Additional space was built in the Leased Premises which allowed us to reconfigure our existing space and to move all of our employees in Port Washington into contiguous space. NMHC and our Affiliate amended the Lease for the space on October 23, 2003 and April 26, 2004. Effective on the occupancy date of the new space, as of May 1, 2004, the Affiliate leased additional square footage in the Leased Premises to NMHC. The total space leased by NMHC is currently 37,108 square feet. The Lease provides that, effective May 1, 2004, the rent payable by NMHC shall be an aggregate annual rent of $594,678 over a ten year term, plus expenses related to real estate taxes, utilities and maintenance which are paid directly to the entities to whom payment must be made. Annual rent increases will be based upon the Consumer Price Index plus 2.5% subject to a maximum annual cap of 3.5%. The Lease expires ten years from the occupancy date of May 1, 2004. 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.
In addition, we rent a two family house in Port Washington, New York (near our offices) from P.W. Capital, LLC, (a company affiliated with our former Chairman of the Board and Director) which is used for out-of-town employees. NMHC evaluated the cost of hotels for these individuals and determined it was more cost efficient to rent the house at an annual rate of $66,000. For the same reasons, we rent two houses from Living In Style, LLC, an entity owned partially by an executive officer and our current Chairman of the Board. Pursuant to leases dated May 1, 2002 and expiring April 30, 2007, we paid an aggregate of $140,000 in rent for these two facilities during the fiscal year ended June 30, 2005. The annual rent for each of the facilities increases by 5% per year.
NMHC derives its revenue from the provision of comprehensive pharmacy benefit management services to sponsors of prescription benefit plans. Substantially all of the services NMHC provides to its sponsors are related to pharmacy benefit programs and services. NMHC also recognizes administrative fees and earns rebates at the time of claims adjudication.
The following table sets forth the breakdown of NMHC's revenues relating to pharmaceuticals dispensed and administrative fees ($ in thousands):
Years Ended June 30, -------------------- 2005 2004 2003 ---- ---- ---- Revenues relating to: Pharmaceuticals $775,351 $630,356 $555,168 Administrative fees and other 25,241 20,742 18,098 -------- -------- ---------
NMHC does not take possession or legal ownership of the pharmaceuticals dispensed by the retail pharmacy network or its out-sourced mail service facilities, although NMHC assumes the legal responsibility and financial risk of paying for dispensed pharmaceuticals whether or not NMHC is paid by its sponsors. NMHC does take possession and dispenses pharmaceuticals from our mail service facility and specialty pharmacy.
NMHC utilizes its comprehensive pharmacy benefit database to perform outcome studies and to develop disease information programs which are used to reduce overall healthcare costs. Our NMHC Integrail division uses its software tools to analyze and predict outcomes for both medical and pharmacy data. These programs currently produce a small amount of revenue, but are starting to attract interest in the marketplace. We believe that these value added information based services are becoming a more important component of managed care as well as management of the overall healthcare dollar, and therefore these services may provide an increasing source of revenue for us in the future.
NMHCmail recognizes revenue at the point of shipment for both the co-pay collected from the individual member, as well as for the "sale" of the prescription to the PBM at specified prices. Revenue from this intercompany sale is eliminated in consolidation. To date, NMHCmail only fills prescriptions for NMHC plan sponsors.
The amount of rebates recognized as reductions to revenue or cost of claims is based on estimates tied to actual claims data. NMHC processes its rebate claims either directly with the drug manufacturers, through its wholly-owned subsidiary, Specialty, for which it receives administrative fees, or through a third party rebate administrator. Effective July 1, 2001, we have entered into an agreement with a third party rebate administrator (the "Administrator") to handle all of our consolidated rebate claims which we do not otherwise submit directly to the drug manufacturers.
NMHC computes the amount of rebates due direct from the drug manufacturers based on the actual claims data, the criteria established in each individual contract, and the specified payment schedules. 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 sponsors are entitled to all or a portion of rebates received by NMHC, which portion varies contractually by sponsor. The manufacturer rebates retained by NMHC, after the sponsors receive their contractual amounts, have historically had a significant impact on our financial performance. For the fiscal years ended June 30, 2005, 2004 and 2003 the rebates retained by NMHC have equaled 15%, 16% and 11%, 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 value added consulting and information-based services through our NMHC Integrail division, home delivery services through NMHCmail, and specialty pharmacy services through our NMHC Ascend division. NMHC believes these services to be in growing demand within the healthcare industry. In addition, NMHC intends to continue to pursue an acquisition program to supplement our organic growth by making acquisitions of other pharmacy benefit management service providers, as well as related services providers.
Of the $149.5 million increase in revenue in fiscal 2005, $25.0 million was due to the inclusion of revenues from PCN, which was included in the revenue from March 7, 2005, but not in the year ended June 30, 2004. In addition, $39.0 million was due to the inclusion of revenue from Inteq, which was included in the revenue for the year ended June 30, 2005, but was only included for three months in the year ended June 30, 2004. Co-payments received from the Mail Service operations 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 sponsors 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 sponsors 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.
Selling, general, and administrative expenses increased $17.2 million, or approximately 34%, 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 were approximately $2.6 million of non-recurring expenses 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 non-recurring charge for the settlement of the Midwest Health Plan lawsuit ("Legal Settlement"). Excluding these non-recurring 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 which were part of NMHC in the twelve months ended June 30, 2005 which were not part of NMHC during all of the twelve months ended June 30, 2004. The major components of the $7.6 million increase in expenses related to the acquisitions were: 1) salaries and benefits - approximately $3.6 million, 2) commissions and fess to outside brokers and sales consultants - approximately $1.5 million, 3) depreciation and amortization - approximately $0.9 million, 4) rent and related expenses - approximately $0.7 million, 5) IT expenses - approximately $0.4 million, 6) professional fees - approximately $0.2 million, and 7) other - approximately $0.3 million. Non-acquisition related increases included: 1) salaries and benefits (from increased headcount) - $3.8 million, 2) commissions and fees to outside brokers and sales consultants - $2.2 million, 3) professional fees (much as a result of compliance with the Sarbanes-Oxley Act) - $2.1 million, 4) IT expenses - $2.0 million and 5) other - $0.4 million.
Gross profit increased from $47.8 million for the fiscal year ended June 30, 2003 to $64.0 million for the fiscal year ended June 30, 2004; a $16.2 million, or 34%, increase. In addition to the revenue volume increase described above, Ascend and Inteq accounted for $4.9 million, or 30%, 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 sponsors, accounted for another $5.5 million, or 34%. 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 8.3% to 9.8% for the twelve months ended June 30, 2003 and June 30, 2004, respectively. The contracts NMHC recognizes on a net revenue basis have the effect of improving the gross margin as a percent of revenue due to the lower revenue base. The new activities at NMHC mail and Ascend also led to an increase in gross profit percentage, year-over-year. Partially offsetting the impact of the net revenue and new activities, NMHC has seen some decline in profit margins due to competitive pressures.
Selling, general, and administrative expenses, which include amounts charged by affiliates, increased $14.6 million, or approximately 41%, from $36.0 million for the fiscal year ended June 30, 2003 to $50.6 million for the fiscal year ended June 30, 2004. Approximately $8.5 million, or 73%, of this increase in selling, general, and administrative expenses is related to new entities which were part of NMHC in the twelve months ended June 30, 2004 which were not part of NMHC during all of the twelve months ended June 30, 2003. The services provided by these entities include specialty pharmacy distribution through NMHC's acquisition of PPP, predictive modeling and consulting services through NMHC's acquisition of Integrail, and mail order distribution through NMHC's owned facility in Miramar, Florida. In addition, PBM services were complemented and enhanced by the acquisition of Inteq. The major components of the $8.5 million increase in expenses related to new services was: 1) salaries and benefits - approximately $4,046,000, 2) postage and supplies - approximately $461,000, 3) equipment rental - approximately $505,000, 4) insurance - approximately $339,000, 5) marketing - approximately $229,000, 6) depreciation and amortization - approximately $556,000, 7) commissions to outside brokers - approximately $599,000, and 8) postage and shipping - approximately $589,000.
Income before the provision for income taxes increased approximately $2.5 million, or 22%, from approximately $11.0 million, for the fiscal year ended June 30, 2003, to approximately $13.5 million for the fiscal year ended June 30, 2004. The primary reason for the increase was the improving efficiencies that come with scale arising from the integration of the acquisitions NMHC has completed. The start-up of the mail order facility had the impact of reducing overall profitability in the year ended June 30, 2004.
Two of these financial covenants are based upon the EBITDA (earnings before interest, taxes, depreciation and amortization) generated by NMHC over specified periods of time. These covenants, consolidated fixed charge ratio and consolidated debt to EBITDA ratio, are evaluated by the lender as a measure of NMHC's liquidity and its ability to meet all of its obligations under the credit facility. EBITDA is presented as cash flow from operations plus or minus the net changes in assets and liabilities and the changes in certain non-cash reconciling items from net cash from operations to net income over the reported periods. While EBITDA is not a measure of financial performance or liquidity under generally accepted accounting principles, it is provided as information for investors for analytical purposes in light of the financial covenants referred to above. EBITDA is not meant to be considered a substitute or replacement for net income or cash flow from operations as prepared in accordance with accounting principles generally accepted in the United States. EBITDA, which increased by approximately $7.7 million or 40%, from $19.3 million for the fiscal year ended June 30, 2004 to $27.0 million for the fiscal year ended June 30, 2005, is calculated as follows:
The total future payments under these contractual obligations as of June 30, 2005 iare as follows:
The shareholders of the Inteq Group are eligible to receive additional consideration of up to $4,200,000, if certain financial targets are met during the year ending April 1, 2005. Of this potential amount, $3,000,000 was deposited into escrow at the time of closing. As of June 30, 2005, $1,024,000 has been earned, of which $957,000 was released from escrow on October 5, 2004, with an additional $67,000 released in January 2005.
The shareholders of PPP are eligible to receive additional consideration of up to $7,000,000, if certain financial targets are met over the three year period beginning August 1, 2003. Such amounts earned are payable within 45 days after the first, second, and third anniversary of the date of acquisition. In the sole discretion of NMHC, up to 50% of any amounts earned can be paid in the form of our stock in lieu of cash. For the first year ended July 31, 2004, $716,000 was earned and was paid on September 15, 2004. Of this amount, $358,000 was paid in cash and $358,000 was paid in the form of our common stock. For the second year through June 30, 2005, $795,000 has been earned and will be paid on September 15, 2005. Up to 50% of this amount may be paid in the form of our stock in lieu of cash.
We entered into an amended and restated preferred stock purchase agreement, dated as of November 26, 2003, with New Mountain Partners, L.P. (the "purchase agreement"). Pursuant to the purchase agreement, we agreed, subject to various conditions, to issue to New Mountain Partners a total of 6,956,522 shares of the series A 7% convertible preferred stock (the "series A preferred stock") at a purchase price of $11.50 per share, for aggregate proceeds of approximately $80 million. On March 19, 2004, we completed the sale of the series A preferred stock to New Mountain Partners and used approximately $49 million of the proceeds of the sale of the series A preferred stock to purchase, pursuant to a tender offer, 4,448,900 shares of our outstanding common stock at $11.00 per share (collectively, the "New Mountain Transaction"). Prior to the closing of the New Mountain Transaction, Bert E. Brodsky, the former chairman of the board of directors, and certain stockholders related to him, held (assuming the exercise of 330,000 options and warrants held by Mr. Brodsky, which occurred in April 2004), in the aggregate, approximately 59% of our outstanding common stock and had agreed to tender 4,448,900 shares, or approximately 54% of our outstanding common stock, held by them, into the tender offer. No other shareholders tendered shares in the offer.
Following the completion of the tender offer, and assuming the exercise of 330,000 options and warrants held by Mr. Brodsky, which occurred in April 2004, New Mountain Partners owned securities at March 19, 2004 that were initially convertible into approximately 64% of NMHC's issued and outstanding common stock and prior to conversion of the series A preferred stock were entitled to cast that number of votes that is equal to approximately 60% of NMHC's aggregate voting power. Following the closing of the New Mountain Transaction, New Mountain Partners were entitled to and did nominate and elect 60% of the members of NMHC's board of directors.
We used the remaining proceeds from the issuance and sale of the series A preferred stock of approximately $24 million, excluding expenses related to the closing of the New Mountain Transaction, for the Inteq Acquisition and working capital purposes.
The series A preferred stock may be redeemed at NMHC's option subsequent to the fourth anniversary of its issuance, subject to certain conditions. After the tenth anniversary of the issuance of the series A preferred stock, each holder of shares of series A preferred stock may require us to redeem all or a part of that holder's shares of series A preferred stock.
NMHC anticipates 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 other pharmacy benefit management companies and companies providing related services. 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 distribution operations. In the event that NMHC's plans change or its assumptions prove to be inaccurate, or the proceeds from the JPMorgan credit facility and the New Mountain Transaction 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.
NMHC's discussion and analysis of its financial condition and results of operations are based upon NMHC's Consolidated Financial Statements, which have been prepared in accordance with U.S. generally accepted accounting principles. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenue and expenses; these estimates and judgments also affect related disclosures of contingent assets and liabilities. On an on-going basis, NMHC evaluates its estimates and judgments, including those related to revenue recognition, bad debt, intangible assets, income taxes, and financing operations. NMHC bases its estimates on experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.
NMHC believes that of its significant accounting policie,s which are described in Note 1 to the Consolidated Financial Statements comprising Item 8 hereof, the following may involve a higher degree of judgment and complexity than others:
(a) Since January 1, 2000, services provided by NMHC have been on a fee for service basis. Under the fee for service arrangement, we are paid by our sponsors for our contractually agreed upon rates based upon actual claims adjudicated, plus a fixed transaction fee.
Revenue under the fee for service arrangement is recognized when the claims are adjudicated. Included as revenue are our administrative fees and charges relating to pharmaceuticals dispensed by our network of pharmacies. Revenue is reduced by the amount of rebates paid to our sponsors.
(b) The specific terms of the contracts that NMHC enters into with its sponsors will determine whether we recognize the gross revenue related to the cost of the prescriptions filled. There are several factors from EITF 99-19 that led us to recognize the majority of our revenue on a gross basis. These include: NMHC acts as a principal and not an agent and is the primary obligor in the relationship among the pharmacies, the sponsors and NMHC, NMHC has credit risk, NMHC has certain latitude in establishing price, and NMHC has discretion in supplier selection. In certain cases, primarily because the amount we earn is fixed, we have not recognized the gross revenue or cost related to prescriptions filled for a specific sponsor. This has no impact on our gross profit since neither the prescription revenue nor the related cost of the prescriptions is recorded.
(d) Rebates are recognized when we are entitled to them in accordance with the terms of our arrangements with drug manufacturers, third party rebate administrators, and sponsors, and when the amount of the rebates is determinable. NMHC records the gross rebate receivable and the appropriate payable to the sponsors based on estimates, which are subject to final settlement. The estimates are based upon the claims submitted and our rebate experience, and are adjusted as additional information becomes available.
NMHC periodically considers whether or not we should record a valuation allowance to reduce our deferred tax assets to the amount that is more likely than not to be realized. While we have considered future taxable income and ongoing tax planning strategies in assessing the need for the valuation allowance, in the event NMHC were to determine that we would be able to realize our deferred tax assets in the future in excess of our net recorded amount, an adjustment to the deferred tax asset would increase income in the period such determination was made. Likewise, should we determine that we would not be able to realize all or part of our net deferred tax asset in the future, an adjustment to the deferred tax asset would be charged to income in the period such determination was made.
The audited financial statements of NMHC as of June 30, 2005, 2004 and 2003, and the related Schedules, are set forth at the pages indicated in Item 15 hereof.