In addition, we have early termination rights which we may exercise by delivery of a notice to the Affiliate 60 days prior to the end of the April 30, 2009 lease year. In consideration of such early termination rights, we would pay to the Affiliate the rent that would otherwise be payable by us to the Affiliate for the succeeding 30 months, and subject to adjustments if the Affiliate is able to lease the Leased Premises to another party during said 30 month period.
We provide comprehensive PBM services to plan clients, which include managed care organizations, local governments, unions, corporations and third party health care plan administrators through our network of licensed pharmacies throughout the United States. Our PBM services include electronic point-of-sale pharmacy claims management, retail pharmacy network management, mail service pharmacy claims management, specialty pharmacy claims management, benefit design consultation, preferred drug management programs, drug review and analysis, consulting services, disease information services, data access, reporting and information analysis, and physician profiling. We also provide a mail service pharmacy and a specialty pharmacy program for our clients and individual patients.
The rebates that we receive from pharmaceutical manufacturers are recognized when we are entitled to them in accordance with the terms of our arrangements with pharmaceutical manufacturers, third party rebate administrators, and our clients, and when the amount of the rebate is determinable. Our revenue is reduced by the amount of rebates remitted to our clients. We compute the estimated amount of rebates due direct from the drug manufacturers based on the actual claims data and the criteria established in each individual contract. The drug manufacturers are obligated to reimburse us for earned rebates within a specified period of time. We reconcile our estimates to amounts received from the manufacturers on a quarterly basis. Certain of our clients are contractually entitled to all or a portion of the rebates we receive. The manufacturer rebates retained by us, after the clients receive their contractual amounts, have historically had a significant impact on our financial performance. For the fiscal years ended June 30, 2006, 2005 and 2004, the rebates retained by us have approximated 13%, 15% and 16%, respectively, of our total gross profit. Due to the expected continued growth and diversification of our business, we expect rebates to continue to account for a significant, but declining, percentage of our total gross profit.
We plan to continue our organic growth through increased marketing of our services and by expanding the range of services offered, including home delivery services through Mail Service, and specialty pharmacy services through our Specialty Service segment. We believe these services to be in growing demand within the healthcare industry. In addition, we intend to continue to pursue an acquisition program to supplement our organic growth by making acquisitions of other specialty pharmacy businesses and PBM businesses meeting specific criteria.
Revenue increased $62.3 million, or approximately 7.8%, from $800.6 million for the fiscal year ended June 30, 2005 to $862.9 million for the fiscal year ended June 30, 2006. Revenue recognized from contracts recorded on a gross revenue basis was $852.3 million for the fiscal year ended June 30, 2006 and $794.8 million for the fiscal year ended June 30, 2005. Revenue recognized from contracts recorded on a net revenue basis was $10.6 million for the fiscal year ended June 30, 2006 and $5.8 million for the fiscal year ended June 30, 2005. The specific terms of the contracts that we enter into with our clients will determine whether we recognize the gross revenue related to the cost of the prescriptions filled. For those contracts that we only recognize net revenue, there is no impact on our gross profit since neither the prescription revenue nor the related costs of the prescriptions is recorded. Whether revenues are recorded on either a gross or net basis, we record the gross amount billed in accounts receivable and the related claims payable to pharmacies on our balance sheets. We include in revenue only those co-payments earned from Mail Service. For the fiscal year ended June 30, 2006, there were approximately $18.4 million of co-payments included in revenue as compared to approximately $15.1 million for the fiscal year ended June 30, 2005. Co-payments retained by pharmacies on prescriptions filled for our participants and not included in our revenue were $321.1 million and $280.9 million, for the fiscal years ended June 30, 2006 and 2005, respectively. Under our client contracts, the pharmacy is solely obligated to collect the co-payments from the participants. Under client contracts, we do not assume liability for participant co-payments in pharmacy transactions. As such, we do not include participant co-payments to pharmacies in our revenue or our cost of claims.
Gross profit increased $4.7 million, or approximately 5.4%, from $86.7 million for the fiscal year ended June 30, 2005 to $91.4 million for the fiscal year ended June 30, 2006. This increase is primarily the result of i) $6.3 million related to the PCN acquisition and ii) increase in volume of claims from our Mail Service pharmacy which resulted in additional gross profit of $1.0 million. These increases were partially offset by i) $1.5 million of additional credit memos issued to various customers, ii) $0.5 million write-down
of obsolete inventory from our Mail Service facility in Miramar, Florida and iii) reduction in non-PCN business. Gross profit, as a percentage of revenue, decreased from 10.8% to 10.6% for the fiscal years ended June 30, 2005 and June 30, 2006, respectively.
In addition, there were two charges against net income available to common stockholders related to the New Mountain Transaction (see “Liquidity and Capital Resources”). The first of these charges relates to series A preferred stock cash dividends, which amounted to $5.6 million for both fiscal years ended June 30, 2006 and 2005. The series A preferred stock provides for 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, March 19, 2009. The dividend of $5.6 million represents the amount accrued and paid for both fiscal years ended June 30, 2006 and 2005. The second charge is for the accretion of transaction expenses which were $0.5 million for both fiscal years ended June 30, 2006 and 2005.
Fiscal Year Ended June 30, 2005 Compared to Fiscal Year Ended June 30, 2004
Revenue increased $149.5 million, or approximately 23.0%, from $651.1 million for the fiscal year ended June 30, 2004 to $800.6 million for the fiscal year ended June 30, 2005. Revenue recognized from contracts recorded on a gross revenue basis was $794.8 million for the fiscal year ended June 30, 2005 and $648.5 million for the fiscal year ended June 30, 2004. Revenue recognized from contracts recorded on a net revenue basis was $5.8 million for the fiscal year ended June 30, 2005 and $2.6 million for the fiscal year ended June 30, 2004. The specific terms of the contracts that we enter into with our clients will determine whether we recognize the gross revenue related to the cost of the prescriptions filled. For those contracts that we only recognize net revenue, there is no impact on gross profit since neither the prescription revenue nor the related costs of the prescriptions is recorded. Whether revenues are recorded on either a gross or net basis, we record the gross amount billed in accounts receivable and the related claims payable to pharmacies on our balance sheets. We include in revenue only those co-payments earned from Mail Service. For the fiscal year ended June 30, 2005, there were approximately $15.1 million of co-payments included in revenue as compared to approximately $2.3 million for the year ended June 30, 2004. Co-payments retained by pharmacies on prescriptions filled for our participants and not included in our revenue were $280.9 million and $203.4 million, for the fiscal years ended June 30, 2005 and 2004, respectively. Under our client contracts, the pharmacy is solely obligated to collect the co-payments from the participants. Under client contracts, we do not assume liability for participant co-payments in pharmacy transactions. As such, we do not include participant co-payments to pharmacies in our revenue or our cost of claims.
Of the $149.5 million increase in revenue in fiscal 2005, $25.0 million was due to the inclusion of revenues from PCN, which we acquired March 7, 2005. In addition, $39.0 million was due to the inclusion of revenue from Inteq, which we acquired April 1, 2004. Co-payments received from Mail Service accounted for $12.9 million of this increase. Another approximately $96.9 million of the overall gross revenue increase was due to revenue related to new clients or new services offered during fiscal 2005 excluding contracts recorded on a net revenue basis. An additional increase of approximately $49.4 million was attributable to other existing clients as a result of several factors including higher charges relating to increased cost of pharmaceuticals, new drugs, plan participant growth and an increase in the average number of claims per plan participant. These increases were partially offset by revenue decreases related to the termination of existing customer contracts throughout the fiscal year, leading to a reduction in revenue of approximately $73.7 million.
Gross profit increased $22.7 million, or approximately 35.5%, from $64.0 million for the fiscal year ended June 30, 2004 to $86.7 million for the fiscal year ended June 30, 2005. In addition to the revenue volume increase described above, PCN accounted for $3.3 million, or 15%, of the increase. Inteq accounted for another $3.8 million, or 17% of the increase. The increase in rebates (and administrative
fees related to the collection of rebates) after accounting for the amount of rebates that are shared with clients, accounted for another $2.5 million, or 11%. The balance of the increase relates to the margins on the new business that replaced the lost business and growth in the existing business from additional services provided. Gross profit, as a percentage of revenue, increased from 9.8% to 10.8% for the year ended June 30, 2004 and June 30, 2005, respectively. The contracts that we recognize on a net revenue basis have the effect of improving the gross margin as a percentage of revenue due to the fact that recorded revenue and costs are lower since only the administrative fees related to these contracts are recorded. The increased activities at Mail Service and Specialty Service also led to an increase in gross profit percentage, year-over-year. Partially offsetting the impact of the net revenue and new activities, we have seen some decline in profit margins due to competitive pressures.
Selling, general and administrative expenses increased $17.2 million, or approximately 34.0%, from $50.6 million for the fiscal year ended June 30, 2004 to $67.8 million for the fiscal year ended June 30, 2005. Included in selling, general and administrative expenses for the fiscal year ended June 30, 2004 was approximately $2.6 million of a non-recurring expense related to the New Mountain Transaction (see “Liquidity and Capital Resources”) and for the fiscal year ended June 30, 2005 was an approximately $1.7 million charge for the settlement of the Midwest Health Plan lawsuit. Excluding these items, the increase in selling, general and administrative expenses was $18.1 million. Approximately $7.6 million, or 42%, of this increase in selling, general and administrative expenses is related to new entities acquired by NMHC during the fiscal year ended June 30, 2005. The major components of the $7.6 million increase in expenses related to the acquisitions were: i) salaries and benefits - approximately $3.6 million, ii) commissions and fees to outside brokers and sales consultants - approximately $1.5 million, iii) depreciation and amortization - approximately $0.9 million, iv) rent and related expenses - approximately $0.7 million, v) IT expenses - approximately $0.4 million, vi) professional fees - approximately $0.2 million, and vii) other - approximately $0.3 million. Non-acquisition related increases included: i) salaries and benefits (from increased headcount) - $3.8 million, ii) commissions and fees to outside brokers and sales consultants - $2.2 million, iii) professional fees (much as a result of compliance with the Sarbanes-Oxley Act) - $2.1 million, iv) IT expenses - $2.0 million and v) other - $0.4 million.
For the fiscal year ended June 30, 2005, we earned other income, net, of approximately $1.5 million. For the fiscal year ended June 30, 2004, we earned other income, net, of approximately $40,000. The primary component of the increase in other income was the realization of a $1.7 million gain from an insurance claim which represented the excess of the insurance proceeds over the carrying value of the assets covered by the claim.
Net income for the fiscal year ended June 30, 2005 was approximately $12.4 million as compared to approximately $8.0 million for the fiscal year ended June 30, 2004, a 55.0% increase. The increase in net income is attributable to the same factors causing the increase in income before income taxes, in addition to the lower effective tax rate.
In addition, there were three other charges recorded against net income (loss) available to common stockholders related to the New Mountain Transaction (see “Liquidity and Capital Resources”). The first of these charges relates to series A preferred stock cash dividends, which amounted to $5.6 million for the fiscal year ended June 30, 2005 and approximately $1.6 million for the fiscal year ended June 30, 2004. The series A preferred stock provides for 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. All dividends accrued in each fiscal year were paid by the end of the given fiscal year. The second charge during the fiscal year ended June 30, 2004 was the $80 million beneficial conversion feature. This non-recurring, non-cash charge represents the difference between the fair market value of our common stock on the date of the closing of the New Mountain Transaction and the effective conversion price of $11.29, which is limited to the $80 million purchase price for the series A preferred stock. The third charge is for the accretion of transaction expenses. Certain transaction costs of approximately $4.7 million related to the New Mountain Transaction series A preferred stock investment are deducted from the net proceeds and the carrying value of the series A preferred stock. These transaction costs are accreted to the series A preferred stock carrying value over the ten-year life of the series A preferred stock investment. Such accretion amounted to approximately $475,000 for the fiscal year ended June 30, 2005 and $135,000 for the fiscal year ended June 30, 2004. After deducting these three charges from net income, there remained net income available to common stockholders of approximately $6.3 million for the fiscal year ended June 30, 2005, as compared to a net loss available to common stockholders of approximately $73.8 million for the fiscal year ended June 30, 2004.
We have invested substantial amounts of time and resources to our Medicare drug benefit program. We have currently committed over $6.3 million in a cash account in connection with CMS requirements. As we become licensed as a risk-bearing entity in additional states, we expect to deposit an additional $8.0 million in the near future to fulfill statutory requirements in various states. We may not be able to realize any return on our investments in Medicare initiatives if the cost and complexity of recent changes by and requirements of CMS exceed our expectations or prevent effective program implementation; if the government alters or reduces funding of Medicare programs because of the higher-than-anticipated cost to taxpayers of the MMA or for other reasons; if we fail to become a risk bearing entity prior to the expiration of the CMS waivers for the 49 other states and territories; or if we fail to design and maintain programs that are attractive to our clients or individual Medicare participants; or if we are not successful in retaining employer groups and their enrollees, or winning contract renewals or new contracts under the MMA’s competitive bidding process.
Historically, the timing of our collections of accounts receivable and payments of accounts payable has generally been a net source of cash from operating activities. This is the result of the terms of trade in place with plan clients on the one hand, and our pharmacy network on the other hand. These terms generally lead to our payments to participating pharmacies being slower than our corresponding collections from plan clients. We believe that this situation is not unusual in the pharmacy benefit management industry and expect to operate on similar terms for the foreseeable future. However, there can be no assurance that such terms of trade will continue in the future and, if they were to change materially, we could require additional working capital financing. We have put in place a $65 million revolving credit facility for acquisitions and working capital financing. However, if such terms of trade were to change materially, and/or if we were unable to obtain additional working capital financing, there could be a material adverse effect on our business, financial condition, or results of operations.
Net cash used in investing activities was $8.0 million for the fiscal year ended June 30, 2006 as compared to $4.1 million for the fiscal year ended June 30, 2005. This increase of $3.9 million is primarily the result of a $2.1 million increase in capital expenditures along with $3.2 million of cash generated from the PCN acquisition in March 2005. The PCN cash balance at the closing date, March 7, 2005, was reported as $3.2 million source of cash, or cash provided by investing activities, calculated by subtracting the $13.5 million acquisition price and related costs from the $16.7 million of cash acquired. These increases were partially offset by a $1.0 million decrease in cash paid for acquisitions as well as a $0.4 million decrease in other financing activities.
On January 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. Subject to certain conditions, the line of credit may be increased by an aggregate of $35.0 million. The line of credit contains various covenants that, among other things, require us to maintain certain financial ratios, which are consolidated net worth, consolidated fixed charge ratio and consolidated debt to EBITDA (earnings before interest, taxes, depreciation and amortization) ratio. As of June 30, 2006, there was no principal balance outstanding under the line of credit, and we were in compliance with all financial covenants as defined in the credit facility. The consolidated fixed charge ratio and the consolidated debt to EBITDA ratio are evaluated by JPMorgan as a measure of our liquidity and our ability to meet all of our obligations under the credit facility.
Net cash provided by operating activities can be reconciled to EBITDA, which we believe to be the most directly comparable financial measure to net cash provided by operating activities, as follows (in thousands):
(1) Includes PCN’s operating results commencing March 7, 2005, the date of acquisition.
The following table summarizes scheduled maturities of our contractual obligations for which cash flows are fixed and determinable as of June 30, 2006 ($ in thousands):
Certain of our business acquisition agreements include “earn-out” provisions. These provisions generally require that we pay to the seller or sellers of the business additional amounts based on the performance of the acquired business. The payments typically are made after a certain period of time and our next earn-out payment to the shareholders of Ascend will be made in fiscal 2007. Since the size of each payment depends upon performance of the acquired business, we do not expect that such payments will have a material adverse impact on our future results of operations or financial condition.
We anticipate that current cash positions, together with anticipated cash flow from operations, will be sufficient to satisfy our contemplated cash requirements for at least 24 months. This is based upon current levels of capital expenditures and anticipated operating results for the next 24 months. However, it is one of our stated goals to acquire specialty pharmacy businesses and PBM businesses meeting specific criteria. Depending on our evaluation of future acquisitions, additional cash may be required to complete these acquisitions. In addition, we will require cash to acquire inventory for our mail service and specialty service operations. In the event that our plans change or our assumptions prove to be inaccurate, or our cash on hand together with the proceeds from our revolving credit facility prove to be insufficient to fund operations and acquisitions, we could be required to seek additional financing sooner than anticipated. There can be no assurance that such financing could be obtained at rates or on terms acceptable to us, if at all.
The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Our estimates and assumptions are based upon a combination of historical information and various other assumptions believed to be reasonable under the particular circumstances. Actual results may differ from our estimates.
We describe below what we believe to be our critical accounting policies. (See also Note 2, “Summary of Significant Accounting Policies,” to our consolidated financial statements included in Part II, Item 8 of this Annual Report on Form 10-K.)
The rebates that we receive from pharmaceutical manufacturers are recognized when we are entitled to them in accordance with the terms of our arrangements with pharmaceutical manufacturers, third party rebate administrators, and our clients, and when the amount of the rebate is determinable. Our revenue is reduced by the amount of rebates we earned by our clients.
Rebates Rebates receivable from pharmaceutical manufacturers are generally billed beginning 30 days from the end of each quarter. We record the gross rebate receivable and the appropriate payable to the clients based on estimates, which are subject to final settlement. The estimates are based upon claims submitted and our rebate experience, and are adjusted as additional information becomes available. Upon billing the manufacturer, any differences between our estimate and the actual amount of the rebates receivable is recorded to cost of claims. Rebates are generally paid to clients on a quarterly basis, or as agreed upon with our clients, subsequent to collections from pharmaceutical manufacturers, although there are certain instances where rebates are paid to clients on a more accelerated basis.
The allowance for doubtful accounts is based on a variety of factors, including the age of the outstanding receivable and the payor’s collection history. When circumstances related to specific collection patterns change, estimates of the recoverability of receivables are adjusted.
Property and Equipment We state property and equipment at cost, less accumulated depreciation and amortization. Equipment under capital leases is recorded at the present value of the total minimum lease payments. We calculate depreciation using the straight-line method for assets with useful lives ranging from 3 to 8 years or, with respect to equipment under capital leases and leasehold improvements, we amortize them on the straight-line basis over the shorter of the lease term or the assets’ useful lives.
Intangible Assets Our intangible assets primarily reflect the value of client relationships that arose in connection with our various business acquisitions. These intangible assets are recorded at cost and are reviewed for impairment whenever events, such as losses of significant clients or other changes in circumstances indicate that the carrying amount may not be recoverable. We continually assess the useful lives of the intangible assets, taking into account historical client turnover experience, including recent losses of clients and expected future losses, to ensure they reflect current circumstances.
Income Taxes We account for income taxes in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 109, “Accounting for Income Taxes.” This statement establishes financial accounting and reporting standards for the effects of income taxes that result from an enterprise’s activities during the current and preceding years. It requires an asset and liability approach for financial accounting and reporting of income taxes. As of June 30, 2006, we have current net deferred tax assets of
Stock-Based Compensation With the adoption of SFAS No. 123(R) on July 1, 2005, we are required to record the fair value of stock-based compensation awards as an expense. In order to determine the fair value of stock options on the date of grant, we apply the lattice-binomial option-pricing model. Inherent in this model are assumptions related to expected stock-price volatility, option life, risk-free interest rate, post-vesting terminations, sub-optimal exercise factor and dividend yield. While the risk-free interest rate, post-vesting terminations, sub-optimal exercise factor and dividend yield are less subjective assumptions that are based on factual data derived from public sources, the expected stock-price volatility and option life assumptions require a greater level of judgment which makes them critical accounting estimates.
In May 2005, the FASB issued SFAS No. 154, “Accounting Changes and Error Corrections,” or SFAS No. 154, a replacement of APB Opinion No. 20, “Accounting Changes,” and SFAS Statement 3, “Reporting Accounting Changes in Interim Financial Statements”. SFAS No. 154 changes the requirements for the accounting for and reporting of a change in accounting principle. Previously, most voluntary changes in accounting principle required recognition via a cumulative effect adjustment within net income in the period of the change. SFAS No. 154 requires retrospective application to prior periods’ financial statements, unless it is impracticable to determine either the period-specific effects or the cumulative effect of the change. SFAS No. 154 is effective for accounting changes made in fiscal years beginning after December 15, 2005, however, SFAS No. 154 does not change the transition provisions of any existing accounting pronouncements. We are currently evaluating the impact SFAS No. 154 will have on our consolidated financial statements when it becomes effective for us in fiscal 2007 and are unable, at this time, to quantify the impact, if any, at the time of adoption.
In June 2006, the FASB issued FASB Interpretation Number 48, “Accounting for Uncertainty in Income Taxes” (“FIN 48”). FIN 48 establishes a recognition threshold and measurement for income tax positions recognized in an enterprise’s financial statements in accordance with FASB Statement No. 109, “Accounting for Income Taxes.” FIN 48 also prescribes a two-step evaluation process for tax positions. The first step is recognition and the second is measurement. For recognition, an enterprise judgmentally determines whether it is more-likely-than-not that a tax position will be sustained upon examination, including resolution of related appeals or litigation processes, based on the technical merits of the position. If the tax position meets the more-likely-than-not recognition threshold it is measured and recognized in the financial statements as the largest amount of tax benefit that is greater than 50% likely of being realized. If a tax position does not meet the more-likely-than-not recognition threshold, the benefit of that position is not recognized in the financial statements.
The information required by this item appears beginning on page of this Annual Report on Form 10-K and is incorporated herein by reference.