In June 2004, we entered into a ten-year lease in a new office building located in Rockville, Maryland for approximately 37,000 square feet of office space and moved our headquarters to the new location in the third quarter of 2004. We also have satellite offices in Florida, Georgia, Louisiana, Minnesota, Mississippi, Nevada, North Carolina, Ohio and Texas.
We also offer supplemental benefit programs developed by us under the brand name “HealthExtras”, which include lump sum accidental disability benefits, accidental death and dismemberment benefits, and emergency accident and sickness medical benefits. We contract with insurance companies to underwrite the insurance components of these programs. As a result, the financial responsibility for the payment of claims resulting from a qualifying event covered by the insurance features of our programs is borne by the third-party insurers. Our supplemental benefits segment accounted for approximately 6%, 9% and 14% of our revenue in the years ended 2005, 2004 and 2003, respectively. Individuals are the major purchasers of these programs.
Member co-payments are not recorded as revenue. The Company incurs no obligations for co-payments to pharmacies and has never made such payments. Under our pharmacy agreements, the pharmacy is solely obligated to collect the co-payments from the members. Under our client contracts, we do not assume liability for member co-payments in pharmacy transactions. As such, we do not include member co-payments to pharmacies in revenue or direct expenses.
On December 16, 2005, we acquired 100% of the common stock of EBRx, Inc. The acquisition was structured as a merger between a wholly-owned subsidiary of ours formed for such purpose and the parent company of EBRx, with that former parent as the surviving entity following the merger. Consideration consisted of a cash payment of $27.9 million and we incurred $400,000 in related transaction costs. The acquisition provides for an additional contingent consideration payment of up to $3.0 million subject to performance based standards including certain specified client retention and gross profit criteria for the twelve months ended December 31, 2006, including a provision for earlier payment based on a modified measurement as of September 30, 2006. The acquisition of EBRx resulted in goodwill of $25.2 million and intangible assets of $6.0 million. The allocation of the purchase price to the net assets acquired will be finalized upon receipt of an independent valuation report, consequently the allocation of the purchase price to intangible assets is subject to adjustment. As agreed in connection with the EBRx acquisition, a separate entity owned by former owners and management of EBRx purchased a 20% ownership interest in EBRx in January 2006.
an exercise price of $15.45 per share, and to pay $2.0 million in cash, all subject to performance-based standards and certain revenue and gross profit criteria attributable to MHS. The acquisition of MHS was accounted for using the purchase method of accounting, and we recorded goodwill of approximately $30.4 million and intangible assets of $8.4 million. In July 2005, subject to the various revenue and gross profit performance requirements, we paid the additional cash and promissory note contingent consideration in a total amount of $6.2 million and issued 100,000 common stock warrants valued at $1.0 million. This total contingent consideration resulted in additional goodwill of $7.2 million. The remaining 200,000 warrants remain subject to future revenue and gross profit performance based requirements.
Effective November 1, 2000, we acquired International Pharmacy Management (“IPM”) for an aggregate purchase price of approximately $9.2 million, consisting of approximately 95% cash and the remainder in common stock. The acquisition of IPM was accounted for using the purchase method of accounting and resulted in $9.2 million of goodwill.
The primary determinant of revenue recognition for the supplemental benefits segment is monthly program enrollment. In general, program revenue is recognized based on the number of members enrolled in each
reporting period multiplied by the applicable monthly fee for their specific membership program. The program revenue recognized by us includes the cost of membership features supplied by others, including the insurance components. Revenue from program payments received, and related direct expenses, is deferred to the extent that they are applicable to future periods or to any refund guarantee we offer.
Gross margins in the PBM segment for year ended December 31, 2005 were 10.6%, or $68.8 million, compared to 10.2%, or $48.3 million, for year ended December 31, 2004. Gross margins for the supplemental benefits segment for the year ended December 31, 2005 were 28.6%, or $12.5 million, compared to 26.6%, or $12.3 million for the year ended December 31, 2004.
Gross margins in the PBM segment are generally predictable based on client contract terms and vendor/supplier contracts. Factors that can result in changes in gross margins include generic substitution rates, changes
Selling, General and Administrative. For the year ended December 31, 2005, selling, general and administrative expenses increased by approximately $10.8 million over the prior year to $46.4 million or 7.0% of operating expenses. This increase was primarily associated with PBM segment growth and the related sales and marketing initiatives, and new client implementations.
Selling, general and administrative expenses for the year ended December 31, 2005, of $46.4 million consisted of $24.7 million in compensation and benefits, $5.9 million in commissions, professional fees and technology service costs, $3.3 million in facility costs, $2.7 million in travel expenses, $1.7 million in insurance and other corporate expenses, $0.9 million for creative development, product endorsement and market research, $3.3 million in other expenses and $3.9 million in depreciation and amortization.
Selling, general and administrative expenses for the year ended December 31, 2004, of $35.6 million consisted of $16.7 million in compensation and benefits, $4.4 million in commissions, 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, $2.0 million for creative development, product endorsement and market research, $3.2 million in other expenses, and $3.0 million in depreciation and amortization.
Other Income. Other Income was $87,000 for the year ended December 31, 2005. In the second quarter of 2004, we reached a legal settlement related to litigation initiated by us on December 3, 2002. The terms of the settlement are confidential; however, the net proceeds from the settlement constitute the significant portion of the $2.1 million in other income reported in the 2004 statement of operations.
Income Tax Expense. The effective income tax rate of 36.4% in 2005 and 37.7% in 2004 represent the combined federal and state income tax rates adjusted as necessary based on the particular jurisdictions where the Company operates. The tax rate in 2005 was lower than 2004, in particular, due to interest income earned on tax free investments.
Net Income. Net income for year ended December 31, 2005 increased by $6.6 million over the same period in 2004. The increase in net income was primarily a function of increased gross margins in the PBM segment and an increase in interest income. PBM segment gross margins increased to $68.8 million in 2005 from $48.3 million in 2004, largely attributable to the $175.7 million increase in PBM revenues from the the year ended December 31, 2004 to the year ended December 31, 2005. Segment operating information for 2005 and 2004 is as follows (in thousands):
Revenue. Revenue from operations for year ended December 31, 2004 was $521.3 million, consisting of $475.2 million generated from the PBM segment and $46.1 million from the supplemental benefits segment. The PBM revenue increased by $143.7 million, including $131.0 million from increased prescription volume, $8.9 million from the acquisition of MHS, and $16.2 million in increased unit prices, slightly offset by a reduction in revenue of $12.4 million due to increased member co-payments. Total claims processed increased to approximately 12.8 million in 2004 from approximately 9.0 million in 2003. A significant contributor to the increase in revenue and prescription volume was a new contract with the State of Louisiana, then covering about 180,000 members, which commenced on July 1, 2004. This contract generated 13.0% and 11.8% of the Company’s PBM and total revenue, respectively. The supplemental benefits revenue decreased by $6.5 million, largely as a result of lower levels of coverage purchased and decreased membership. Revenue for year ended December 31, 2003 was $384.1 million, consisting of approximately $331.5 million and $52.6 million attributable to the PBM and supplemental benefits segments, respectively.
Direct Expenses. Direct expenses for year ended December 31, 2004 were $460.8 million, consisting of $427.0 million in direct expenses from the PBM segment and $33.8 million in direct expenses from the supplemental benefits segment. PBM segment direct expenses increased by $124.8 million, while the supplemental benefits segment direct expenses decreased by approximately $5.2 million. The PBM segment’s $124.8 million increase in direct expenses are a direct function of the $143.7 million increase in PBM revenue. The net $119.6 million increase is consistent with our anticipated gross margin contribution from increased prescription volume, the acquisition of MHS and increased unit prices, offset by increased member co-payments. The decrease in direct expenses in the supplemental benefits segment was largely a result of a modest decrease in membership and the negotiation of lower costs for certain of the benefits in our programs.
Gross margins in the PBM segment are generally predictable based on client contract terms and vendor/supplier contracts. 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 have materially changed in 2004 in a manner that would meaningfully affect current or anticipated results. In 2004, gross margins were improved by an increased volume of higher margin workers compensation business resulting from the acquisition of the MHS business. This increase was largely offset in percentage terms by the addition of the State of Louisiana contract that has lower percentage margin contributions than our historical averages. Excluding these changes, there were no other significant factors that influenced reported gross margins in 2004 or indicate likely changes in the near future.
Selling, general and administrative expenses for year ended December 31, 2003, of $25.9 million included $10.7 million in compensation and benefits, $4.8 million in commissions, other professional fees, and insurance, $3.2 million in other expenses, $2.4 million in depreciation and amortization, $1.8 million for creative development, product endorsement and market research, $1.8 million in facility costs, and $1.2 million in travel expenses.
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. In November 2004, we received $54.8 million in net proceeds from the sale of common shares in a public offering. During 2005, 2004 and 2003, we generated positive cash flow from operations and anticipate similar results in 2006 and the foreseeable near term future. Cash and cash equivalents and marketable securities at December 31, 2005 were $55.6 million.
Net Cash Provided by Operating Activities. Our operating activities generated $28.3 million of cash from operations in 2005, a $16.3 million increase from the $12.0 million generated in 2004. This $28.3 million in cash provided by operating activities in 2005 reflects $23.0 million in net income, plus $5.7 million in non-cash changes, reduced by a net $0.4 million decrease in working capital and other assets and liabilities. The cash provided by operating activities of $12.0 million in 2004 reflects net income of $16.4 million, plus $8.1 million in non-cash charges, reduced by a $12.5 million increase in working capital and other assets and liabilities (including a $15.8 million increase in accounts receivable driven by an increase in revenue).
of options, warrants and ESPP purchases. In 2004, we received $54.8 million in net proceeds from the sale of common shares in a public offering and repaid $21.8 million in notes payable. In addition, during 2004, we increased our borrowings by $37.3 million to finance the acquisition of MHS and received $2.2 million in proceeds from the exercise of options, warrants and ESPP purchases.
The Company has no off-balance-sheet transactions. The following table reflects our current contractual commitments as of December 31, 2005 (in thousands):
Using the December 31, 2005 effective interest rates and outstanding balances, and factoring the required future payments on the term loan, the Company estimates its interest payments on its notes payable to be $616,000, $328,000 and $46,000 for 2006, 2007 and 2008, respectively.
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 of America requires management to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying notes. Actual results could differ from those estimates. The most significant estimates included in these financial statements include the following: the value of intangible assets acquired in business combinations and related amortization periods, and rebates due from pharmaceutical manufacturing companies.
Trade accounts receivable are recorded at the invoiced amount and do not bear interest. The allowance for doubtful accounts is our best estimate of the amount of probable credit losses in our existing accounts receivable. We determine the allowance based on historical write-off experience by industry and regional economic data. We review our allowance for doubtful accounts monthly. Past due balances over 90 days and over a specified amount are reviewed individually for collectibility. All other balances are reviewed on a pooled basis by type of receivable. Account balances are charged off against the allowance when we feel it is probable the receivable will not be recovered. We do not have any off-balance-sheet credit exposure related to our customers.
The Company accounts for its goodwill under SFAS No. 142, “Goodwill and Other Intangible Assets.” Under SFAS No. 142, goodwill is not amortized, but it is tested for impairment at least annually. Each year, the Company tests for impairment of goodwill according to a two-step approach. In the first step, the Company tests for impairment of goodwill by estimating the fair values of its reporting units using the present value of future cash flows approach, subject to a comparison for reasonableness to its market capitalization at the date of valuation. For the purposes of performing this impairment test, the Company’s business segments are its reporting units. If the carrying amount 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.
In December 2004, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 123 (revised 2004), “Share-Based Payment”, (“FAS 123(R)”). This Statement requires companies to expense the estimated fair value of stock options and similar equity instruments issued to employees. Currently, companies are required to calculate the estimated fair value of these share-based payments and can elect to either include the estimated cost in earnings or disclose the pro forma effect in the footnotes to their financial statements. We have chosen to disclose the pro forma effect. The fair value concepts were not changed significantly in FAS 123(R); however, in adopting this Standard, companies must choose among alternative valuation models and amortization assumptions. On April 14, 2005, the SEC announced a deferral of the effective date of FAS 123(R) for calendar-year companies until the beginning of 2006. FAS 123(R) provides a choice of two methods for adoption: