In June 2004, we entered into a ten-year lease for approximately 37,000 square feet of office space in a new office building located in Rockville, Maryland and moved our headquarters to the new location in the third quarter
of 2004. In June 2006, this lease was amended to add an additional 7,000 square feet of office space in the same building which we occupied in February 2007. We also have satellite offices in Florida, Georgia, Iowa, Louisiana, Mississippi, Nevada, New Mexico, North Carolina and Texas.
The following selected financial data has been derived from the audited financial statements of the Company. The selected financial data should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the audited consolidated financial statements, including notes thereto.
This Form 10-K may contain forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934. These forward-looking statements involve a number of risks and uncertainties including, without limitation, those identified under Item 1A. “Risk Factors” and elsewhere in this Form 10-K. 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 SEC that attempt to advise interested parties of the risks and factors that may affect our business.
HealthExtras provides pharmacy benefit management services, referred to as PBM, and supplemental benefit programs. Our PBM segment, which operates primarily under the brand name Catalyst Rx, accounted for approximately 97%, 94% and 91% of our revenue in the years ended 2006, 2005 and 2004, respectively, and is expected to be the primary source of our growth and profits in the future. Our PBM clients include more than 1,000 self-insured employers, including state and local governments, managed care organizations, third-party administrators, referred to as TPAs, and unions, who contract with us to administer the prescription drug component of their overall health benefit programs. Our PBM segment revenue increased by 89% to $1.2 billion in 2006 from $650.9 million in 2005. During 2006, we initiated services with several large new PBM clients. As a result, total claims processed increased to 29.3 million in 2006 from 17.1 million in 2005. In particular, beginning July 1, 2006, we commenced providing PBM services to over 1.0 million members of Wellmark Blue Cross Blue Shield of Iowa. For the year ended December 31, 2006, this new client was responsible for 5.1 million claims and accounted for 13.9% of our PBM revenue and 13.5% of our total revenue for the year.
Pharmacy benefit claim payments from our clients are recorded as revenue, and prescription costs to be paid to pharmacies are recorded as direct expenses. Under our network contracts, we generally have an independent obligation to pay pharmacies for the drugs dispensed and, accordingly, have assumed that risk independent of our
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 thousands):
On November 3, 2006, we purchased all of the outstanding common stock of R/xx Pharmacy Solutions, Inc. referred to as “R/xx”, an Arizona corporation, for $16.0 million in cash and $0.7 million in related transaction costs. The acquisition provides for an additional cash consideration payment of $2.0 million subject to certain client retention criteria. 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 affiliate, Pharmacy Benefit Consultants, Inc., referred to as “PBC”, and have agreed to purchase PBC if requested by its shareholder on terms determined by PBC’s success in generating new business. The acquisition of R/xx resulted in goodwill of $13.4 million and intangible assets of $5.6 million. The allocation of the purchase price to the net assets acquired is preliminary and may be adjusted upon completion of a valuation study which is currently in progress. Consequently, the allocation of purchase price to intangible assets is subject to adjustment. Additionally, the cost of the acquisition may be increased depending on the resolution of the contingent consideration
On December 16, 2005, we acquired the common stock of EBRx, Inc. The acquisition was structured as a merger between a wholly-owned subsidiary of the Company, HCEM Corp., and the parent company of EBRx, with the former parent as the surviving entity following the merger. Consideration consisted of a cash payment of $27.9 million and $0.8 million in related transaction costs. HCEM was funded by us with a $4.0 million equity investment and the remaining consideration was provided in the form of subsidiary debt. As contemplated by the original structure and terms of the transaction, a separate entity owned by former owners of EBRx and its management team, purchased a 20% ownership interest in the parent of EBRx through a $1.0 million equity investment, on January 3, 2006. This equity investment was made in the form of a note receivable and is recorded in the current other assets category in our consolidated balance sheet. The note receivable was collateralized by certificates of deposit having an aggregate principal amount of $1.0 million. The note bore interest of 4.38% per annum and had an indefinite due date. In addition, the terms of the transaction provided that we may purchase the remaining 20% minority ownership
Based on a valuation report of the allocation of the purchase price to the net assets acquired, the acquisition of EBRx resulted in goodwill of $27.3 million, inclusive of the $2.4 million contingent consideration payment, and customer relationship intangibles of $7.4 million and non-competition agreements of $0.2 million. The customer relationship intangibles are being amortized on a straight-line basis over an 11-year life and the non-competition agreements are being amortized on a straight-line basis over a 3-year life.
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.
Direct Expenses. Direct expenses for the year ended December 31, 2006 were $1.2 billion, consisting of $1.1 billion in direct expenses from the PBM segment and $27.6 million in direct expenses from the supplemental benefits segment. PBM segment direct expenses increased by $555.0 million, while the supplemental benefits segment direct expenses decreased by approximately $5.3 million. The PBM segment’s increase in direct expenses is related to the $578.2 million increase in PBM revenue. 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, 2005 were $627.2 million, consisting of approximately $594.3 million and $32.9 million attributable to the PBM and supplemental benefit segments, respectively. The direct expenses of $1.2 billion and $627.2 million for the years ended December 31, 2006 and 2005 represented 96.2% and 95.1% of operating expenses for the respective periods.
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.
Net Income. Net income for year ended December 31, 2006 increased by approximately $8.6 million over the same period in 2005 to $31.6 million. The increase in net income was primarily a function of increased gross margins 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 $79.9 million in 2006 from $56.7 million in 2005, largely attributable to the onset of new clients. Segment operating information for 2006 and 2005 is as follows (in thousands):
of MHS operations, and less than a month of EBRx operations; $8.7 million from an increase in the proportionate amount of prescription costs paid by the plan sponsor; and $1.9 million of all other revenue increases. Total claims processed increased to approximately 17.1 million in 2005 from approximately 12.8 million in 2004. A significant contributor to the increase in revenue and prescription volume was a contract with the State of Louisiana, currently covering about 145,000 members, which commenced on July 1, 2004. This contract generated 20.0% and 11.8% of our total revenue and 21.3% and 13.0% of our PBM revenue, in 2005 and 2004, respectively. Supplemental benefits revenue decreased by $2.5 million, due to decreased membership. Revenue for the year ended December 31, 2004 was $521.3 million, consisting of approximately $475.2 million and $46.1 million attributable to the PBM and supplemental benefits segments, respectively.
Direct Expenses. Direct expenses for year ended December 31, 2005 were $627.2 million, consisting of $594.3 million in direct expenses from the PBM segment and $32.9 million in direct expenses from the supplemental benefits segment. PBM segment direct expenses increased by $158.0 million, while the supplemental benefits segment direct expenses decreased by approximately $2.7 million. The PBM segment’s increase in direct expenses is related to the $175.7 million increase in PBM revenue. 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.
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. In 2005, gross margins were improved by an increased level of generic substitution and an increased volume of higher margin workers compensation business resulting from the acquisition of the MHS business. These increases were largely offset in percentage terms by the addition of the State of Louisiana contract that has lower percentage margin contributions than our historical averages.
Selling, general and administrative expenses for the year ended December 31, 2004, of $24.4 million consisted of $9.4 million in compensation and benefits, $2.6 million in professional fees and technology service costs, $2.6 million in facility costs, $2.0 million in travel expenses, $1.7 million in insurance and other corporate expenses, $0.7 million for product endorsement and market research, $2.4 million in other expenses, which includes $0.6 million in recruitment and temporary help,, and $3.0 million in depreciation and amortization.
Interest Expense. Interest expense of $1.1 million for the year ended December 31, 2005 was consistent with the prior year expense. During 2004, we maintained higher average outstanding debt levels, particularly after the MHS acquisition in June, compared to 2005, but the 2004 interest rates were also lower on average than 2005, resulting in similar interest expense during both years. At the time of the MHS acquisition in June 2004 we entered into a $20.0 million term loan and increased our line of credit. In the fourth quarter of 2004 we raised capital through the sale of common stock and repaid the line of credit. The line of credit expired in June 2006. During 2005, we continued to service the term loan.
Our sources of funds are usually cash flows from operations. We have in the past raised funds by borrowing on bank debt and selling equity in the capital markets to fund acquisitions. During the last several years we generated positive cash flow from operations and anticipate similar results in 2007 and the foreseeable near-term future. Cash and cash equivalents and marketable securities at December 31, 2006 were $91.7 million. At December 31, 2006, we had available a $50.0 million revolving credit facility with no outstanding borrowings.
Net Cash Provided by Operating Activities. Our operating activities generated $52.4 million of cash from operations in 2006, a $24.1 million increase from the $28.3 million generated in 2005. This $52.4 million in cash provided by operating activities in 2006 reflects $31.6 million in net income, plus $11.4 million in non-cash charges and a net $9.4 million decrease in working capital and other assets and liabilities. The cash provided by operating activities of $28.3 million in 2005 reflects net income of $23.0 million, plus $5.7 million in non-cash charges, reduced by a $0.4 million increase in working capital and other assets and liabilities.
which $15.9 million was used to acquire R/xx. Cash used for investing activities in 2005 primarily consisted of $27.7 million in purchases of marketable securities net of maturities and $33.2 million paid for business acquisitions.
The Company has no off-balance-sheet transactions. The following table reflects our current contractual commitments as of December 31, 2006 (in thousands):
payments in pharmacy transactions. As such, we do not include member co-payments to pharmacies in revenue or direct expenses.
In our acquisitions, we are required to make judgments regarding the fair values of the assets acquired and the liabilities assumed. For significant acquisitions, management has engaged independent consultants to assist it in estimating the fair values of acquired intangible assets.
The estimated fair value and the weighted average useful-life of the intangible assets are based on income-method valuation calculations. 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, 2006 and 2005.
We account for contingent consideration according to EITF 95-8, Accounting for Contingent Consideration Paid to the Shareholders of an Acquired Enterprise in a Purchase Business Combination, to determine whether contingent consideration should be accounted for as an adjustment to the purchase accounting.
In July 2006, the FASB issued Interpretation No. 48, Accounting for Uncertain Tax Positions (“FIN 48”). This interpretation clarifies the accounting for uncertain tax positions in accordance with FASB Statement No. 109, Accounting for Income Taxes. The interpretation addresses the recognition and measurement of uncertain income tax positions using a “more-likely-than-not” threshold and introduces a number of new qualitative and quantitative disclosure requirements. The interpretation is effective for fiscal years beginning after December 15, 2006. We will be required to adopt this interpretation as of January 1, 2007. The cumulative affect of adopting FIN 48 will be recorded in retained earnings. We are evaluating the requirements of FIN 48 and expect adoption will not have a material impact on our financial condition, results of operations or cash flows.
In September 2006, the FASB issued SFAS No. 157, Fair Value Measurements (“SFAS 157”), which addresses how companies should measure fair value when they are required to use a fair value measure for recognition or disclosure purposes under generally accepted accounting principles. SFAS 157 applies to financial statements that are issued for fiscal years beginning after November 15, 2007 and to interim periods within those fiscal years. We are currently evaluating the impact SFAS 157 may have on our financial condition, results of operations or cash flows.
We are subject to interest rate risk on our short-term investments. We have determined that a 10% move in the current weighted average interest rate of our marketable securities would not have a material effect in our financial position, results of operations or cash flows.