Eight of our eleven satellite offices, with a total of 43,000 square feet, are under leases that expire over terms through October 2011 and the other offices are under month-to-month leases. We believe that suitable space on commercially reasonable terms will be available as required.
This Form 10-K may contain forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934, as amended. These forward-looking statements involve a number of risks and uncertainties. We undertake no obligation to revise any forward-looking statements in order to reflect events or circumstances that may arise after the date of this report. Readers are urged to carefully review and consider the various disclosures made in this report and in our other filings with the SEC that attempt to advise interested parties of the risks and factors that may affect our business.
HealthExtras provides pharmacy benefit management, referred to as PBM, services and supplemental benefit programs. Our PBM segment, which operates under the brand name “Catalyst Rx”, accounted for approximately 94%, 91% and 86% of our revenue in the years ended 2005, 2004 and 2003, respectively, and is expected to be the primary source of our growth and profits in the future. Our PBM clients include more than 1,000 self-insured employers, including state and local governments, third-party administrators, referred to as TPAs, and managed care organizations, who contract with us to administer the prescription drug component of their overall health benefit programs. Total claims processed increased to 17.1 million in 2005 from 12.8 million in 2004, respectively and our PBM segment revenue increased by 37% from 2004 to 2005.
Catalyst Rx provides our clients access to a contracted, non-exclusive national network of more than 55,000 pharmacies. Catalyst Rx’s services provide our clients’ members with timely and accurate benefit adjudication, while controlling pharmacy spending trends through customized plan designs, physician orientation programs, and member education. Catalyst Rx uses an electronic point-of-sale system of eligibility verification and plan design information, and offers access to rebate arrangements for certain branded pharmaceuticals. When a member of one of our clients presents a prescription or health plan identification card to a retail pharmacist in our network, the system provides the pharmacist with access to online information regarding eligibility, patient history, health plan formulary listings, and contractual reimbursement rates. The member generally pays a co-payment to the retail pharmacy and the pharmacist fills the prescription. We electronically aggregate pharmacy benefit claims, which include prescription costs plus our claims processing fees, for consolidated billing and payment. We receive payments from clients, make payments of amounts owed to the retail pharmacies pursuant to our negotiated rates, and retain the difference, including claims processing fees.
Pharmacy benefit claim payments from our clients are recorded as revenue, and prescription costs to be paid to pharmacies are recorded as direct expenses. Under our network contracts, we generally have an independent obligation to pay pharmacies for the drugs dispensed and, accordingly, have assumed that risk independent of our 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.
If we had included co-payments in our reported revenue and direct expenses, each would have increased by $279.2 million, $213.0 million and $141.0 million, respectively, for the years ended 2005, 2004 and 2003. Our operating and net income, consolidated balance sheets and statements of cash flows would not have been affected.
The following tables illustrate the effects on the reported PBM revenue and direct expenses if Catalyst Rx had included the actual member co-payments as indicated by our claims processing system (in thousands):
On June 18, 2004, we acquired 100% of the common stock of MHS for a cash payment of $37.3 million and 100,739 shares of our common stock valued at $1.5 million. In addition, we agreed to issue $4.0 million principal amount of non-negotiable promissory notes, warrants to purchase up to 300,000 shares of our common stock at
We have successfully integrated IPM, Catalyst, MHS, and PNNC into our financial, organizational, management and technology structure. As a result, we achieved cost savings from the consolidation of certain corporate activities and the elimination of certain duplicate components of our corporate operations. We expect to integrate the operations of EBRx in 2006.
Direct Expenses. Direct expenses for year ended December 31, 2005 were $613.3 million, consisting of $582.1 million in direct expenses from the PBM segment and $31.2 million in direct expenses from the supplemental benefits segment. PBM segment direct expenses increased by $155.1 million, while the supplemental benefits segment direct expenses decreased by approximately $2.6 million. The PBM segment’s $155.1 million increase in direct expenses are related to the $175.7 million increase in PBM revenue. The resulting segment gross margin, calculated as segment revenue less segment direct expenses, is consistent with our anticipated gross margin contribution from increased prescription volume, the State of Louisiana contract, the acquisition of MHS, an increase in the proportionate amount of prescription costs paid by the plan sponsor, and all other sources of changes in gross margin. The decrease in direct expenses in the supplemental benefits segment was largely a result of a modest decrease in membership and the negotiation of lower costs for certain of the benefits in our programs.
Direct expenses for year ended December 31, 2004 were $460.8 million, consisting of $427.0 million and $33.8 million attributable to the PBM and supplemental benefit segments, respectively. The direct expenses of $613.3 million and $460.8 million for years ended December 31, 2005 and 2004 represented 93.0% and 92.8% of operating expenses for the respective periods.
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 2005 in a manner that would meaningfully affect current or anticipated results. In 2005, gross margins were improved by an increased level of generic substitution and an increased volume of higher margin workers compensation business resulting from the acquisition of the MHS business. These increases were largely offset in percentage terms by the addition of the State of Louisiana contract that has lower percentage margin contributions than our historical averages. Excluding these changes, there were no other significant factors that influenced reported gross margins in 2005 or indicate likely changes in the near future.
Interest Income. Interest income increased to $2.3 million in the year ended December 31, 2005 from $383,000 in the prior year. The increase was primarily due to a substantial increase in funds available for investment resulting from our sale of common stock in the fourth quarter of 2004.
Interest Expense. Interest expense of $1.1 million for the year ended December 31, 2005 was consistent with the prior year expense. During 2004, the Company maintained higher average outstanding debt levels, particularly after the MHS acquisition in June, compared to 2005, but the 2004 interest rates were also lower on average than 2005, resulting in similar interest expense during both years. At the time of the MHS acquisition in June 2004 we entered into a $20.0 million term loan and increased our line of credit. In the fourth quarter of 2004 we raised capital through the sale of common stock and repaid the line of credit. The line of credit expires in June 2006. During 2005, we continued to service the term loan.
Gross margins in the PBM segment for the year ended December 31, 2004 were 10.2%, or $48.3 million, compared to 8.8%, or $29.3 million, for the year ended December 31, 2003. Gross margins for the supplemental benefits segment for the year ended December 31, 2004 were 26.6%, or $12.3 million, compared to 25.8%, or $13.6 million for the year ended December 31, 2003.
Selling, general and administrative expenses of $35.6 million for the year ended December 31, 2004, included $16.7 million in compensation and benefits, $5.5 million in commissions, other professional services, and insurance, $4.1 million in other expenses, $3.0 million in depreciation and amortization, $2.1 million for creative development, product endorsement and market research, $2.6 million in facility costs, and $1.6 million in travel expenses.
Net Cash Used in Investing Activities. Net cash used in investing activities for the year ended December 31, 2005 was $62.7 million compared to $46.3 million in 2004. During 2005 we purchased $45.6 million in marketable securities, we received $17.9 million in proceeds from maturing marketable securities, and paid $33.2 million for business acquisitions, of which $26.7 million was for EBRx and $6.5 million was additional consideration for the MHS acquisition. Cash used for investing activities in 2004 primarily consisted of $37.7 million paid to acquire MHS and $9.7 million in capital expenditures, largely associated with our new headquarters office space.
Net Cash Provided by (Used in) Financing Activities. Net cash used in financing activities for the year ended December 31, 2005 was $4.8 million compared to cash provided by financing activities of $72.4 million in 2004. In 2005 we repaid $14.0 million in notes payable and received proceeds of $9.2 million from the exercise
In our acquisitions, we are required to make judgments regarding the fair values of the assets acquired and the liabilities assumed. For significant acquisitions, management engages independent consultants to assist it in estimating the fair values of acquired intangible assets.
intangible assets is evaluated periodically and adjusted as necessary to match the period that the assets are expected to provide economic benefits. We concluded that no impairment of intangible assets existed at December 31, 2005 and 2004.
The Company accounts for contingent consideration according to EITF 95-8, “Accounting for Contingent Consideration Paid to the Shareholders of an Acquired Enterprise in a Purchase Business Combination” to determine whether contingent consideration should be accounted for as an adjustment to the purchase accounting.
From time to time we issue warrants to purchase shares of our common stock under arrangements with our business partners or as consideration in acquisitions. We are required to estimate the fair value of such warrants for purposes of recording these transactions in our financial statements upon achieving a measurement date. Such estimates require judgments regarding, among other things, expected term, risk-free interest rates and common stock volatility.
1. A “modified prospective” method in which compensation cost is recognized beginning with the effective date (a) based on the requirements of FAS 123(R) for all share-based payments granted after the effective date; and (b) based on the requirements of FAS 123 for all awards granted to employees prior to the effective date of FAS 123(R) that remain unvested on the effective date.
2. A “modified retrospective” method which includes the requirements of the modified prospective method described above, but also permits entities to restate based on the amounts previously recognized under FAS 123 for purposes of pro forma disclosures for all prior periods presented.
The Company plans to use the modified prospective method to adopt the requirements of FAS 123(R).
As permitted by FAS 123, the Company currently accounts for share-based payments to employees using APB Opinion No. 25’s intrinsic value method and, as such, recognizes no compensation cost for employee stock options. In December 2005, in anticipation of the requirements of FAS 123(R), the Company accelerated, effective December 31, 2005, the vesting of 1.1 million outstanding stock options. The acceleration of vesting was undertaken so that compensation expense that otherwise would have been required to be recognized with respect to these unvested stock options will not be reported in future periods. Based on the Company’s historical option forfeiture rate, the Company incurred a charge of approximately $800,000 or approximately $600,000 after taxes. Had we adopted FAS 123(R) in prior periods, the impact of that standard would have approximated the impact of FAS 123 as described in the disclosure of pro forma net income and earnings per share under “Stock-Based Compensation” in Note 1 to our consolidated financial statements. The Company estimates that it will incur less than $400,000 of expense in 2006 related to FAS 123(R) for remaining unvested stock options and activity in the employee stock purchase plan.
On March 29, 2005, the SEC staff issued Staff Accounting Bulletin No. 107 (“SAB 107”), which expresses the SEC staff’s view on FAS 123R. SAB 107 provides guidance regarding certain matters important to selecting and applying valuation models. We will consider SAB 107 in our implementation of FAS 123(R).
In July 2005, the FASB issued an Exposure Draft of a proposed Interpretation, “Accounting for Uncertain Tax Positions”. The proposed Interpretation clarifies the accounting for uncertain tax positions in accordance with FASB Statement No. 109, “Accounting for Income Taxes”. The proposed Interpretation requires that a tax position meet a “probable recognition threshold” for the benefit of the uncertain tax position to be recognized in the financial statements. A tax position that fails to meet the probable recognition threshold will result in either the reduction of a current or deferred tax asset or receivable, or recording a current or deferred tax liability. The proposed Interpretation also provides guidance on measurement, de-recognition of tax benefits, classification, interim period accounting disclosure, and transition requirements in accounting for uncertain tax positions. The proposed Interpretation had a 60-day comment period and shall be effective for all companies as of the first fiscal year ending after December 15, 2005. We believe that the adoption of this statement will not have a material effect on our financial conditions or results of operations.
We are subject to interest rate risk on our short-term investments. We have determined that a 10% move in the current weighted average interest rate of our short-term investments would not have a material effect in our financial position, results of operations and cash flows in the next year. We are not subject to interest rate risk on our outstanding term loan because we have entered into an interest rate swap that fixes the interest rate at 5.23%.