We lease twenty-five facilities throughout the United States and Puerto Rico. Our corporate headquarters office, containing 75,000 square feet, is located in Rockville, Maryland and accommodates our executive and corporate functions. We also have satellite offices in Alabama, Arizona, California, Florida, Georgia, Hawaii, Iowa, Louisiana, Mississippi, Nevada, New Mexico, North Carolina, Ohio, Pennsylvania, Puerto Rico and Texas. We believe all of our facilities are well-maintained and in good operating condition and have adequate capacity to meet our current business needs.
The following selected financial data has been derived from the audited financial statements of the Company. We have completed a number of acquisitions over the past five years which may affect year over year comparisons of our selected financial data. The revenue and operating results related to acquisitions of companies are included from the respective acquisition dates. The selected financial data should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” included as
Pharmacy benefit claims 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 clients. When we administer pharmacy reimbursement contracts and do not assume a credit risk, we record only our administrative or processing fees as revenue. Rebates earned under arrangements with manufacturers are recorded as a reduction of direct expenses. The portion of manufacturer rebates due to clients is recorded as a reduction of revenue.
SFAS No. 131, Disclosures about Segments of an Enterprise and Related Information, establishes standards for the way that public enterprises report information about operating segments in financial statements. We have determined that we operate in only one segment-the pharmacy benefits management, or PBM, segment.
As a part of this arrangement, we received $7.0 million in cash. We have considered the accounting for the investment and the contract extension and have recorded a liability in our consolidated balance sheet at December 31, 2008, pursuant to Financial Accounting Standard No. 150, Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity. We are also recognizing expense associated with the accretion of $1.0 million in other value to an ultimate redemption value of $8.0 million. We have a contractual obligation to redeem the total investment in cash in the year 2013.
On May 16, 2008, we acquired HospiScript Services, LLC and Concept Pharmaceuticals, LLC, a related party to HospiScript Services through common ownership (collectively, “HospiScript”). HospiScript provides pharmacy medication therapy management services to the hospice industry.
Total consideration for the acquisition of HospiScript consisted of cash payments of $102.7 million and $0.4 million in transaction related costs. Additionally, the acquisition provides for possible contingent consideration payments through 2010 of up to $8.1 million, subject to specified operating performance standards, of which approximately $0.9 million was earned in 2008. Contingent consideration earned is accounted for as additional goodwill.
Revenue. Revenue from operations for the year ended December 31, 2008 was approximately $2.5 billion. Revenue increased over the comparable period in 2007 by $685.7 million. Total claims processed increased to approximately 52.0 million in 2008 from approximately 41.5 million in 2007. Contributors to the increase in revenue and prescription volume were primarily due to our contracts with the State of Maryland and Ohio, which commenced on July 1, 2007, and Puerto Rico’s MCS Commercial business and MCS Medicare Part D business, which commenced on December 1, 2007 and January 1, 2008, respectively, as well as our acquisition of IPS and HospiScript.
Direct Expenses. Direct expenses for the years ended December 31, 2008 and 2007 were $2.4 billion and $1.7 billion, respectively. The increase in direct expenses is primarily related to the $685.7 million increase in revenue. Direct expenses for 2008 and 2007 represented 97.3% and 97.0% of total operating expenses for the respective periods.
Gross margin, calculated as revenue less direct expenses, is generally predictable based on client contract terms and vendor/supplier contracts. Other factors that can result in changes in gross margins include generic substitution rates, changes in the utilization of preferred drugs with higher discounts and changes in the volume of prescription dispensing at lower cost network pharmacies. None of the foregoing factors materially changed in 2008 in a manner that would meaningfully affect current results. Gross margin increased to $143.3 million for the year ended December 31, 2008 from $110.4 million for the comparable period in 2007.
Selling, General and Administrative. For the year ended December 31, 2008, selling, general and administrative expenses increased by approximately $13.8 million over the prior year to $67.8 million or 2.7% of operating expenses. This increase was primarily associated with our growth and the associated personnel, facility and vendor costs to serve and implement new clients as well as incremental selling, general and administrative costs related to our evaluation of various strategic opportunities and to our acquisition of IPS and HospiScript.
Interest Expense. Interest expense increased to $0.3 million for the year ended December 31, 2008 from $0.2 million for the year ended December 31, 2007. The increase in interest expense was attributable to the net drawings on our line of credit during 2008. At December 31, 2008, we had available a $50.0 million revolving credit facility with no outstanding borrowings.
Income Tax Expense. The effective income tax rates of 36.7% in 2008 and 37.6% in 2007 represent the combined federal and state income tax rates adjusted as necessary based on the particular jurisdictions where we operate. The effective tax rate in 2008 was lower than in 2007 primarily due to a decrease in our state effective tax rates.
Revenue. Revenue from operations for the year ended December 31, 2007 was approximately $1.9 billion compared to approximately $1.3 billion in the comparable period in 2006. Revenue increased over the comparable period in 2006 by $586.7 million. Total claims processed increased to approximately 41.5 million in 2007 from approximately 29.3 million in 2006. Contributors to the increase in revenue and prescription volume were our contracts with Wellmark Blue Cross Blue Shield of Iowa, covering over 1.0 million members, which commenced on July 1, 2006, and the States of Maryland and Ohio, which commenced on July 1, 2007. These contracts generated 29% of our consolidated revenue in 2007.
Direct Expenses. Direct expenses for the year ended December 31, 2007 were $1.7 billion compared to $1.2 billion in the comparable period in 2006. The increase in direct expenses was primarily related to the $586.7 million increase in revenue. Also included in the direct expenses for 2007 are charges of approximately $1.9 million reflective of the resolution of a previously disclosed arbitration proceeding which stems from a prior acquisition, and related adjustments. The direct expenses of $1.7 billion and $1.2 billion for the years ended December 31, 2007 and 2006 represented 97.0% and 96.2% of total operating expenses for the respective periods.
Gross margin as a percentage of revenue was 5.9% and 7.4% for the years ended December 31, 2007 and 2006, respectively. In 2007, composite gross margin percentages were reduced by the addition of several new large contracts including Wellmark Blue Cross Blue Shield of Iowa and the State of Maryland, which are more competitively priced due to their size. These decreases were somewhat offset by gross margin improvements resulting from an increased level of generic substitution and higher network discount rates.
Selling, General and Administrative. For the year ended December 31, 2007, selling, general and administrative expenses increased by approximately $7.6 million over the prior year to $54.0 million or 3.0% of operating expenses. This increase was primarily associated with our growth and the associated personnel and vendor costs to serve and implement new clients.
Interest Income. Interest income increased to $6.6 million for the year ended December 31, 2007 from $5.1 million for the year ended December 31, 2006. The increase was primarily due to an increase in average funds available for investment during the period and an increase in the rate of return available in the marketplace.
Our sources of funds are usually cash flows from operating activities. We have in the past also raised funds by borrowing on bank debt and selling equity in the capital markets to fund acquisitions; however, no assurances can be given that we will be able to raise funds in light of present credit market conditions. During the last several years, we have generated positive cash flow from operations and anticipate similar results in 2009. At December 31, 2008, we had available a $50.0 million revolving credit facility and our cash and cash equivalents were $55.0 million. The decrease of $26.0 million in our cash and cash equivalents since the end of fiscal 2007 resulted primarily from cash used for acquisitions offset by cash generated from operations.
We have approximately $12.7 million at par value in investments related to auction rate securities (ARS), all of which are classified as non-current at December 31, 2008. Our ARS are floating rate securities with longer-term maturities with auction reset dates from 7 to 35 day intervals. Beginning in February 2008, auctions for these securities began to fail. We are unlikely to be able to access these funds until future auctions for these ARS are successful, or until we sell the securities in a secondary market which currently is not fully active, although there have been instances of redemptions at par to date by issuers. As such, these investments currently lack short-term liquidity and are therefore classified as non-current on our December 31, 2008 balance sheet.
For each of our ARS, we evaluate the risks related to the structure, collateral and liquidity and estimate the fair value of the securities using a discount model based on (a) the underlying structure of each security; (b) the present value of future principal and interest payments discounted at rates considered to reflect current market conditions; and (c) considerations of the probabilities of redemption or auction success for each period. Based on the results of these assessments, we recorded a temporary impairment charge of $1.1 million in the fourth quarter of 2008 to reduce the value of our ARS classified as available-for-sale securities. If circumstances arise which would require us to change assumptions or the credit rating of the security issuer deteriorates, we may be required to adjust the carrying values of our available-for-sale ARS through an other-than-temporary impairment charge in current period earnings.
Net Cash Provided by Operating Activities. Our operating activities generated $78.6 million of cash from operations in 2008, a $24.0 million increase from the $54.6 million generated in 2007. This $78.6 million in cash provided by operating activities in 2008 reflects $50.4 million in net income, plus $17.4 million in non-cash charges and $10.8 million net decrease in working capital and other assets and liabilities. This $10.8 million net decrease in working capital was primarily due to a $49.5 million increase in accounts receivable offset by a $58.3 million increase in accounts payable and other current liabilities. The increase in accounts receivable and accounts payable was primarily due to increases in our claims volume.
Our operating activities generated $54.6 million of cash from operations in 2007, a $2.2 million increase from the $52.4 million generated in 2006. This $54.6 million in cash provided by operating activities in 2007 reflects $39.3 million in net income, plus $12.7 million in non-cash charges and $2.6 million net increase in working capital and other assets and liabilities. This $2.6 million net increase in working capital was primarily due to a $54.2 million increase in accounts receivable and $5.2 million increase in income tax receivable offset by a $64.1 million increase in accounts payable and other current liabilities. The cash provided by operating activities of $52.4 million in 2006 reflects net income of $31.6 million, plus $11.4 million in non-cash charges, and a net $9.4 million decrease in working capital and other assets and liabilities.
Net Cash Used in Investing Activities. Net cash used in investing activities for the year ended December 31, 2008 was $120.3 million compared to $38.4 million in 2007. During 2008, approximately $142.4 million of cash was used relating to business acquisitions. Additionally, during 2008, we had $8.7 million in capital expenditures and net sales of marketable securities of $30.9 million.
Net cash used in investing activities for the year ended December 31, 2007 was $38.4 million compared to $36.5 million in 2006. During 2007, we had $3.7 million in capital expenditures and net purchases of $1.4 million in marketable securities. The acquisition of our remaining 20% minority ownership interest resulted in a cash payment of $30.3 million, of which $1.3 million was attributable to the minority interest and approximately $29.0 million was recorded as additional purchase price. Also, additional contingent consideration and other payments of approximately $5.1 million relating to prior business acquisitions were paid during 2007. The current period also reflects $1.0 million of cash provided upon the repayment of a note receivable as well as $1.0 million resulting from the lifting of restrictions on certain cash deposits. Net cash used in investing activities for the year ended December 31, 2006 consisted primarily of $5.7 million in capital expenditures (net of proceeds from sales of property and equipment of $1.0 million), net purchases of $14.5 million in marketable securities, and payments of $16.3 million, net of cash acquired, for business acquisitions, of which $15.9 million was used to acquire R/xx.
Net Cash Provided by Financing Activities. Net cash provided by financing activities for the year ended December 31, 2008 was $15.7 million compared to $15.3 million in 2007. In 2008, we purchased $1.8 million of treasury stock, received proceeds of $4.6 million from the exercise of options and $0.4 million in proceeds from issuance of common stock pursuant to the Employee Stock Purchase Plan. In addition, we received an income tax payable benefit of $5.5 million from the exercise of stock options and restricted stock vesting, and cash of $7.0 million related to the formation of First Rx Specialty and Mail Services, LLC.
Management’s Discussion and Analysis of the Financial Condition and Results of Operations discusses our consolidated financial statements. 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 amounts reported in the consolidated financial statements and accompanying notes. 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 could differ from those estimates. Certain of the accounting policies which most impact our consolidated financial statements and that require management to make difficult, subjective or complex judgments are described below. 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.
We recognize revenues from services provided to our clients for sales of prescription drugs either by pharmacies in our nationwide network or through our mail order facilities, and related claims processing fees. Revenue is recognized when the claims are adjudicated. Pharmacy claims are adjudicated at the point-of-sale using an on-line claims processing system. When we have a contractual obligation to pay a network pharmacy provider for benefits provided to our clients’ members, total payments from these clients are recorded as revenue and payments to the network pharmacy provider and the claim adjudication service costs are recorded as direct expenses. Generally, these contracts require us to assume the credit risk of our clients’ abilities to pay. In addition, under the vast majority of our client contracts, we are at risk for the difference between the payments we receive from our clients and the negotiated reimbursements we pay to the pharmacies. When we administer pharmacy reimbursement contracts and do not assume credit risk, we record only the net revenue and the administrative or processing fees. Rebates earned under arrangements with manufacturers are recorded as a reduction to direct expenses. The portion of such rebates due to our clients is recorded as a reduction of revenue. Manufacturers’ rebates are based on estimates, which are subject to final settlement with the contracted party.
The 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 account for our goodwill under SFAS No. 142. Under SFAS No. 142, goodwill is not amortized, but it is tested for impairment at least annually. Each year, we test for impairment of goodwill according to a two-step approach. In the first step, we test for impairment of goodwill by estimating the fair values of our reporting units using a present value of future cash flows approach, subject to a comparison to market capitalization at the date of valuation. Although we operate in one reportable segment, for the purposes of performing this impairment test under FAS 142, we have identified three reporting units. If the carrying amount of the reporting unit exceeds the fair value, the second step of the goodwill impairment test is performed to measure the amount of the impairment loss, if any. In the second step the implied fair value of the goodwill is estimated as the fair value of the reporting unit used in the first step less the fair values of all other net tangible and intangible assets of the reporting unit. If the carrying amount of the goodwill exceeds its implied fair market value, an impairment loss is recognized in an amount equal to that excess, not to exceed the carrying amount of the goodwill. In addition, goodwill of a reporting unit is tested for impairment between annual tests if an event occurs or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying value.
We have approximately $12.7 million at par value in investments related to auction rate securities (ARS), all of which are classified as non-current at December 31, 2008. For each of our ARS, we evaluate the risks related to the structure, collateral and liquidity and estimate the fair value of the securities using a discount model based on (a) the underlying structure of each security; (b) the present value of future principal and interest payments discounted at rates considered to reflect current market conditions; and (c) considerations of the probabilities of redemption or auction success for each period. Based on the results of these assessments, we record either a temporary impairment charge, net of tax, in accumulated other comprehensive income or an other-than-temporary impairment charge in other income in our statement of operations. Accordingly, because we have the intent and ability to hold these securities until liquidity returns to the market, other secondary markets develop, or the securities mature, we recorded a temporary impairment charge of $1.1 million in the fourth quarter of 2008 to reduce the value of our ARS classified as available-for-sale securities. If circumstances arise which would require us to change our assumptions or the credit rating of the security issuer deteriorates, we may be required to adjust the carrying values of our available-for-sale ARS through an other-than-temporary impairment charge in current period earnings.
FIN 48 requires that we recognize the financial statement benefit of a tax position only after determining that the relevant tax authority would more likely than not sustain the position following an audit. For tax positions meeting the more-likely-than-not threshold, the amount recognized in the financial statements is the largest benefit that has a greater than 50 percent likelihood of being realized upon ultimate settlement with the relevant tax authority.
We may from time to time be assessed interest or penalties by major tax jurisdictions, although any such assessments historically have been minimal and immaterial to our financial results. Our policy is that we recognize interest and penalties accrued on any unrecognized tax benefits as a component of income tax expense.
In April 2008, the FASB issued FASB Staff Position (FSP) FAS 142-3, Determination of the Useful Life of Intangible Assets. FSP FAS 142-3 amends the factors that should be considered in developing renewal or extension assumptions used to determine the useful life of a recognized intangible asset under FASB Statement No. 142, Goodwill and Other Intangibles. FSP FAS 142-3 is effective for fiscal years beginning after December 15, 2008 and early adoption is prohibited. The guidance for determining the useful life of a recognized intangible asset must be applied prospectively to intangible assets acquired after the effective date. The disclosure requirements must be applied prospectively to all intangible assets recognized as of, and subsequent to, the effective date. We do not expect the adoption of FSP FAS 142-3 will have a material impact on our financial position, results of operations or cash flows.
includes a substantial number of new disclosure requirements. SFAS No. 141(R) is effective for fiscal years beginning after December 15, 2008 with early application prohibited. We will adopt SFAS No. 141(R) beginning in the first quarter of fiscal 2009 and will change our accounting treatment for business combinations on a prospective basis.
We are subject to interest rate risk on our investments. We do not expect our financial position, results of operations or cash flows to be affected to any significant degree by a sudden change in market interest rates.
Our audited Consolidated Financial Statements are contained in a separate section of this Annual Report on Form 10-K on pages through and Financial Statement Schedule on page S-1 attached hereto.