The Company’s principal business operations are conducted from a 102,134 square foot leased office facility located at 2441 Warrenville Road, Suite 610 in Lisle, Illinois (outside of Chicago). This lease expires in January 2018.
Besides the Lisle, Specialty Service and Mail Service facilities, the Company maintains operations in several other leased locations in the U.S. and Canada, including operations in Ontario (Milton), Arizona, Hawaii, Georgia, Arkansas, and Pennsylvania.
On June 22, 2006, the Company completed a public offering in Canada and the U.S. of 6,400,000 common shares at a price of Cdn $6.75 per common share. The gross proceeds of the offering were $38.7 million (Cdn $43.2 million), excluding underwriting fees and issuance costs of $2.6 million and $1.4 million, respectively.
Effective January 1, 2007, the Company adopted the FASB’s guidance for uncertainty in income taxes and, as a result, the Company recognized an adjustment in the liability for unrecognized income tax benefits of $0.2 million and a corresponding reduction in the beginning balance of retained earnings.
of $20.75 per share. The gross proceeds to the Company from the offering were $214.8 million. Share issuance costs were approximately $11.7 million for underwriting discounts and commissions, and related professional services.
The Company completed its acquisition of MedfusionRx on December 28, 2010. The purchase price for MedfusionRx was $101.7 million in cash, subject to a customary working capital adjustments, with an additional $5.5 million potential earn-out payment subject to the achievement of certain performance targets in the 2012 fiscal year.
This Management’s Discussion and Analysis (“MD&A”) of SXC Health Solutions Corp. (the “Company”) should be read in conjunction with the audited consolidated financial statements. This MD&A also contains forward looking statements and should be read in conjunction with the risk factors described in Item 1A “Risk Factors.”
Certain information in this MD&A, in various filings with regulators, in reports to shareholders and in other communications is forward-looking within the meaning of certain securities laws and is subject to important risks, uncertainties and assumptions. This forward-looking information includes, amongst others, information with respect to the Company’s objectives and the strategies to achieve those objectives, as well as information with respect to the Company’s beliefs, plans, expectations, anticipations, estimates and intentions. There are a number of important factors that could cause actual results to differ materially from those indicated by such forward-looking statements. Such factors include, but may not be limited to, the ability of the Company to adequately address: the risks associated with further market acceptance of the Company’s products and services; its ability to manage its growth effectively; its reliance on and ability to retain key customers and key personnel; industry conditions such as consolidation of customers, competitors and acquisition targets; the Company’s ability to acquire a company, manage integration and potential dilution associated therewith; the impact of technology changes on its products/service offerings, including the impact on the intellectual property rights of others; the effects of regulatory and legislative changes in the healthcare industry; and the sufficiency and fluctuations of its liquidity and capital needs.
When relying on forward-looking information to make decisions, investors and others should carefully consider the foregoing factors and other uncertainties and potential events. In making the forward-looking statements contained in this MD&A, the Company does not assume any significant acquisitions, dispositions or one-time items. It does assume, however, the renewal of certain customer contracts. Every year, the Company has major customer contracts that come up for renewal. In addition, the Company also assumes new customer contracts. In this regard, the Company is pursuing large opportunities that present a very long and complex sales cycle which substantially affects its forecasting abilities. The Company has assumed certain timing for the realization of these opportunities which it thinks is reasonable but which may not be achieved. Furthermore, the pursuit of these larger opportunities does not ensure a linear progression of revenue and earnings since they may involve significant up-front costs followed by renewals and cancellations of existing contracts. The Company has assumed certain revenues which may not be realized. The Company has also assumed that the material factors referred to in the previous paragraph will not cause such forward-looking information to differ materially from actual results or events. The foregoing list of factors is not exhaustive and is subject to change and there can be no assurance that such assumptions will reflect the actual outcome of such items or factors. For additional information with respect to certain of these and other factors, refer to the risks and uncertainties section of Item 1A of this Annual Report on Form 10-K.
THE FORWARD-LOOKING INFORMATION CONTAINED IN THIS MD&A REPRESENTS THE COMPANY’S CURRENT EXPECTATIONS AND, ACCORDINGLY, IS SUBJECT TO CHANGE. HOWEVER, THE COMPANY EXPRESSLY DISCLAIMS ANY INTENTION OR OBLIGATION TO UPDATE OR REVISE ANY FORWARD-LOOKING INFORMATION, WHETHER AS A RESULT OF NEW INFORMATION, FUTURE EVENTS OR OTHERWISE, EXCEPT AS REQUIRED BY APPLICABLE LAW.
The Company provides comprehensive PBM services to customers, which include managed care organizations, local governments, unions, corporations, HMOs, employers, workers’ compensation plans, third party health care plan administrators, and federal and state government programs through its network of licensed pharmacies throughout the United States. The PBM services include electronic point-of-sale pharmacy claims management, retail pharmacy network management, mail service pharmacy, specialty service pharmacy, Medicare Part D services, benefit design consultation, preferred drug management programs, drug review and analysis, consulting services, data access and reporting and information analysis. The Company owns a Mail Service pharmacy (“Mail Service”) and a Specialty Service pharmacy (“Specialty Service”). In addition, the Company is a national provider of drug benefits to its customers under the federal government’s Medicare Part D program.
The Company evaluates customer contracts to determine whether it acts as a principal or as an agent in the fulfillment of prescriptions through its retail pharmacy network. The Company acts as a principal in most of its transactions with customers and revenue is recognized at the prescription price (ingredient cost plus dispensing fee) negotiated with customers, plus an administrative fee, if applicable (“gross reporting”). Gross reporting is appropriate when the Company (i) has separate contractual relationships with customers and with pharmacies, (ii) is responsible to validate and manage a claim through the claims adjudication process, (iii) commits to set prescription prices for the pharmacy, including instructing the pharmacy as to how that price is to be settled (co-payment requirements), (iv) manages the overall prescription drug relationship with the patients, who are participants of customers’ plans, and (v) has credit risk for the price due from the customer. In instances where the
Company merely administers a customer’s network pharmacy contract to which the Company is not a party and under which the Company does not assume pricing risk and credit risk, among other factors, the Company only records an administrative fee as revenue. For these customers, the Company earns an administrative fee for collecting payments from the customer and remitting the corresponding amount to the pharmacies in the customer’s network. In these transactions, the Company acts as an agent for the customer. As the Company is not the principal in these transactions, the drug ingredient cost is not included in revenue or in cost of revenue (“net reporting”). As such, there is no impact to gross profit based upon whether gross or net reporting is used.
The Company is also a leading provider of HCIT solutions and services to providers, payors, and other participants in the pharmaceutical supply chain in North America. The Company’s product offerings include a wide range of software products for managing prescription drug programs and for drug prescribing and dispensing. The Company’s solutions are available on a license basis with on-going maintenance and support or on a transaction fee basis using an Application Service Provider (“ASP”) model. The Company’s payor customers include managed care organizations, Blue Cross Blue Shield organizations, government agencies, employers and intermediaries such as pharmacy benefit managers. The solutions offered by the Company’s services assist both payors and providers in managing the complexity and reducing the cost of their prescription drug programs and dispensing activities.
Profitability of the HCIT business depends primarily on revenue derived from transaction processing services, software license sales, hardware sales, maintenance, and professional services. Recurring revenue remains a cornerstone of the Company’s business model and consists of transaction processing services and maintenance. Growth in revenue from recurring sources has been driven primarily by growth in the Company’s transaction processing business in the form of claims processing for its payor customers and switching services for its provider customers. Through the Company’s transaction processing business, where the Company is generally paid based on the volume of transactions processed, the Company continues to benefit from the growth in pharmaceutical drug use in the United States. The Company believes that aging demographics and increased use of prescription drugs will continue to benefit the transaction processing business. In addition to benefiting from this industry growth, the Company continues to focus on increasing recurring revenue in the transaction processing area by adding new transaction processing customers to its existing customer base. The recognition of revenue depends on various factors including the type of service provided, contract parameters, and any undelivered elements.
The Company’s operating expenses primarily consist of cost of revenue, product development costs, selling, general and administrative (“SG&A”) costs, depreciation, and amortization. Cost of revenue includes the costs of drugs dispensed as well as costs related to the products and services provided to customers and costs associated with the operation and maintenance of the transaction processing centers. These costs include salaries and related expenses for professional services personnel, transaction processing centers’ personnel, customer support personnel, any hardware or equipment sold to customers and depreciation expense related to data center operations. Product development costs consist of staffing expenses to produce enhancements and new initiatives. SG&A costs relate to selling expenses, commissions, marketing, network administration and administrative costs, including legal, accounting, investor relations and corporate development costs. Depreciation expense relates to the depreciation of property and equipment used by the Company. Amortization expense relates to definite-lived intangible assets from business acquisitions.
The complicated environment in which the Company operates presents it with opportunities, challenges, and risks. The Company’s clients are paramount to its success; the retention of existing and winning of new clients and members poses the greatest opportunity, and the loss thereof represents an ongoing risk. The preservation of the Company’s relationships with pharmaceutical manufacturers and retail pharmacies is very important to the execution of its business strategies. The Company’s future success will hinge on its ability to drive Mail Service volume and increase generic dispensing rates in light of the significant brand-name drug patent expirations expected to occur over the next several years. The Company’s ability to continue to provide innovative and competitive clinical and other services to clients and patients, including the Company’s active participation in the Medicare Part D benefit and the rapidly growing specialty pharmacy industry, also plays an important part in the Company’s future success.
The Company operates in a competitive environment where clients and other payors seek to control the growth in the cost of providing prescription drug benefits. The Company’s business model is designed to reduce the level of drug cost. The Company helps manage drug cost primarily by its programs designed to maximize the substitution of expensive brand drugs with equivalent but much lower cost generic drugs, obtaining competitive discounts from suppliers, securing rebates from pharmaceutical manufacturers and third party rebate administrators, securing discounts from retail pharmacies, applying the Company’s sophisticated clinical programs, and efficiently administering prescriptions dispensed through the Company’s Mail Service and Specialty Service pharmacies.
Selected financial highlights for the year ended December 31, 2010 compared to the same period in 2009
Total revenue in 2010 was $1.95 billion as compared to $1.44 billion in 2009. The increase is largely attributable to an increase in PBM revenue of $505.6 million for the year ended December 31, 2010, compared to the same period in 2009. PBM revenues increased primarily due to growth in the customer base throughout 2010 and the end of 2009. The increased customer base was complemented by additional services sold to existing customers.
On December 28, 2010, the Company completed the acquisition of MedfusionRx, L.L.C. and certain affiliated entities and certain assets of Medtown South, L.L.C, (together "MedfusionRx") a specialty pharmacy provider with expertise in providing clinical services to patients with complex chronic conditions. The purchase price for MedfusionRx was $101.7 million in cash, subject to a customary post-closing working capital adjustment, and an opportunity for the former owners of MedfusionRx to earn an additional $5.5 million in cash, subject to the satisfaction of certain performance targets in the 2012 fiscal year, in each case based on the terms and subject to the conditions contained in the MedfusionRx purchase agreement. The Company expects the acquisition to transform the Company's Specialty Service pharmacy business by expanding its presence and enhancing its capabilities in this rapidly growing segment of the PBM industry.
Revenue increased $509.8 million, or 35.4%, to $1.95 billion during 2010 primarily due to new customer starts as of January 1, 2010. Revenues have also increased as compared to the same period in 2009 due to an increase in new PBM services sold to several existing HCIT customers during 2010 and the end of 2009. Overall, these changes are a result of synergies between the HCIT and PBM segments which have allowed the Company to focus on offering a broader array of products and services to the Company's customers.
Product development costs for the year ended December 31, 2010 were $12.4 million compared to $12.0 million for the year ended December 31, 2009. Product development costs represent the cost of labor related to development activities and includes stock-based compensation cost of $0.2 million for each of the years ended December 31, 2010 and 2009. Product development continues to be a key focus of the Company as it continues to pursue enhancements of existing products, as well as the development of new offerings, to support market expansion and to take advantage of cross-selling opportunities within its existing customer base.
Amortization expense for the year ended December 31, 2010 was $7.9 million compared to $9.7 million for the same period in 2009. The decrease is due to many of the intangibles being amortized at a declining rate using a future economic benefit model instead of a straight- line methodology. Due to the acquisition of MedfusionRx, amortization of the Company’s intangible assets is expected to increase to approximately $14.2 million in 2011.
Cost of revenue increased $504.6 million to $1.25 billion during 2009, primarily due to the increased revenues from the PBM segment driven by the factors noted above. Cost of revenue in the PBM segment relates to the actual cost of the prescription drugs sold. Cost of revenue for the HCIT segment relates primarily to the cost of labor to deliver the services provided.
Product development costs for the year ended December 31, 2009 were $12.0 million compared to $10.1 million for the year ended December 31, 2008. Product development costs represent the cost of labor related to development activities and include stock-based compensation cost of $0.2 million and $0.3 million for the years ended December 31, 2009 and 2008, respectively. Product development continues to be a key focus of the Company as it continues to pursue enhancements of existing products, as well as the development of new offerings, to support market expansion and to take advantage of cross-selling opportunities within its existing customer base.
SG&A costs for the year ended December 31, 2009 were $85.8 million compared to $68.8 million for the year ended December 31, 2008. SG&A costs consist primarily of employee costs in addition to professional services costs, facilities, and costs not related to cost of revenue. SG&A costs also include stock-based compensation cost of $2.8 million and $3.2 million for the years ended December 31, 2009 and 2008, respectively. The increase in SG&A costs is largely attributable to increased operating expenses due to the acquisition of NMHC. The growth in the overall customer base also caused SG&A to increase due to increased payroll, professional services, and facility costs in order for the Company to properly service its customers. The decrease in stock-based compensation is primarily attributable to stock options that fully vested in 2008, partially offset by new grants in 2008 as well as in 2009. The Company also incurred additional stock-based compensation expense in 2008 related to the assumption and grant of restricted stock units in connection with the acquisition of NMHC.
Amortization expense for the year ended December 31, 2009 was $9.7 million compared to $9.4 million for the same period in 2008. The increase is due to a full year of amortization of intangible assets associated with the acquisition of NMHC versus a partial year in 2008, offset by a reduction in amortization due to the intangibles that are amortized at a declining rate using a future economic benefit model instead of a straight-line methodology.
Interest expense and other expense, net, for 2008 also includes a $0.4 million expense for fair value adjustments related to the Company's derivative instruments. The derivative instruments were designated as cash flow hedges late in 2008. Hedge accounting was in place for most of 2009; however, a charge of $0.6 million was recorded to other expense when hedge accounting was discontinued in the fourth quarter of 2009. Hedge accounting was discontinued due to the extinguishment of the Company's long-term debt obligation. The derivative instruments were hedging against changes in future interest payments on the long-term debt, and as the future interest payments were no longer probable of occurring, hedge accounting could no longer be applied. As such, changes in the fair value of the instruments will be recorded as additional charges or income in the statement of operations through the remainder of the contract term, which ends in June 2011.
Interest paid on the Company's term loan totaled $1.8 million for the year ended December 31, 2009, compared to $2.2 million in the same period in 2008.
Revenue was $1.34 billion for the year ended December 31, 2009 as compared to $771.8 million for the same period in 2008. Revenues increased during 2009 due to the inclusion of a full year of revenue related to the NMHC business as compared to only eight months in 2008. In addition, the terms of services for several HCIT customers were changed to include, or add more, PBM services. Revenues also increased due to the launch of new customer contracts throughout 2009.
Cost of revenue was $1.20 billion for the year ended December 31, 2009, compared to $702.3 million for the same period in 2008. Cost of revenue has increased in line with the increase in PBM revenues, and is predominantly comprised of the cost of prescription drugs. As a percentage of revenue, cost of revenue was 89.7% and 91.0% for the years ended December 31, 2009 and 2008, respectively. The decrease in the cost of revenue as a percentage of revenue is due to the improved purchasing efficiencies for prescription drugs realized as a result of the increased size of the organization and the increased use of lower cost generic drugs. The Company will continue to seek opportunities for increased generic prescription drug usage to help reduce overall prescription drug costs to the Company and its customers.
Gross profit was $138.2 million for the year ended December 31, 2009, compared to $69.5 million for the same period in 2008. Gross profit increased primarily due to new customers added during 2009, along with a full year of PBM operations as compared to 8 months in 2008, both of which increased the volumes in the PBM segment. Gross profit percentage was 10.3% and 9.0% for the years ended December 31, 2009 and 2008, respectively, with the improvement driven by the purchasing efficiencies realized from the NMHC acquisition.
Selected balance sheet highlights at December 31, 2010 are as follows:
At December 31, 2010, cash and cash-equivalents increased $16.9 million to $321.3 million from $304.4 million at December 31, 2009. The increase is primarily related to strong operating cash flows of $96.3 million, offset by cash used to acquire MedfusionRx.
Restricted cash totaling $13.8 million relates to cash balances required to be maintained in accordance with various state statutes, contractual terms with customers and other customer restrictions related to the PBM business. The Company continues to monitor changes in balance requirements that may release restrictions and allow the funds to be used for general corporate purposes.
inventory balance from period to period are caused by some seasonality in certain products, taking advantage of buying opportunities, and changing inventory levels due to customer demands.
Customer deposits payable of $15.4 million relate to deposits required by the Company for certain customers in order to satisfy liabilities incurred on the customer’s behalf for the adjudication of pharmacy claims, and are related to the restricted cash balances discussed above.
Pharmacy benefit claims payable of $84.6 million predominantly relates to amounts owed to retail pharmacies for prescription drug costs and dispensing fees in connection with prescriptions dispensed by the retail network pharmacies for the Company’s customers when the Company is the principal contracting party with the pharmacy. Pharmacy benefit claims payable increased $22.9 million from the balance at December 31, 2009 due to increased transaction volumes during 2010.
For the year ended December 31, 2010, the Company generated $96.3 million of cash through its operations. Cash provided by operating activities has increased $9.9 million compared to the same period in 2009 mainly due to the increased profitability of the Company. The Company’s continued focus on timely collection of its receivables, and effectively managing its working capital has also increased operating cash flows. Cash from operations consisted of net income of $64.7 million, adjusted for $16.3 million in depreciation and amortization expense, $5.9 million in stock-based compensation expense, an increase in rebates payable of $14.8 million, and an increase in pharmacy benefit claims payable of $22.9 million. These were partially offset by an increase of rebates receivable of $16.6 million, a decrease of accrued liabilities of $9.5 million, an increase in accounts receivable of $9.5 million, and $13.1 million in tax benefits from option exercises. The increases in accounts receivable, rebates receivable, rebates payable, and pharmacy benefit claims payable are all driven by the increased revenues and transactions of the PBM segment as discussed earlier.
Changes in non-cash items such as depreciation and amortization are caused by the purchase and acquisition of capital and intangible assets. As these assets become fully depreciated or amortized, the related expenses will decrease.
Changes in operating assets and liabilities, as well as non-cash items related to income taxes, will fluctuate based on working capital requirements and the required tax provision, which is determined by examining taxes actually paid or owed, as well as amounts expected to be paid or owed.
For the year ended December 31, 2010, the Company used $103.7 million of cash for investing activities, which consisted primarily of cash used to acquire MedfusionRx. Additionally, the Company used $9.1 million for purchases of property and equipment to support increased transaction volume, and $2.2 million to purchase short-term investments. These uses of cash were offset by $6.8 million in proceeds received from the sale of short-term investments.
For the year ended December 31, 2008, the Company used $112.8 million of cash for investing activities, which consisted primarily of cash used for the acquisitions of NMHC and the assets of Zynchros Inc., along with the purchases of property and equipment to support increased transaction volume.
Cash flows from financing activities generally fluctuate based on the timing of option exercises by the Company’s employees, which are affected by market prices, vesting dates and expiration dates. The associated tax benefit on the exercise of stock options will also fluctuate based on the timing of option exercises, the market price of the Company's shares at the time of exercise, and the exercise price of the option.
The above table excludes $0.6 million related to the Company’s accrued liability for uncertain tax positions; the Company is unable to reliably estimate the period of cash settlement, if any, with the respective taxing authorities.
The following table provides summary quarterly results (unaudited) for the eight quarters prior to and including the quarter ended December 31, 2010 (in thousands except share and per share data):
The preparation of financial statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the dates of the financial statements and the reported amounts of revenue and expenses during the period. Significant items subject to such estimates and assumptions include revenue recognition, purchase price allocation in connection with acquisitions, the carrying amount of property and equipment, the value of intangible assets acquired and related amortization periods, impairment of goodwill, rebates, contingencies, the valuation allowances for receivables and future income taxes and accruals for income tax uncertainties. Actual results could differ from those estimates. Note 2 to the Company’s 2010 consolidated financial statements include a Summary of Significant Accounting Policies. The understanding of the accounting policies used to prepare the consolidated financial statements
is important to understanding the Company’s results of operations and financial condition.
Goodwill and intangible assets are impacted by the Company’s fair value measurements at initial recording. Beginning in 2009, the
Company applied the revised business combination guidance as issued by the Financial Accounting Standards Board (“FASB”). Measurements of goodwill and purchased intangible assets are based on models derived from a market participant point of view. Along with the methodology of how assets and liabilities acquired are measured, the new guidance also impacts the types of assets and liabilities required to be measured and recorded. Management’s conclusion on who would make up the market participants, the types of assets and liabilities required to be measured, and the methodology used to measure the assets and liabilities will all have a significant impact on the purchase price allocation for business combinations.
From time to time in connection with its operations, the Company is named as a defendant in actions for damages and costs allegedly sustained by the plaintiffs. Management also considers other areas of the Company’s business that may be subject to litigation and liability for damages arising from errors in processing the pricing of prescription drug claims, failure to meet performance measures within certain contracts relating to its services performed or its ability to obtain certain levels of discounts or rebates on prescription purchases from retail pharmacies, drug manufacturers and third party administrators or other actions or omissions. Reserves for contingencies are based upon the Company’s consideration of these proceedings and disputes. Management assesses the probability that these contingencies will be realized, and whether the outcome is reasonably estimable. The Company’s estimates for reserves recorded may be impacted by the history of similar claims, the limitations of any insurance coverage, advice from outside counsel, and management’s strategy with regard to the settlement or defense against such claims and obligations.
See Note 2 to the consolidated financial statements for information on recent accounting pronouncements. The Company is currently assessing the impact on its financial condition and future operating results for recently issued accounting guidance, and does not expect the recently issued guidance to have a significant impact on the Company’s financial condition or future results of operations.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of SXC Health Solutions Corp. as of December 31, 2010 and 2009, and the results of their operations and their cash flows for each of the years in the three year period ended December 31, 2010 in conformity with U.S. generally accepted accounting principles.
As discussed in Note 2 to the consolidated financial statements, in 2008, the Company changed the date of its annual goodwill impairment test from December 31 to October 31.
In our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2010, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission.
SXC Health Solutions Corp. (the “Company”) is a leading provider of pharmacy benefits management (“PBM”) services and healthcare information technology (“HCIT”) solutions to the healthcare benefits management industry. The Company’s product offerings and solutions combine a wide range of PBM services, software applications, application service provider (“ASP”) processing services and professional services designed for many of the largest organizations in the pharmaceutical supply chain, such as federal, provincial, and state and local governments, pharmacy benefit managers, managed care organizations, retail pharmacy chains and other healthcare intermediaries. The Company is headquartered in Lisle, Illinois with several locations in the U.S. and Canada. The Company trades on the Toronto Stock Exchange under ticker symbol “SXC” and on the Nasdaq Global Market under ticker symbol “SXCI.” For more information please visit www.sxc.com.
On December 28, 2010, the Company completed its acquisition of MedfusionRx, L.L.C. and certain affiliated entities and certain assets of Medtown South, L.L.C. (collectively, "MedfusionRx"). Effective April 30, 2008, the Company completed its acquisition of National Medical Health Card Systems, Inc. (“NMHC”). Please see Note 4 for more information on these acquisitions.
Effective with the quarter ended September 30, 2009, the Company adopted the FASB’s Accounting Standards Codification (“the Codification”), which is now the exclusive authoritative reference for nongovernmental U.S. GAAP. Where applicable, titles and references to accounting standards have been updated to reflect the Codification.
The preparation of the consolidated financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, and disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenue and expenses during the reporting periods. Significant items subject to such estimates and assumptions include revenue recognition, purchase price allocation in connection with acquisitions, valuation of property and equipment, valuation of intangible assets acquired and related amortization periods, impairment of goodwill, contingencies, valuation allowances for receivables and income taxes. Actual results could differ from those estimates.
When the Company enters into arrangements with multiple deliverables, exclusive of arrangements with software deliverables, it applies the FASB's guidance for revenue arrangements with multiple deliverables and evaluates each deliverable to determine whether it represents a separate unit of accounting based on the following criteria: (i) whether the delivered item has value to the customer on a stand-alone basis, and (ii) if the contract includes a general right of return relative to the delivered item, delivery or performance of the undelivered item(s) is considered probable and substantially in the control of the Company. Revenue is allocated to each unit of accounting or element based on relative selling prices. The Company determines relative selling prices by using either (i) vendor specific objective evidence (“VSOE”) if it exists; or (ii) third-party evidence of selling price ("TPE"). When neither VSOE nor TPE of selling price exists for a deliverable, the Company uses its best estimate of the selling price for that deliverable.
PBM revenue: The Company’s PBM revenue is primarily derived from sales of prescription drugs, together with any associated administrative fees, to customers and participants, either through the Company’s nationwide network of pharmacies, Mail Service or Specialty Service. Revenue related to the sales of prescription drugs by the Company’s nationwide network of pharmacies, Mail Service pharmacy or Specialty Service pharmacy is recognized when the claims are adjudicated and the prescription drugs are shipped. Claims are adjudicated at the point-of-sale using the Company’s on-line processing system. The Company’s Mail Service primarily fills prescriptions for the Company’s customers. Revenue from Specialty Service primarily represents sales of biopharmaceutical drugs and is reported at the net amount billed to third party payors, patients and others. The Company records an offsetting reduction to revenue for any rebates earned from pharmaceutical manufacturers and third party administrators which are payable to the Company’s customers.
The Company evaluates customer contracts to determine whether the Company acts as a principal or as an agent in the fulfillment of prescriptions through its retail pharmacy network. The Company acts as a principal in certain of its transactions with customers and, in these cases, revenues are recognized at the prescription price (ingredient cost plus dispensing fee) negotiated with customers, plus the Company’s administrative fees (“gross reporting”). Gross reporting is appropriate when the Company (i) has separate contractual relationships with customers and with pharmacies, (ii) is responsible to validate and manage a claim through its claims adjudication process, (iii) commits to set prescription prices for the pharmacy, including instructing the pharmacy as to how that price is to be settled (co-payment requirements), (iv) manages the overall prescription drug plan relationship with the patients, who are members of customers’ plans, and (v) has credit risk for the amount due from the customer.
System sales revenue: Revenue from software licenses is recognized in accordance with the AICPA's accounting guidance for software. Revenue is recognized when all the conditions described above are satisfied. In the event the fee is not fixed or determinable, revenue is recognized as the payments become due from the customer. In cases where collection is not deemed probable, revenue is recognized upon receipt of cash, assuming all other criteria have been met.
The Company’s cost of revenue includes the cost of pharmaceuticals dispensed, either directly through Mail Service or Specialty Service, or indirectly through its nationwide network of retail pharmacies. Cost of revenue is reduced for rebates earned from pharmaceutical manufacturers and third party administrators. Cost of revenue also includes the cost of personnel to support the Company’s transaction processing services, system sales, maintenance, and professional services. In addition, the Company includes in cost of revenue an amount of depreciation expense that is related to property and equipment used to provide services to customers.
The Company considers cash on hand, deposits in banks, money market funds, and bank term deposits with original maturities of ninety days or less as cash and cash equivalents. The amounts presented in the consolidated balance sheets approximate fair value of cash and cash equivalents. These assets are deemed level one securities in the fair value hierarchy.
Restricted cash balances at December 31, 2010 are restricted as to use and relate primarily to minimum cash balances required in accordance with various state statutes, contractual terms with customers and other customer restrictions related to the Company’s PBM business.
As of December 31, 2009, the Company held debt securities, U.S. government treasuries, and other short-term investments that were classified as available-for-sale securities. These securities were classified as available-for-sale since they did not qualify as trading securities or as held-to-maturity securities. Management assessed the classification of each investment at the purchase date, and reviewed the classification at each reporting period. The available-for-sale securities were carried at fair value based on current market prices obtained from industry pricing sources (e.g. Bloomberg). Unrealized gains and losses on the securities were recorded in other comprehensive income, net of tax. The securities had maturities of less than one year, and were accordingly classified as current assets. As of December 31, 2010, the Company did not hold any debt securities, U.S. government treasuries, and other short-term investments.
The fair value of the contingent purchase price liability associated with the acquisition of MedfusionRx is based upon a probability weighted discounted cash flow model, based on the Company's expectation of the amount to be paid in the future to settle the contingent purchase price. The inputs utilized in calculating the fair value of the contingent purchase price liability are not observable in the market place. The fair value of the Company’s interest rate contracts is based upon observable market-based inputs that reflect the current value of the difference between the fixed rate payments the Company will make to the counter party, and the future variable rate receipts from the counterparty. The Company’s short-term investments held at December 31, 2009 were valued based upon market prices for those specific securities obtained from industry pricing sources.
Other assets and liabilities held by the Company deemed as financial instruments and required to be carried at fair value include cash and cash equivalents, accounts receivable, rebates receivable, accounts payable, salaries and wages payable, accrued liabilities (current portion), pharmacy benefit management rebates payable and pharmacy benefit claim payments payable. The estimated fair values of these financial instruments approximate their carrying amounts due to the short-term nature of their maturities.
Deferred charges consisted of deferred financing costs relating to the issuance of long-term debt. Amortization was provided using the effective-interest method over the term of the related debt. As of December 31, 2009, the Company expensed all of the remaining deferred financing costs due to the extinguishment of the Company’s long-term debt associated with these costs.
Long-lived assets or asset groups held and used, including P&E and purchased intangibles subject to amortization are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Circumstances which could trigger a review include, but are not limited to: significant decreases in the market price of the asset; significant adverse changes in the business climate or legal factors; the accumulation of costs significantly in excess of the amount originally expected for the acquisition or construction of the asset; current period cash flow or operating losses combined with a history of losses or a forecast of continuing losses associated with the use of the asset; and a current expectation that the asset will more likely than not be sold or disposed of significantly before the end of its previously estimated useful life. Recoverability is assessed based on the carrying amount of the asset and the sum of the undiscounted cash flows expected to result from the use and the eventual disposal of the asset or asset group. An impairment loss is recognized when the carrying amount is not recoverable and exceeds the fair value of the asset or asset group. The impairment loss is measured as the amount by which the carrying amount exceeds fair value. During each of the years ended December 31, 2010, 2009, and 2008, no events or circumstances occurred that indicated that the carrying amounts of the long-lived assets may not be recoverable.
Goodwill is the residual amount that results when the purchase price of an acquired business exceeds the sum of the amounts allocated to the identifiable assets acquired, less liabilities assumed, based on their fair values. Goodwill is allocated to the Company’s reporting unit that is expected to benefit from the business combination as of the date of the business combination.
Circumstances that could trigger an interim impairment test include: a significant adverse change in the business climate or legal factors; an adverse action or assessment by a regulator; unanticipated competition; the loss of key personnel; a change in reportable segments; the likelihood that a reporting unit or significant portion of a reporting unit will be sold or otherwise disposed of; the results of testing for recoverability of a significant asset group within a reporting unit; and the recognition of a goodwill impairment loss in the financial statements of a subsidiary that is a component of a reporting unit.
The impairment test is carried out in two steps. In the first step, the carrying amount of the reporting unit is compared with its fair value. When the fair value of a reporting unit exceeds its carrying amount, goodwill of the reporting unit is considered not to be impaired and the second step of the impairment test is unnecessary. The second step is carried out when the carrying amount of a reporting unit exceeds its fair value, in which case the implied fair value of the reporting unit’s goodwill is compared with its carrying amount to measure the amount of the impairment loss, if any. The implied fair value of goodwill is determined in the same manner as the value of goodwill is determined in a business combination using the fair value of the reporting unit as if it was the purchase price. When the carrying amount of reporting unit goodwill exceeds the implied fair value of the goodwill, an impairment loss is recognized in an amount equal to the excess and is presented as a separate line item in the consolidated statements of operations. The Company completed its goodwill impairment test for 2010 and determined no impairment existed. Based on the testing results, an impairment in the near future is not considered reasonably likely. The Company previously completed the impairment test in 2009 and 2008 and concluded no impairment existed.
remaining customer relationships are currently amortized over either five years or ten years on a straight-line basis. The remaining intangible assets are amortized on a straight-line basis over 1 to 15 years.
The Company requires deposits from certain customers in order to satisfy liabilities incurred by the Company on the customer’s behalf for the adjudication of pharmacy claims. Customer deposits totalled $15.4 million and $14.8 million as of December 31, 2010 and 2009, respectively.
The Company administers a rebate program through which it receives rebates and administrative fees from pharmaceutical manufacturers and third party administrators that are shared with a majority of the Company’s customers. The rebates earned for the administration of the program are recorded as a reduction of cost of revenue and the portion of the rebate payable to customers is treated as a reduction of revenue. Rebates receivable include billed and unbilled PBM receivables from pharmaceutical manufacturers and third party administrators. The Company records the gross rebate receivable and the related payable to the customers based on estimates, which are subject to final settlement due to the required validation of claims data submitted to the pharmaceutical manufacturers and third party administrators, as well as contingent items contained in the total calculation for rebates earned. The estimates are based upon claims submitted and the Company’s rebate contracts, and are adjusted as additional information becomes available. Upon billing the pharmaceutical manufacturer or third party administrator, any difference between the Company’s estimate and the actual amount of the rebate receivable is recorded to cost of revenue, net of the estimated impact to the Company’s customers. The Company generally pays rebates to its customers on a quarterly basis, or as agreed upon with its customers. There are certain instances where the Company pays rebates to its customers on a more accelerated basis.
In late 2008, the Company entered into new contracts for manufacturer rebates and currently only acts as the principal contracting party. Prior to entering into the new contracts, the Company had two rebate programs. In one of the programs the Company acted as an agent for its customers, and in the other as a principal, as it acts in the current rebate program.
Basic earnings per share (“EPS”) is computed by dividing net income by the weighted-average number of common shares outstanding for the period. Diluted EPS is computed by dividing net income by the weighted-average number of common shares adjusted for the dilutive effect of outstanding stock-based awards. The dilutive effect is calculated by assuming that the proceeds from the exercise of in-the-money stock options were used to acquire shares of common stock at the average market price for the period.
Effective January 1, 2010, the Company adopted the amendment to revenue recognition guidance for transactions with multiple deliverables. The updated accounting guidance changes the criteria necessary for a delivered item to be considered a separate element by removing the requirement of using objective and reliable evidence of fair value in determining the amount of revenue to recognize. In place of having objective and reliable evidence of fair value for delivered and undelivered elements, a company may use its best estimate of selling price to determine the amount of revenue to recognize. The new guidance did not have a material impact on the Company’s financial results.
Effective January 1, 2010, the Company adopted the amended revenue recognition guidance for transactions involving tangible products that have software components. The new accounting guidance removes the non-software components and software elements of the tangible product from the scope of software revenue recognition accounting guidance. The new guidance did not have a material impact on the Company’s financial results.
The acquisition of MedfusionRx will help transform the Company's Specialty Service pharmacy business by expanding its presence and enhancing its capabilities in this rapidly growing segment of the PBM industry. The acquisition will also provide an opportunity to create new revenues and generate cost savings through purchasing synergies.
The MedfusionRx purchase agreement includes contingent purchase price consideration in the form of an earn-out payment of up to $5.5 million contingent upon the MedfusionRx book of business meeting or exceeding certain gross profit targets for the 2012 fiscal year. The $4.9 million fair-value of the contingent purchase price was accrued at the date of acquisition as part of the total consideration transferred. The Company utilized a probability weighted discounted cash flow method to arrive at the fair value of the contingent consideration. The Company will continue to reassess the fair value of the contingent purchase price until the applicable earn-out period has lapsed. Any future changes to the fair value of the contingent purchase price will be recognized in earnings of the Company. As the fair value measurement for the contingent consideration is based on inputs not observed in the market, the measurement is classified as a Level 3 measurement as defined by fair value measurements guidance.
The MedfusionRx acquisition was accounted for under the acquisition method of accounting with the Company treated as the acquiring entity. Accordingly, the consideration paid by the Company to complete the acquisition has been allocated to the assets acquired and liabilities assumed based upon their estimated fair values as of the date of acquisition. The excess of the purchase price over the estimated fair values of the net assets acquired was recorded as goodwill. All of the assets and liabilities recorded for the MedfusionRx acquisition are included within the Company's PBM segment. Goodwill is non-amortizing for financial statement purposes and the entire goodwill balance generated from the MedfusionRx acquisition is tax deductible.
The following summarizes the preliminary fair values assigned to the assets acquired and liabilities assumed at the acquisition date and are subject to change. The purchase price allocation and related valuation process are not complete. Final determination of the fair value may result in further adjustments to the amounts presented below (in thousands):
During the year ended December 31, 2010, the Company did not recognize any amortization expense from intangible assets acquired due to the timing of when the acquisition of MedfusionRx closed. Amortization related to the intangible assets acquired from the MedfusionRx acquisition is expected to be $7.0 million in 2011.
The following unaudited pro forma financial information presents the combined historical results of operations of the Company and MedfusionRx as if the acquisition had occurred on the first day of the comparable period presented. The unaudited pro forma financial information includes certain adjustments related to the acquisition, such as increased amortization from the fair value of intangible assets acquired recorded as part of the purchase accounting, and consequential income tax effects from the acquisition. Unaudited pro forma results of operations are as follows (dollars in thousands, except share and per share amounts):
This unaudited pro forma financial information is not intended to represent or be indicative of what would have occurred if the transaction had taken place on the dates presented and is not indicative of what the Company’s actual results of operations would have been had the acquisition been completed at the beginning of the periods indicated above. Further, the pro forma combined results do not reflect one-time costs to fully merge and operate the combined organization more efficiently, or anticipated synergies expected to result from the combination and should not be relied upon as being indicative of the future results that the Company will experience.
The Company and NMHC have similar missions and core values, and the Company believes the synergies gained from this business combination will create long-term value for customers, vendors and shareholders, as well as opportunities for new and existing employees by making the Company better positioned to compete in the changing PBM environment.
Direct costs of the acquisition include investment banking fees, legal and accounting fees and other external costs directly related to the acquisition.
The acquisition was accounted for under the purchase method of accounting with the Company treated as the acquiring entity. Accordingly, the consideration paid by the Company to complete the acquisition has been allocated to the assets acquired and liabilities assumed based upon their estimated fair values as of the date of acquisition. The excess of the purchase price over the estimated fair values of the net assets acquired and liabilities assumed was recorded as goodwill and allocated to the Company's PBM segment. Goodwill is non-amortizing for financial statement purposes and is not tax deductible. The changes in goodwill from December 31, 2008 are primarily due to deferred tax adjustments, changes in the estimated fair value of acquired fixed assets, and revisions to the estimated fair values of assumed liabilities related to the NMHC acquisition. During the third quarter of 2009, the Company recorded an adjustment to goodwill and deferred tax liabilities. The adjustment decreased goodwill and decreased deferred tax liabilities (non-current) by approximately $2.1 million.
The following summarizes the final fair values assigned to the assets acquired and liabilities assumed at the acquisition date (in thousands):
management tools to approximately 45 health plan and PBM customers. The zynchros.com platform helps payors to effectively manage their formulary programs, and to maintain Medicare Part D compliance of their programs. The Company recorded identifiable intangible assets of $1.7 million with estimated useful lives of 4 to 5 years and goodwill of $2.4 million associated with the acquisition. The goodwill acquired was allocated to the Company’s HCIT segment. Zynchros results of operations are included in the 2008 consolidated statement of operations for the period from December 19, 2008 through December 31, 2008 and were not material to the Company’s results of operations for the twelve months then ended.
Net property and equipment was made up of the following at December 31, 2010 and 2009:
Depreciation expense, including property and equipment acquired under capital leases, totaled $8.4 million, $8.0 million, and $6.6 million for the years ended December 31, 2010, 2009, and 2008, respectively. Of the total depreciation expense, $2.4 million, $2.2 million, and $1.8 million was related to the data center operations and allocated to cost of revenue for the years ended December 31, 2010, 2009 and 2008, respectively.
Future amortization associated with intangible assets at December 31, 2010 is estimated to be $14.2 million in 2011, $11.5 million in 2012, $9.6 million in 2013, $8.2 million in 2014, $6.0 million in 2015 and $6.7 million for years after 2015.
The Company repaid the entire outstanding principal under the Term Loan Facility on December 31, 2009. In exchange for a payment of $45.6 million, the Company was relieved of its future obligations to the lender. The Company also cancelled the Revolving Credit Facility on the same date. There was no gain or loss on extinguishment of the principal balance of the debt when it was repaid to the lender; however, the Company recorded a charge of $1.1 million to interest expense upon the extinguishment to expense the unamortized financing costs related to the Credit Facilities. The financing costs initially were $1.8 million and had been presented on the consolidated balance sheet as deferred financing charges. These costs were previously amortized into interest expense over the life of the loan using the effective interest method.
On September 23, 2009, the Company completed a public offering of 10,350,000 shares of its common stock. The shares were offered to the public at a price of $20.75 per share. The gross proceeds to the Company from the offering totalled $214.8 million, excluding $11.7 million for underwriting discounts and commissions, and other offering costs.
Effective on March 11, 2009, the Board of Directors of the Company adopted the SXC Health Solutions Corp. Long-term Incentive Plan (the “LTIP”), which was approved by the shareholders of the Company at the Annual and Special Meeting of Shareholders on May 13, 2009. The LTIP provides for the grant of stock option awards, stock appreciation rights, restricted stock awards, restricted stock unit awards, performance awards and other stock-based awards to eligible persons, including executive officers and directors of the Company. The purpose of the LTIP is to advance the interests of the Company by attracting and retaining high caliber employees and other key individuals who perform services for the Company, a subsidiary or an affiliate; align the interests of the Company’s shareholders and recipients of awards under the LTIP by increasing the proprietary interest of such recipients in the Company’s growth and success; and motivate award recipients to act in the best long-term interest of the Company and its shareholders. The LTIP provides for a maximum of 2,140,000 common shares of the Company to be issued in addition to the common shares that remained available for issuance under the previous option plan (the “Plan”).
committee. Options issued under the LTIP entitle holders to purchase one common share as defined by the LTIP.
The LTIP replaced the Plan, and no further grants or awards will be issued under the Plan. At December 31, 2010, 3,524,177 common shares had been reserved for issuance under the LTIP and the Plan.
The following table summarizes the information about the Canadian dollar stock options outstanding at December 31, 2010 in Canadian dollars:
The total fair value of Canadian stock options which vested during the years ended December 31, 2010, 2009, and 2008 was as follows (in thousands):
As of December 31, 2010, there was no unrecognized compensation cost related to Canadian dollar stock options as all options were fully vested.
2010, 2009, and 2008. The Company began issuing these stock options subsequent to May 2007:
U.S. dollar options granted during 2010, 2009, and 2008 were primarily subject to a graded vesting schedule of four years. U.S. dollar options granted expire five to seven years from the grant date.
The aggregate intrinsic value and remaining contractual term of exercisable stock options at December 31, 2010 was $15.2 million and 2.16 years, respectively. The aggregate intrinsic value and remaining contractual term of all vested options and options that are expected to vest are $46.1 million and 3.19 years, respectively. The intrinsic value of options exercised during 2010 and 2009 was $17.5 million and $2.5 million, respectively. There were no options exercised during 2008. The total fair value of stock options which vested during the years ended December 31, 2010, 2009, and 2008 was approximately $2.3 million, $1.6 million, and $0.8 million, respectively.
As of December 31, 2010, there was $4.8 million of unrecognized compensation cost related to U.S. dollar stock options which is expected to be recognized over a weighted-average period of 1.2 years.
On May 16, 2007, shareholders of the Company approved the creation of the Employee Stock Purchase Plan (“ESPP”) which allows eligible employees to withhold annually up to a maximum of 15% of their base salary, or $25,000, subject to U.S. Internal Revenue Service limitations, for the purchase of the Company’s common shares. Common shares will be purchased on the last day of each offering period at a discount of 5% of the fair market value of the common shares on such date. The aggregate number of common shares that may be awarded under the ESPP may not exceed 200,000 common shares.
In September 2008, the Company granted an additional 102,000 RSUs with a grant date fair value of $7.95 per share to certain new employees who were previous employees of NMHC. These restricted stock units vest in one-fourth increments on each grant date anniversary.
During 2010, the Company granted 131,520 time-based RSUs and 116,480 performance based RSUs to its employees and non-employee directors with an average grant date fair value of $32.20. During 2009, the Company granted 203,870 time-based RSUs and 140,540 performance based RSUs to its employees and non-employee directors with an average grant date fair value of $13.11. Time-based RSUs vest on a straight-line basis over a range of three to four years and performance-based RSUs cliff vest based upon reaching agreed upon three-year performance conditions. The number of outstanding performance-based RSUs as of December 31, 2010, assumes the associated performance targets will be met at the maximum level for the performance-based RSUs.
At December 31, 2010, there were 282,232 time-based RSUs and 237,260 performance based RSUs outstanding. The total intrinsic value of RSUs that vested during the year was $4.6 million. At December 31, 2010, there was $8.9 million of unrecognized compensation cost related to RSUs which is expected to be recognized over a weighted-average period of 1.33 years. The following table summarizes the information about RSUs at December 31, 2010, 2009, and 2008:
The Company allocated stock-based compensation costs to the same statement of operations line item as the cash compensation to those employees. Accordingly, the allocation of the compensation costs is as follows for the years ended December 31, 2010, 2009, and 2008 (in thousands):
The total income tax benefit, using the Company’s statutory tax rates, recognized in the statements of operations for stock-based compensation arrangements for years ended December 31, 2010, 2009, and 2008 was $2.2 million, $1.4 million, and $1.5 million, respectively.
The income tax effects of temporary differences that give rise to significant portions of deferred income tax assets and liabilities are as follows.
Income from U.S. operations before income taxes was $92.6 million, $66.8 million, and $12.9 million for the years ended December 31, 2010, 2009 and 2008, respectively. Income from Canadian operations before income taxes, including taxable income attributable to intercompany debt, was $5.0 million, $1.3 million, and $7.4 million for the years ended December 31, 2010, 2009 and 2008, respectively.
U.S. GAAP accounting guidance for uncertain tax positions prescribes a recognition threshold and measurement attribute criteria for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. As of December 31, 2010 and 2009, the Company has an accrued liability in the consolidated balance sheets of $0.6 million and $0.5 million, respectively, related to various uncertain federal and state income tax matters, the resolution of all of which would not have a material impact on the Company’s effective tax rate.
The following table sets forth the computation for basic and diluted EPS for the years ended December 31, 2010, 2009, and 2008 (in thousands, except share and per share data):
(a) The components of cash and cash equivalents are as follows (in thousands):
The Company has a 401(k) savings plan that allows eligible employees to defer a percentage of their salary, not to exceed $16,500 in 2010 and 2009 and $15,500 in 2008. The Company matches an amount equal to 100% of the first 1% of eligible earnings and 50% of the next 5% of eligible earnings. All participant contributions are 100% vested. Employer contributions become 100% vested after completion of three years of service. For 2010, 2009 and 2008, the Company’s contributions to this plan were $1.7 million, $1.3 million, and $0.8 million, respectively.
The Company manages its business in two segments, PBM and HCIT, and evaluates segment performance based on revenue and gross profit.
Revenue primarily consists of sales of prescription drugs, together with any associated administrative fees, to customers and participants, either through the Company’s nationwide network of pharmacies, Mail Service pharmacy or Specialty Service pharmacy. Revenue related to the sales of prescription drugs is recognized when the claims are adjudicated and the prescription drugs are shipped. Claims are adjudicated at the point-of-sale using an on-line processing system.
All revenues of the Company are primarily earned in the United States. The Company’s Canadian operations represented less than 1% of the Company’s consolidated revenues for the years ended December 31, 2010, 2009 and 2008.
During the year ended December 31, 2010, one customer accounted for 10.5% of revenue. During the year ended December 31, 2009, one customer accounted for 12.6% of total revenue and another for 11.7% of total revenue. During the year ended December 31, 2008, one customer accounted for 12.3% of total revenue and another for 11.2% of total revenue. In 2010, 2009 and 2008, these major customers were included in the PBM segment.
At December 31, 2010 and 2009, no one customer accounted for more than 10% of the total accounts receivable balance.
To protect itself against the interest rate exposures, and pursuant to the terms of the Company’s $48 million credit agreement, the Company entered into interest rate contracts with notional amounts equal to 50% of the borrowed amount, or $24 million, for a three-year period from the date of issue. The Company entered into a 3-year interest rate swap agreement with a notional amount of $14 million to fix the LIBOR rate on $14 million of the term loan at 4.31%, resulting in an effective rate of 7.56% after adding the 3.25% margin per the credit agreement. Under the interest rate swap, the Company received LIBOR-based variable interest rate payments and made fixed interest rate payments, thereby creating the equivalent to fixed-rate debt. Additionally, the Company entered into a 3-year interest rate cap with a notional amount of $10 million to effectively cap the LIBOR rate on $10 million of the term loan at 4.50%, resulting in a maximum effective rate of 7.75% after adding the 3.25% margin per the credit agreement, excluding the associated fees. These instruments were designated as cash flow hedges during 2008.
As of December 31, 2010, both derivative instruments are “out of the money” and the Company is not currently exposed to any credit risk for amounts reflected on the consolidated balance sheet should the counterparty in the agreement fail to meet its obligations under the agreement. The Company does not anticipate the instruments coming “out of the money” prior to their expiration in 2011. To manage credit risks, the Company selects counterparties based on credit assessments, limits overall exposure to any single counterparty, and monitors the market position with each counterparty. The Company assesses interest rate cash flow risk by continually identifying and monitoring changes in interest rate exposures that may adversely impact expected future cash flows and by evaluating hedging opportunities. The Company does not enter into derivative instruments for any purpose other than hedging identified exposures. That is, the Company does not speculate using derivative instruments and has not designated any instruments as fair value hedges or hedges of the foreign currency exposure of a net investment in foreign operations.
When available and appropriate, the Company uses quoted market prices in active markets to determine fair value, and classifies such items within Level 1. Level 1 values include instruments traded on a public exchange. Level 2 inputs are inputs other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly, for substantially the full term of the financial instrument. Level 2 inputs include quoted prices for similar assets or liabilities in active markets, quoted prices for identical or similar assets or liabilities in markets that are not active, or inputs other than quoted prices that are observable for the asset or liability or can be derived principally from or corroborated by observable market data. If the Company were to use one or more significant unobservable inputs for a model-derived valuation, the resulting valuation would be classified in Level 3.
the opportunity to earn an additional $5.5 million in cash, subject to the satisfaction of certain performance targets in the 2012 fiscal year. The $4.9 million fair-value of the contingent purchase price was accrued at the date of acquisition as part of the total consideration transferred. The Company utilized a probability weighted discounted cash flow method to arrive at the fair value of the contingent consideration based on the expected results of Medfusion in 2012. As the fair value measurement for the contingent consideration is based on inputs not observed in the market, the measurement is classified as a Level 3 measurement as defined by fair value measurements guidance. There were no adjustments to the fair value of the contingent purchase price between the date of acquisition and the year end of the Company.
The Company has classified derivative liabilities as accrued liabilities as of December 31, 2010 and as other noncurrent liabilities at December 31, 2009 in the consolidated balance sheets. The fair values represent quoted prices from a financial institution which are derived from movements in the underlying interest rate markets. The total fair value was $0.3 million and $0.7 million for the years ended December 31, 2010 and 2009, respectively, and was mostly recognized as other (income) expense in the consolidated statement of operations.