain of the benefits in our programs.
Direct expenses for year ended December 31, 2003 were $341.2 million, consisting of approximately $302.2 million and $39.0 million attributable to the PBM and supplemental benefit segments, respectively. The direct expenses of $460.8 million and $341.2 million for years ended December 31, 2004 and 2003 represented 92.8% and 93.0% of operating expenses for the respective periods.
Selling, general and administrative expenses for year ended December 31, 2003 were approximately $25.9 million or 7.0% of total operating expenses, $15.6 million of which related to the PBM segment, $4.9 million related to the supplemental benefits segment, while the remaining $5.4 million related to corporate overhead. These expenses included approximately $10.7 million in compensation and benefits, $4.8 million in commissions, other professional fees, and insurance, $3.2 million in other expenses, $2.4 million in depreciation and amortization, $1.8 million for creative development, product endorsement and market research, $1.8 million in facility costs, and $1.2 million in travel expenses.
Other Income. In the second quarter of 2004, we reached a legal settlement related to litigation initiated by us on December 3, 2002. The terms of the settlement are confidential; however, the net proceeds from the settlement constitute the significant portion of the $2.1 million in other income reported in the 2004 statement of operations.
Operating expenses of the segments exclude $6.2 million and $5.4 million in corporate overhead that was not allocated by management in assessing segment performance for the years ended December 31, 2004 and 2003, respectively.
Revenue decreases in the supplemental benefits segment were a function of contractual changes in the economic terms of our marketing arrangements. While net membership levels were largely unchanged from 2002 to 2003, our marketers began to incur the direct marketing costs for new members added during the year and we recognized lower revenue levels accordingly. The reduction in revenue of approximately $13.5 million in the supplemental benefits segment in 2003 was more than offset by the $15.4 million decrease in the segment’s combined marketing and creative development expenses recorded in selling, general and administrative expenses. The decrease in combined marketing and creative development expenses was primarily attributable to the restructured distribution arrangements under which the distributor became responsible for marketing expenses.
increase of $50.1 million was attributable to $55.5 million of revenue from prescription volume increases and $2.2 million to increased unit prices, offset by a $7.6 million reduction in revenue due to increased member co-payments. Supplemental benefits revenue decreased by $13.5 million. Revenue for the year ended December 31, 2002 was $248.4 million, consisting of approximately $182.3 million and $66.1 million attributable to the PBM and supplemental benefits segments, respectively.
Selling, general and administrative expenses for the year ended December 31, 2003 totaled $25.9 million or 7.0% of operating expenses, $15.6 million of which was related to the PBM segment, $4.9 million was related to the supplemental benefits segment, while the remaining $5.4 million was related to corporate overhead. These expenses include $10.7 million in compensation and benefits, $4.8 million in commissions, other professional services and insurance, $3.2 million in other expenses, $2.4 million in depreciation and amortization, $1.8 million for creative development, product endorsement and market research, $1.8 million in facility costs, and $1.2 million in travel expenses. We had no supplemental benefits direct marketing expense in 2003, as direct marketing expenses were paid by the distributor.
Selling, general and administrative expenses for the year ended December 31, 2002, were approximately $35.5 million or 14.5% of total operating expenses, $5.9 million of which related to the PBM segment, $23.1 million related to the supplemental benefits segment, while the remaining $6.5 million related to corporate overhead. These expenses included $4.1 million for creative development, product endorsements and market research, $12.6 million in direct marketing, $8.2 million in compensation and benefits, $1.6 million in commissions, professional fees and other insurance, $2.4 million in other expenses, $1.4 in facility costs, $826,000 in travel expenses, $1.7 million in depreciation and amortization, and $2.7 million related to the impairment of and write-off of property and equipment.
Income Tax (Benefit) Expense. Through the third quarter of 2002, we maintained a full valuation allowance against our deferred tax assets due to the uncertainly as to their ultimate realization. Due to the recording of the full valuation allowance, no provision for income taxes was recorded in the first nine months of 2002. In the fourth quarter of 2002, as a result of our 2002 and projected profitability, we recognized a $10.2 million tax credit principally resulting from releasing the valuation allowance against our deferred tax assets. In 2003, our effective tax rate was 37.7% and the provision for income taxes was $6.3 million.
Net Income. Net income in 2003 decreased by $3.1 million from 2002 despite a $13.6 million improvement in operating income. The decrease was attributable in large part to the recognition of a $10.2 million tax benefit in 2002 versus a $6.3 million tax expense in 2003. The increase in operating income was primarily a function of increased gross margins in the PBM segment. PBM segment gross margins increased from $14.2 million in 2002 to $29.3 million in 2003, an increase largely attributable to a comparable percentage increase in revenues.
Net income for the year ended December 31, 2003, was $10.3 million compared to $13.5 million in 2002. The $13.5 million net income in 2002 included a tax benefit of $10.2 million, while the $10.3 net income for 2003 included a $6.3 million provision for income taxes, as discussed above. As a percentage of revenue, pre-tax income increased from 1.3% to 4.3%.
Net Cash Used in Investing Activities. Net cash used in investing activities for year ended December 31, 2004 was $46.3 million compared to $4.8 million in 2003. This increase reflects the $37.7 million we paid to acquire MHS and $9.7 million in capital expenditures, largely associated with our new headquarters office space.
The Company has no off-balance-sheet transactions. The following table reflects our current contractual commitments as of December 31, 2004 (in thousands):
Using the December 31, 2004 effective interest rates and outstanding balances, and factoring the required future payments on the term loan, the Company estimates its interest payments on its notes payable to be $1.1 million, $866,000, $626,000 and $215,000 for 2005, 2006, 2007 and 2008, respectively.
Prior to October 2002, payments from distributors related to new member enrollments were recorded as revenue to the extent of related direct expenses, which cumulatively exceeded payments from distributors.
We have historically maintained a prepaid balance for the cost of insurance benefits included in its programs. The carrying value of the prepayment was adjusted at the end of each quarter based on factors including enrollment levels in each product, enrollment trends, and the remaining portion of the unexpired prepayment period.
Rebates earned under arrangements with manufacturers are recorded as a reduction of direct expenses. The portion of such rebates due to clients is recorded as a reduction of revenue. Manufacturer rebates are based on estimates, which are subject to final settlement with the contracted party on an annual basis. Resulting adjustments historically have not been significant.
The estimated fair value and the weighted average useful-life of the intangible assets are based on income-method valuation calculations, performed by an independent consulting firm. The remaining useful life of intangible assets is evaluated periodically and adjusted as necessary to match the period that the assets are expected to provide economic benefits. We concluded that no impairment of intangible assets existed at December 31, 2004 and 2003.
The PBM industry is very competitive. If we do not compete effectively, our business, results of operations and financial condition could suffer. The industry is highly consolidated and dominated by a few large companies with significant resources, purchasing power and other competitive advantages, which we do not have. A limited number of firms, including national PBM companies such as Medco, “Medco,” Express Scripts, Inc., “Express Scripts” and Caremark Rx, Inc., “Caremark,” have an aggregate market share of approximately 70% of prescription volume. Our competitors also include drug retailers, physician practice management companies, and insurance companies/health maintenance organizations. We may also experience competition from other sources in the future. PBM companies compete primarily on the basis of price, service, reporting capabilities and clinical services. In most cases, our competitors are large, profitable and well-established companies with substantially greater financial and marketing resources than our resources.
Our PBM operations are dependent to a significant extent on our ability to obtain discounts on prescription purchases from retail pharmacies that can be utilized by our clients and their members. Our contracts with retail pharmacies, which are non-exclusive, are generally terminable by either party on short notice. If one or more of our top pharmacy chains elects to terminate its relationship with us or if we are only able to continue our relationship on terms less favorable to us, access to retail pharmacies by our clients and their health plan members, and our business, results of operations and financial condition could suffer. In addition, some large retail pharmacy chains either own or have strategic alliances with PBMs or could attempt to acquire or enter into these kinds of relationships in the future. Ownership of, or alliances with, PBMs by retail pharmacy chains, particularly large pharmacy chains which together control 45% of retail pharmacy business, could have material adverse effects on our relationships with those retail pharmacy chains, particularly the discounts they are willing to make available, and on our business, results of operations and financial condition.
legal restrictions are imposed on the ability of pharmaceutical manufacturers to offer rebates or purchase our programs or services; or
pharmaceutical manufacturers choose not to offer rebates or purchase our programs or services.
we could fail to successfully integrate the operations, services and products of an acquired company;
there could be inconsistencies in standards, controls, procedures and policies among the companies being combined or assimilated which would make it more difficult to implement and harmonize company-wide financial, accounting, billing, information technology and other systems;
our management’s attention could be diverted from other business concerns; and
If we become subject to liability claims that are not covered by our insurance policies, we may be liable for damages and other expenses that could have a material adverse effect on our business, results of operations and financial condition.
Disruption of our point of sale information system and transaction processing system, which relies on third parties, could have a material adverse effect on our business, results of operations and financial condition.
Network Access Legislation. A majority of states now have some form of legislation, referred to as “any willing provider” legislation, which affects our ability to limit access to a pharmacy provider network or remove a network provider. Such legislation may require us or our clients to admit any retail pharmacy willing to meet a health plan’s price and other terms for network participation or may restrict or prevent removal of a provider from a network except in compliance with certain procedures, referred to as “due process” legislation.
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 laws discussed above. We have implemented policies regarding, among other things, disclosure to health plan sponsors, with respect to any commissions paid by or to us that might fall within the scope of those 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.
Plan or Benefit Design Regulations. Some states have enacted legislation that prohibits a health care 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 PBMs. 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. This type of legislation does not generally apply to us, but it may apply to certain of our clients, such as HMOs and health insurers. If this type of legislation were to become widespread and broad in scope, it could have the effect of limiting the economic benefits achievable through PBMs 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 lowest price that the pharmacy makes available to any third-party plan. This type of legislation may adversely affect our ability to negotiate discounts in the future from network pharmacies. In addition, under the MMA, effective January 1, 2005, AWP will no longer serve as the basis for Medicare Part B drug reimbursement, except for certain enumerated products. Part B drugs will be reimbursed based on average sales price, “ASP.” Drugs that will be reimbursed under an ASP reimbursement system by Medicare do not represent a significant portion of our business and we therefore do not expect ASP reimbursement for such drugs to have a material effect on our business.
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 these laws to the activities of PBMs is often unclear. We have registered under these laws in those states in which we have concluded that registration is required.
Confidential Information. Most of our activities involve the receipt or use by us of confidential medical information concerning individual members, including the transfer of the confidential information to the member’s health benefit plan. In addition, we use aggregated population data for research and analysis purposes. The Health Insurance Portability and Accountability Act, “HIPAA,” requires our PBM clients to enter into business associate agreements with us that require us to assure confidential treatment of health care information, to only use or disclose that information as needed to provide our services, to use certain standard codes and data sets in processing claims and to safeguard and protect confidential information. We currently believe that compliance with the HIPAA regulations should not have a material adverse effect on our business operations.
PDPs will be risk-bearing entities, paid on a capitated basis, which may impact profitability.
The implicit role PBMs will play in the outpatient prescription drug benefit program will increase governmental scrutiny on the industry.
If we are chosen as a PDP or fallback plan, this will be the first time we are a direct contractor to the federal government and subject to the rules, regulations and enforcement authority of the federal government over its contractors.
Over 50 million consumers have registered on the “Do-Not-Call Registry” established by the Federal Trade Commission “FTC”, which became effective on October 1, 2003. This Registry limits the ability to telemarket our supplemental benefit programs. Although we do not believe the Registry has had a material adverse effect on sales of our supplemental benefit programs to date, it could have such an effect in the future.
The passing of Christopher Reeve, a key promoter of our supplemental benefit programs, could significantly impair our brand recognition and, thus, our ability to sell our programs.
The management and staff at HealthExtras were deeply saddened by the loss of Christopher Reeve in October 2004. Our relationship with him has allowed us to share in his optimism, energy and convictions over the past eight years. Mr. Reeve was an integral part of the development and marketing of the programs offered in our supplemental benefits segment. We believe that the benefits of these programs can still be communicated effectively in the market with a less direct personal association. Should the marketing affiliations be discontinued, or should our alternative marketing efforts produce disappointing results, our revenues and earnings could be adversely affected.
A significant majority of all of our supplemental benefit program sales is attributable to our marketing relationships with Stonebridge Life Insurance Company, the successor to JC Penney Life Insurance Company, a member of the AEGON Group of Companies, “Stonebridge,” American Express Travel Related Services Company, Inc., “Amex” and Citibank N.A. If we lose one or more of these relationships and are unable to replace them with other marketing outlets, our access to potential customers would decline and our business, results of operations and financial condition could suffer.
We are dependent on third party providers for the benefits included in our supplemental benefit programs. Those benefits are provided pursuant to arrangements with The Chubb Group of Insurance Companies, National Union Fire Insurance Company of Pittsburgh, a subsidiary of American International Group Inc., Unum Life Insurance Company of America, and others, which may be terminated on relatively short notice. If we were to lose these relationships and were unable to replace them quickly and cost effectively, we would not be able to satisfy consumer demand for our programs.
If we fail to comply with all of the various and complex laws and regulations governing our products and marketing, we could be subject to fines or additional licensing requirements or lose the ability to market in particular jurisdictions.
Complex laws, rules and regulations of each of the 50 states and the District of Columbia pertaining to insurance impose strict and substantial requirements on insurance coverage sold to consumers and businesses. Compliance with these laws, rules and regulations can be arduous and imposes significant costs. The underwriters of the insurance benefits included in our programs are responsible for obtaining and maintaining regulatory approvals for those benefits. If the appropriate regulatory approvals for those insurance benefits are not maintained, we would have to stop including them. An independent licensed insurance agency is responsible for solicitations regarding the insurance benefits involved in our programs.