Our Maryland Heights, Missouri facility houses our corporate offices and our Specialty Distribution Services operations. We believe our facilities have been well maintained and are in good operating condition. Our existing facilities comprise approximately 1,950,000 square feet in the aggregate.
We own and lease computer systems at the processing centers. In late 1999, we entered into a five-year agreement with EDS to outsource our information systems operations. EDS has responsibility for operating and maintaining the computer systems. Our software for claims processing and drug utilization review and other products has been developed internally by us or purchased under perpetual, nonexclusive license agreements with third parties. Our computer systems at each site are extensively integrated and share common files through local and wide area networks. Uninterruptable power supply and diesel generators allow our computers, telephone systems and mail pharmacy at each major site to continue to function during a power outage. To protect against loss of data and extended downtime, we store software and redundant files at both on-site and off-site facilities on a regular basis and have contingency operation plans in place. We cannot, however, provide any assurance that our contingency or disaster recovery plans would adequately address all relevant issues.
We report two segments, PBM and non-PBM. We derive revenues primarily from the sale of PBM services in the United States and Canada. Revenue generated by our segments can be classified as tangible product revenue or service revenue. We earn tangible product revenue from the sale of prescription drugs by retail pharmacies in our retail pharmacy networks and from dispensing prescription drugs from our mail pharmacies. Service revenue includes administrative fees associated with the administration of retail pharmacy networks contracted by certain clients, market research programs, informed decision counseling services, certain SDS services, and sample fulfillment and sample accountability services by PMG. Tangible product revenue generated through both our PBM and non-PBM segments represented 98.6% of revenues for the year ended December 31, 2002 as compared to 98.3% and 98.6%, respectively, for the years ended December 31, 2001 and 2000.
The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Our estimates and assumptions are based upon a combination of historical information and various other assumptions believed to be reasonable under the particular circumstances. Actual results may be different from our estimates. Certain of the accounting policies that most impact our consolidated financial statements and that require our management to make difficult, subjective or complex judgments are described below. This should be read in conjunction with Note 1, “Summary of Significant Accounting Policies” and with the other notes to the consolidated financial statements.
If we merely administer a client’s network pharmacy contracts to which we are not a party and under which we do not assume credit risk, we record only our administrative fees as revenue. For these clients, we earn an administrative fee for collecting payments from the client and remitting the corresponding amount to the pharmacies in the client’s network. In these transactions we act as a conduit for the client. Because we are not the principal in these transactions, drug ingredient cost is not included in our revenues or in our cost of revenues.
Certain implementation and other fees paid to clients upon the initiation of a contractual agreement are considered an integral part of overall contract pricing and are recorded as a reduction of revenue. Where they are refundable upon cancellation, these payments are capitalized and amortized as a reduction of revenue on a straight-line basis over the life of the contract.
As mentioned previously, we administer two rebate programs through which we receive rebate and administrative fees from pharmaceutical manufacturers. Rebates earned for the administration of these programs performed in conjunction with claim processing services provided to clients, are recorded as a reduction of cost of revenue. Manufacturer rebates and associated administrative fees are recognized as earned when the prescriptions covered under contractual agreements with the manufacturers are dispensed. These revenues are not dependent upon future pharmaceutical sales. With respect to rebates based on actual market share performance, we estimate rebates receivable from pharmaceutical manufacturers on a quarterly basis based on our estimate of the number of rebatable prescriptions and the rebate per prescription. These estimates are adjusted to actual when the number of rebatable prescriptions and rebate per prescription have been determined and the billing to the manufacturers has been completed. With respect to rebates that are not based on market share performance, no estimation is required because the manufacturer billing amounts are determinable when the drug is dispensed. We share all or a portion of rebates with clients.
Revenues for network pharmacy claims increased $2,437,545,000 or 40.8% in 2002 over 2001 and $1,812,736,000, or 43.5%, in 2001 over 2000. The increase in 2002 network pharmacy claims revenue over 2001 is due to higher drug ingredient costs, the acquisition of NPA, an increase in the rate of utilization of prescription drugs by members and a higher mix of clients utilizing retail pharmacy networks contracted by us versus retail pharmacy networks contracted by the client. As previously discussed under “-Critical Accounting Policies,” when clients utilize our retail pharmacy networks, we record ingredient cost charged to clients in revenue and the corresponding ingredient cost paid to network pharmacies in cost of revenue. The increase in drug ingredient costs is primarily attributable to increases in the average wholesale price index used to calculate payments due to pharmacies and payments due from clients. Network pharmacy claims processed increased 20.7% to 354,890,000 in 2002 over 2001. Excluding NPA, network pharmacy claims processed increased 10.1% over 2001. The increase in network pharmacy claims revenue in 2001 over 2000 is primarily due to a higher mix of clients utilizing our retail pharmacy networks, increased membership and member utilization, and higher drug ingredient costs.
Included in PBM revenues are amounts received from pharmaceutical manufacturers in support of certain programs, such as our Drug Choice Management Program and our Therapy Adherence Program. Such programs support our clients’ formulary choices. These payments are not part of our rebate program. When we receive manufacturer support for these programs, we disclose in our program communications that one or more manufacturers have provided financial support for the program. We have been phasing out manufacturer funding for these programs, and such funding will be completely phased out by October 1, 2003. We will continue to provide formulary support programs without this targeted manufacturer funding. Manufacturer funding for these programs totaled $22,538,000, $24,705,000, and $30,427,000, respectively, for 2002, 2001 and 2000.
Other revenue decreased $10,423,000 in 2001 from 2000 due to the restructuring of an agreement with PlanetRx.com, Inc. (“PlanetRx”) in July 2000. Other revenue in 2000 included a $4,300,000 fee from PlanetRx to terminate the prior contract and no additional cash payments were made to us under the restructured agreement.
We have been successful in offsetting margin pressure due to lower pricing on administrative fees and other clinical programs with higher profits from increased utilization of our mail service pharmacies, increased utilization of generic drugs and improved formulary compliance, and we expect these trends to continue. Our PBM gross profit increased $209,139,000 or 36.7% in 2002 over 2001 and $57,798,000 or 11.3% in 2001 over 2000. A portion of the 2002 increases resulted from the acquisition of NPA, the increase in the average wholesale price index and the contract renegotiation with a large client in the first quarter of 2002, discussed above. In addition, increases in 2002 and 2001, were partially the result of increased mail utilization and a shift to utilization of generic versus brand drugs, on which we earn higher margins. For 2002, generic drugs comprised 44.2% of all prescriptions compared to 41.1% in 2001.
Non-PBM cost of revenues and gross profit increased 147.8% and 69.8%, respectively, in 2002 as compared to 2001, reflecting the increased volume in SDS and the addition of PMG. The percentage increase in non-PBM cost of revenues grew faster than the percentage increase in revenues due to the additional volume in the sample card program (discussed above) and other specialty distribution programs where we include the ingredient costs of pharmaceuticals in our SDS revenues and cost of revenues. The percentage increase in the non-PBM cost of revenues was partially offset by PMG, which does not purchase samples from the manufacturers, but records an administrative fee for verification of practitioner licensure and distribution of samples to doctors based on orders received from pharmaceutical sales representatives. As with revenues, the 2002 increases in cost of revenues and gross profit were partially offset by the discontinuance of our acute home infusion services business in mid-2001. Cost of revenues for non-PBM services decreased 21.2% in 2001 as compared to 2000, while non-PBM revenues decreased only 15.6% primarily due to the discontinuance of our acute home infusion services, which was less profitable than our SDS business.
As compared to 2000, selling, general and administrative expenses increased $19,936,000, or 5.9%, in 2001. The increases are primarily due to expenditures required to support the continued growth and development of our pharmacy benefit management. These increases were partially offset by a net decrease in depreciation and amortization expense. Increases in depreciation and amortization associated with additional property and equipment placed into service was more than offset by a decrease in amortization expense related to the UnitedHealthcare customer contract intangible asset, which fully amortized in 2000.
Therefore, at December 31, 2002 and 2001 we own approximately 1,096,000 common shares, or 1.8% and 17.8%, respectively, of PlanetRx (after giving effect to the December 4, 2000 8-for-1 reverse stock split) which are carried at no value.
Our effective tax rate decreased to 38.2% in 2002 from 39.9% in 2001. The decrease is primarily due to the adoption of FAS 142, which eliminated the amortization of goodwill, a portion of which is non-deductible. Our effective tax rate of 39.9% for 2001 reflects the benefit of lower taxes paid in several states and a decrease in non-deductible goodwill as a percentage of taxable income. Our $165,207,000 write-off of marketable securities in 2000 (see “-Other (Expense) Income, net”), resulted in a pre-tax loss of $4,468,000. Despite the $62,118,000 tax benefit arising from the write-off, we had a tax provision of $3,553,000 reflecting tax expense on non-deductible goodwill and customer contract amortization as well as expense of $574,000 from the ordinary gain on the restructuring of our swaps in 2000 (see “-Other (Expense) Income, net”).
Basic and diluted earnings per share increased 62.5% and 63.5%, respectively for the twelve months ended December 31, 2002 over 2001. Excluding goodwill amortization, our net income increased $51,837,000 or 34.3% in 2002 over 2001 while basic and diluted earnings per share increased 34.0% and 34.9% in 2002 over 2001, respectively. Excluding goodwill amortization in 2001 and 2000, our net income increased $134,417,000 in 2001 over 2000 while basic and diluted earnings per share increased $1.72 and $1.68, respectively.
Our 2001 net income increased $133,826,000 from a loss of $9,126,000 in 2000. Net income for 2000 was affected by the following one-time items:
A non-cash impairment charge during the second and fourth quarters of 2000 totaling $165,207,000 ($103,089,000 net of tax) relating to our PlanetRx investment (see “-Other (Expense) Income, net”)
During 2002, net cash provided by operations increased $144,980,000 to $425,970,000 from $280,990,000 in 2001. This increase is primarily due to changes in our results of operations and management of working capital. In addition, net cash provided by operations in 2001 was negatively impacted by the termination of a large contract in late 2000, which resulted in the payment of remaining liabilities during the first and second quarters of 2001. During 2001, net cash provided by operations increased $35,080,000 to $280,990,000 from $245,910,000 in 2000.
We established the Express Scripts Foundation, an independent charitable foundation, in 2001. During 2002, we recorded, as selling, general and administrative expense, charitable contributions of approximately $13.8 million, the majority of which was contributed to the Express Scripts Foundation. The Company has no commitment to make future contributions to the Foundation; we expect any future contributions would be funded from operating cash flow.
On December 19, 2002, we entered into an agreement with MPB under which we acquired certain assets from MPB for approximately $14.0 million in cash and entered into an outsourcing arrangement with respect to MPB’s operations. MPB is a St. Louis-based pharmacy benefit manager and subsidiary of Medicine Shoppe International, Inc., a franchisor of apothecary-style retail pharmacies, owned by Cardinal Health, Inc. MPB processes approximately 6.0 million retail claims and 85,000 mail order claims annually. The transaction was accounted for under the provisions of FAS 141, “Business Combinations.” The purchase price has been preliminarily allocated based upon the estimated fair value of net assets acquired at the date of the acquisition. A portion of the excess of purchase price over tangible net assets acquired has been preliminarily allocated to intangible assets other than goodwill in the amount of $2,526,000. This asset is included in other intangible assets on the balance sheet and is being amortized using the straight-line method over the estimated useful life of 20 years. In addition, the excess of the purchase price over tangible net assets and identified intangible assets acquired has been preliminarily allocated to goodwill in the amount of $15,000,000, which is not being amortized. The transaction was structured as a purchase of assets, making amortization expense of intangible assets, including goodwill, tax deductible.
On April 12, 2002, we completed the acquisition of NPA, a privately held full-service PBM, for a purchase price of approximately $466 million, which includes the issuance of 552,000 shares of our common stock (fair value of $26.4 million upon the transaction announcement date), transaction costs and a working capital purchase price adjustment of $46.8 million received during the third and fourth quarter of 2002. The transaction was accounted for under the provisions of FAS 141. The purchase price has been preliminarily allocated based upon the estimated fair value of net assets acquired at the date of the acquisition. A portion of the excess of purchase price over tangible net assets acquired has been preliminarily allocated to intangible assets consisting of customer contracts in the amount of $76,290,000 and non-competition agreements in the amount of $2,860,000, which are being amortized using the straight-line method over the estimated useful lives of 20 years and five years, respectively. These assets are classified as other intangible assets. In addition, the excess of the purchase price over tangible net assets and identified intangible assets acquired has been preliminarily allocated to goodwill in the amount of $398,835,000, which is not being amortized.
The acquisition of NPA was funded with the proceeds of a new $325 million Term B loan facility, $78 million of cash on hand, the issuance of 552,000 shares of our common stock (fair value of $26.4 million upon the transaction announcement date), and $25 million in borrowings under our revolving credit facility. We have filed an Internal Revenue Code Section 338(h)(10) election, making amortization expense of intangible assets, including goodwill, tax deductible. We estimate this election will provide a tax benefit to us of approximately $85 million on a present value basis.
On February 25, 2002, we purchased substantially all of the assets utilized in the operation of Phoenix Marketing Group, a wholly-owned subsidiary of Access Worldwide Communications, Inc. for $34.1 million in cash, including acquisition-related costs, plus the assumption of certain liabilities. Phoenix Marketing Group is one of the largest prescription drug sample fulfillment and sample accountability companies. The acquisition has been accounted for under the provisions of FAS 141. The purchase price has been preliminarily allocated based upon the estimated fair value of net assets acquired at the date of the acquisition. The excess of purchase price over tangible net assets acquired has been preliminarily allocated to intangible assets consisting of customer contracts in the amount of $4,000,000 and non-competition agreements in the amount of $180,000 which are being amortized using the straight-line method over the estimated lives of eight years and four years, respectively, and trade name in the amount of $1,700,000, which is not being amortized. These assets are included in other intangible assets. In addition, the excess of purchase price over tangible net assets acquired was preliminarily allocated to goodwill in the amount of $22,136,000, which is not being amortized. The transaction was structured as a purchase of assets, making amortization expense of intangible assets, including goodwill, tax deductible.
During 2002, we utilized internally generated cash to prepay the remaining $105 million of our Term A loans and amended our existing credit facility to add a $325 million Term B loan to fund the acquisition of NPA. At December 31, 2002, our credit facility with a commercial bank syndicate consists of $325 million of Term B loans and a $150 million revolving credit facility (of which nothing is outstanding at December 31, 2002). As a result of the Term A debt prepayments during 2002, we recorded an extraordinary charge of $1,027,000, net of tax. During 2001, we prepaid $50 million of our Term A loans and recorded an extraordinary charge of $372,000, net of tax. Additional debt prepayments, if any, will be made in such amounts and at such times as we deem appropriate based upon prevailing market and business conditions. The revolving credit facility matures on March 31, 2005. The Term B loan has a maturity of six years and will amortize 1% in years one through four, 25% in year five and 71% in year six. The capital stock of most of our existing and subsequently acquired domestic subsidiaries has been pledged as collateral for the credit facility.
On February 7, 2003, we prepaid $25 million of our Term B loan. The prepayment will reduce debt the principle amounts that mature in 2003 through 2007.
Our credit facility requires us to pay interest quarterly on an interest rate spread based on several London Interbank Offered Rates (“LIBOR”) or base rate options. Using a LIBOR spread, the Term B loans have an interest rate of 3.84% at December 31, 2002. The credit facility contains covenants that limit the indebtedness we may incur, the common shares we may repurchase, dividends we may pay and the amount of annual capital expenditures. The covenants also establish a minimum interest coverage ratio, a maximum leverage ratio, and a minimum fixed charge coverage ratio. In addition, we are required to pay an annual fee of 0.25%, payable in quarterly installments, on the unused portion of the revolving credit facility ($150,000,000 at December 31, 2002). During 2002, the lenders approved the amendment of certain covenants, relating to restricted junior payments and asset sales, and a provision enabling a future accounts receivable securitization facility. At December 31, 2002, we were in compliance with all covenants associated with the credit facility.
To alleviate interest rate volatility on our Term A and Term B loans, we have entered into interest rate swap arrangements, which are discussed in “-Market Risk” below.
In June 1999, we issued $250 million of 9.625% Senior Notes due 2009, of which approximately $10.1 million was repurchased on the open market during 2000. The Senior Notes, which require interest to be paid semi-annually on June 15 and December 15, are callable at 104.8% beginning in June 2004. The call payment premium decreases to 103.2% in June 2005, to 101.6% in June 2006, and beginning in June 2007 are callable at 100.0%. The Senior Notes are unconditionally and jointly and severally guaranteed by most of our wholly-owned domestic subsidiaries. The Senior Note indenture contains covenants that limit the indebtedness we may incur, the common shares we may repurchase, dividends we may pay, certain investing activity, and the amount of annual capital expenditures. The covenants also establish a minimum interest coverage ratio.
Contractual bligations Total 2004 - 2005 2006 - 2007 AFTER 2007
FAS 142 requires goodwill no longer be amortized. Instead, all goodwill (including goodwill associated with acquisitions consummated prior to the adoption of FAS 142) is to be evaluated for impairment annually or when events or circumstances occur indicating goodwill might be impaired. All goodwill impairment losses are to be presented as a separate line item in the operating section of the consolidated results of operations (unless the impairment loss is associated with a discontinued operation or the initial adoption of FAS 142, which would be recorded as a change in accounting principle). In accordance with the implementation provisions of FAS 142, we completed our transitional impairment test under FAS 142 during the second quarter of 2002, and our first annual impairment test during the fourth quarter of 2002, neither of which indicated any impairment.
In July 2001, FAS 143, “Accounting for Asset Retirement Obligations” was issued. SFAS 143 addresses the financial accounting and reporting for obligations associated with the retirement of tangible long-lived assets and the associated asset retirement costs. FAS 143 requires the capitalization of any retirement costs as part of the total cost of the related long-lived asset and the subsequent allocation of the total expense to future periods using a systematic and rational method. FAS 143 is effective for fiscal years beginning after June 15, 2002. We have not determined the impact that this statement will have on our consolidated financial position or consolidated results of operations.
In December 2002, FAS 148, “Accounting for Stock-Based Compensation - Transition and Disclosure - an amendment to FAS 123" was issued. FAS 148 provides alternative methods of transition for companies voluntarily planning on implementing the fair value recognition provisions of FAS 123. The statement also revises the disclosure provisions of FAS 123 to require more prominent disclosure of the method of accounting for stock-based compensation, and requiring disclosure of pro forma net income and earnings per share as if the fair value recognition provisions of FAS 123 had been applied from the original effective date of FAS 123. We have adopted the disclosure provisions of FAS 148 effective in 2002.
Changes in prices charged by manufacturers and wholesalers for pharmaceuticals affect our revenues and cost of revenues. Most of our contracts provide that we bill clients based on a generally recognized price index for pharmaceuticals, and accordingly we have been able to recover price increases from our clients under the terms of our agreements.
We use interest rate swap agreements to manage the impact of interest rate fluctuations on future variable interest payments under our bank credit facility. As of December 31, 2002, we have two swap agreements to fix the variable interest rate payments on approximately $150 million of our debt under our credit facility. Under one of our swap agreements, we agree to receive a variable rate of interest on the notional principal amount of approximately $100 million based upon a three month LIBOR rate in exchange for payment of a fixed rate of 6.25% per annum. The notional principal amount will decrease to $60 million in April 2003 and to $20 million in April 2004 until maturing in April 2005. On October 1, 2002, we entered into a second swap agreement to fix the variable rate interest payments on an additional $50 million of debt under our credit facility. Under this swap agreement, which matures in September 2003, we agree to receive a variable rate of interest on the notional principal of $50 million based upon a three month LIBOR rate in exchange for payment of a fixed rate of 1.66% per annum.
As discussed in Note 1 to the consolidated financial statements, in 2002 the Company changed its method of accounting for goodwill to conform to Statement of Financial Accounting Standards No. 142.
Acquisitions, net of cash acquired, and investment in joint venture (487,982 ) (20,265 ) -
Net cash used in investing activities (548,728 ) (76,719 ) (73,578 )
Earnings per share and weighted average shares oustanding included in Notes to Consolidated Financial Statements have been restated to reflect the two-for-one stock split effective June 22, 2001.
Accounts receivable. Based on our revenue recognition policies discussed below, certain claims at the end of a period are unbilled. Revenue and unbilled receivables for those claims are estimated each period based on the amount to be paid to the pharmacies and historical gross margin. Estimates are adjusted to actual at the time of billing. In addition, revenue and unbilled receivables for rebates based on market share performance are calculated quarterly based on an estimate of rebatable prescriptions and the rebate per prescription. These estimates are adjusted to actual when the number of rebatable prescriptions and the rebate per prescription have been determined and the billing to the manufacturers has been completed. Historically, adjustments to our original estimates have been immaterial. As of December 31, 2002 and 2001, unbilled receivables were $547,686,000 and $435,708,000, respectively. Unbilled receivables are billed to clients typically within 30 days based on the contractual billing schedule agreed upon with the client.
We provide an allowance for doubtful accounts equal to estimated uncollectible receivables. This estimate is based on the current status of each customer’s receivable balance as well as current economic and market conditions. As of December 31, 2002 and 2001, we have an allowance for doubtful accounts of $35,822,000 and $24,157,000, respectively. The increase is primarily due to certain customers who are experiencing financial difficulties in the current economy.
Property and equipment. Property and equipment is carried at cost and is depreciated using the straight-line method over estimated useful lives of seven years for furniture, five years for equipment and purchased computer software and three years for personal computers. Leasehold improvements are amortized on a straight-line basis over the term of the lease or the useful life of the asset, if shorter. Expenditures for repairs, maintenance and renewals are charged to income as incurred. Expenditures that improve an asset or extend its estimated useful life are capitalized. When properties are retired or otherwise disposed of, the related cost and accumulated depreciation are removed from the accounts and any gain or loss is included in income. Research and development expenditures relating to the development of software for internal purposes, are charged to expense until technological feasibility is established. Thereafter, the remaining software production costs up to the date placed into production, are capitalized and included as Property and Equipment. Amortization of the capitalized amounts commences on the date placed into production, and is computed on a product-by-product basis using the straight-line method over the remaining estimated economic life of the product but not more than five years. Reductions, if any, in the carrying value of capitalized software costs to net realizable value are expensed.
Available-for-sale securities are reported at fair value, which is based upon quoted market prices, with unrealized gains and losses, net of tax, reported as a component of other comprehensive income in stockholders’ equity until realized. Unrealized losses are recognized as expense when a decline in fair value is determined to be other than temporary. At December 31, 2002 and 2001, our investment in PlanetRx was the only available-for-sale security we held. During 2000, we recorded a non-cash impairment charge to fully write-off the value of our investment (see Note 3).
Goodwill. During 2002, we adopted FAS 142, “Goodwill and Other Intangible Assets.” In compliance with FAS 142, we stopped amortizing goodwill effective January 1, 2002. Instead, all goodwill (including goodwill associated with acquisitions consummated prior to the adoption of FAS 142) is to be evaluated for impairment annually or when events or circumstances occur indicating that goodwill might be impaired. In accordance with the implementation provisions of FAS 142, we completed our transitional impairment test during the second quarter of 2002, and our first annual impairment test during the fourth quarter of 2002, neither of which indicated any impairment (see Note 2).
Impairment of long lived assets. We evaluate whether events and circumstances have occurred that indicate the remaining estimated useful life of long lived assets, including intangible assets, may warrant revision or that the remaining balance of an asset may not be recoverable. The measurement of possible impairment is based on the ability to recover the balance of assets from expected future operating cash flows on an undiscounted basis. Impairment losses, if any, would be determined based on the present value of the cash flows using discount rates that reflect the inherent risk of the underlying business. No such impairment existed as of December 31, 2002 and 2001.
We administer two rebate programs through which we receive rebates and administrative fees from pharmaceutical manufacturers. We recognize rebates and administrative fees receivable from manufacturers and the corresponding amounts payable to clients when the prescriptions covered under contractual agreements with the manufacturers are dispensed; these revenues are not dependent upon future pharmaceutical sales. When we earn rebates and administrative fees in conjunction with formulary management services, but do not process the underlying claims, we record rebates received from manufacturers, net of the portion payable to customers, in revenue. When we provide formulary management services to a client in conjunction with claims processing, we record rebates and administrative fees received from manufacturers as a reduction of cost of revenues and the portion of the rebate payable to customers is treated as a reduction of revenue. With respect to rebates that are based on actual market share performance, we estimate the portion of rebates payable to clients on a quarterly basis based on historical sharing percentages and our estimate of rebates receivable from pharmaceutical manufacturers. These estimates are adjusted to actual when amounts are received from manufacturers and the portion payable to clients is paid. With respect to rebates that are not based on market share performance, no estimation is required because the client portion is determinable when the drug is dispensed. We share all or a portion of rebates with clients (see further discussion under “- Cost of Revenues”).
Employee stock-based compensation. We account for employee stock options in accordance with Accounting Principles Board No. (“APB”) 25, “Accounting for Stock Issued to Employees.” Under APB 25, we apply the intrinsic value method of accounting and, therefore, have not recognized compensation expense for options granted, because we grant options at a price equal to market value at the time of grant. During 1996, FAS 123, “Accounting for Stock-Based Compensation” became effective for us. FAS 123 prescribes the recognition of compensation expense based on the fair value of options determined on the grant date. However, FAS 123 grants an exception that allows companies currently applying APB 25 to continue using that method. We have, therefore, elected to continue applying the intrinsic value method under APB 25. The following table shows stock-based compensation expense included in net income and pro forma stock-based compensation expense, net income and earnings per share had we elected to record compensation expense based on the fair value of options at the grant date for the years ended December 31, 2002, 2001 and 2000 (see also Note 11):
Comprehensive income. In addition to net income, our components of comprehensive income (net of taxes) are foreign currency translation adjustments, cumulative effect of changes in accounting for derivative financial instruments, realized and unrealized losses on derivative financial instruments designated as cash flow hedges, and unrealized losses on available-for-sale securities. We have displayed comprehensive income within the Statement of Changes in Stockholders’ Equity.
In December 2002, FAS 148, “Accounting for Stock-Based Compensation - Transition and Disclosure - an amendment to FAS 123” was issued. FAS 148 provides alternative methods of transition for companies voluntarily planning on implementing the fair value recognition provisions of FAS 123. The statement also revises the disclosure provisions of FAS 123 to require more prominent disclosure of the method of accounting for stock-based compensation, and requiring disclosure of pro forma net income and earnings per share as if the fair value recognition provisions of FAS 123 had been applied from the original effective date of FAS 123. We have adopted the disclosure provisions of FAS 148 effective in 2002.
The transition provisions of EITF 02-16 require implementation for new arrangements, including modifications of existing arrangements, entered into after December 31, 2002. Early application is permitted as of the beginning of periods for which financial statements have not been issued and prior period reclassification is allowed to the extent there is no impact on net income. The application of the provisions of EITF 02-16 do not change our consolidated net income, consolidated gross profit, consolidated financial position or our consolidated cash flows. We have elected to early adopt the provisions of EITF 02-16. As a result of the adoption, our 2002, 2001 and 2000 revenues have been reduced by $926.8 million, $740.8 million and $810.4 million, respectively, representing the gross amount of rebates and administrative fees received from manufacturers. Cost of revenues have been reduced by the same amounts. We pay the majority of these amounts to our clients and the amounts that we pay over to our clients continue to be recorded as a reduction of revenue. Therefore, consolidated net income and consolidated gross profit have not changed.
In November 2002, the FASB issued Interpretation (“FIN”) No. 45, “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others, and interpretation of FASB Statements No. 5, 57, and 107 and rescission of FASB Interpretation No. 34.” FIN 45 elaborates on the disclosures to be made by a guarantor in interim and annual financial statements about obligations under certain guarantees. It also clarifies that, in certain cases, a guarantor is required to recognize, at the inception of a guarantee, a liability for the fair value of the obligation undertaken in issuing the guarantee. The initial recognition and measurement provisions of FIN 45 are applicable, on a prospective basis, to guarantees issued or modified after December 31, 2002. The disclosure requirements are effective for financial statements of interim or annual periods ending after December 15, 2002. Implementation of FIN 45 is not expected to have a significant impact on our consolidated statement of operations, consolidated financial position or our consolidated cash flows.
The following is a summary of our goodwill and other intangible assets (amounts in thousands).
On April 12, 2002, we completed the acquisition of NPA, a privately held full-service PBM, for a purchase price of approximately $466 million, which includes the issuance of 552,000 shares of our common stock (fair value of $26.4 million upon the transaction announcement date), transaction costs and a working capital purchase price adjustments of $46.8 million received during the third and fourth quarter of 2002. The transaction was accounted for under the provisions of FAS 141. The purchase price has been preliminarily allocated based upon the estimated fair value of net assets acquired at the date of the acquisition. A portion of the excess of purchase price over tangible net assets acquired has been preliminarily allocated to intangible assets consisting of customer contracts in the amount of $76,290,000 and non-competition agreements in the amount of $2,860,000, which are being amortized using the straight-line method over the estimated useful lives of 20 years and five years, respectively. These assets are classified as other intangible assets. In addition, the excess of the purchase price over tangible net assets and identified intangible assets acquired has been preliminarily allocated to goodwill in the amount of $398,835,000, which is not being amortized.
On February 25, 2002, we purchased (through PMG) substantially all of the assets utilized in the operation of Phoenix Marketing Group (Holdings), Inc., a wholly-owned subsidiary of Access Worldwide Communications, Inc. for $34.1 million in cash, including acquisition-related costs, plus the assumption of certain liabilities. PMG, one of the largest prescription drug sample fulfillment and sample accountability companies, works with pharmaceutical manufacturers worldwide to verify practitioner licensure and to deliver sample medicines and clinical information to physicians’ offices. Approximately 83 million and 95 million sample units were shipped by PMG or Phoenix Marketing Group (Holdings), Inc. in 2002 and 2001, respectively.
The following unaudited pro forma information presents a summary of our combined results of operations and those of NPA and Phoenix as if the acquisitions had occurred at the beginning of the periods presented, along with certain pro forma adjustments to give effect to amortization of other intangible assets, interest expense on acquisition debt and other adjustments. The following pro forma financial information is not necessarily indicative of the results of operations as they would have been had the transactions been effected on the assumed date, nor is it necessarily an indication of trends in future results (in thousands, except per share data):
On March 1, 2001, our Canadian subsidiary, ESI Canada, Inc., completed its acquisition of Centre d’autorisation et de paiement des services de sante, Inc. (“CAPSS”), a leading Quebec-based PBM, for approximately CAN$26.8 million (approximately US$17.5 million), which includes a purchase price adjustment for closing working capital. The transaction, which has been accounted for under the purchase method of accounting, was funded with our operating cash flow. The results of operations of CAPSS have been included in the consolidated financial statements and PBM segment since March 1, 2001. The purchase price has been allocated based upon the estimated fair value of net assets acquired at the date of the acquisition. The excess of purchase price over tangible net assets acquired has been allocated to intangible assets consisting of customer contracts in the amount of US$5,149,000 (at the March 1, 2001 exchange rate), which are being amortized using the straight-line methods over the estimated useful life of 20 years and are included in other intangible assets, and goodwill in the amount of US$11,655,000 (at the March 1, 2001 exchange rate), which, effective January 1, 2002, is no longer being amortized. Pro forma information, as if CAPSS had been acquired as of the beginning of the year, is not being presented as the inclusion of CAPSS financial data would not have a material impact to our consolidated financial statements.
On August 31, 1999, we, along with YourPharmacy.com, Inc. (“YPC”), our wholly-owned subsidiary, entered into an Asset Contribution and Reorganization Agreement (the “Contribution Agreement”) with PlanetRx, PRX Holdings, Inc. (“Holdings”), and PRX Acquisition Corp. (“Acquisition Sub”). Pursuant to the Contribution Agreement, YPC agreed to contribute certain operating assets constituting its e-commerce business in prescription and non-prescription drugs and health and beauty aids to Holdings in exchange for 19.9% of the post-initial public offering common equity of Holdings (the “IPO”), and PlanetRx was also to assume certain obligations of YPC. Simultaneously with this transaction, Acquisition Sub was to merge into PlanetRx and PlanetRx shareholders would receive stock in Holdings, which would change its name to “PlanetRx.com, Inc.” As a result of the transactions, YPC would be a 19.9% shareholder in the new PlanetRx (formerly Holdings), which would conduct business as an internet pharmacy.
Effective July 5, 2000, we restructured our agreement with PlanetRx in exchange for a one-time cash payment of $8 million. Approximately $3.7 million of the payment represented amounts earned through the second quarter of 2000, the remaining $4.3 million represented a fee for the termination of the prior contract. No additional cash payments were paid to us under the restructured agreement.
During 2000, we recorded a non-cash impairment charge to write-off our investment in PlanetRx common stock as the loss in value was deemed to be other than temporary. Therefore, any unrealized losses associated with recording our investment in PlanetRx at current market value that we had recorded in stockholders’ equity were written off to the current period earnings, in addition to any additional charges necessary to write-off our investment. Additionally, during 2000 we donated approximately 200,000 shares (after giving effect to the 8-for-1 reverse stock split on December 4, 2000) of PlanetRx common stock and realized expenses related to the donation of approximately $713,000. At December 31, 2002 and 2001 we own approximately 1,096,000 shares, or 1.8% and 17.8%, respectively, (after giving effect to the 8-for-1 reverse stock split on December 4, 2000) of PlanetRx which are carried at no value.
In March 2002, we renegotiated certain terms of our relationship with Manufacturer's Life Insurance Company “Manulife” and entered into an amended agreement which, among other things, extended the term of the agreement through March 2009. During 2001, Manulife earned 101,000 shares of our common stock to be issued in 2002. In lieu of the issuance of the 101,000 shares, we made a cash payment to Manulife. Therefore, the advance discount recorded in other intangible assets as of December 31, 2001 was recorded against revenue during the first quarter of 2002. In addition, the amendment eliminated the ability for Manulife to receive shares of our common stock or the warrants contemplated in the original agreement.
Term A loans due March 31, 2005 with an interest rate of
During 2002, we utilized internally generated cash to prepay the remaining $105 million of our Term A loans and amended our existing credit facility to add a $325 million Term B loan to fund the acquisition of NPA. At December 31, 2002, our credit facility with a commercial bank syndicate consists of $325 million of Term B loans and a $150 million revolving credit facility (of which nothing is outstanding at December 31, 2002). As a result of the Term A debt prepayments during 2002, we recorded an extraordinary charge of $1,655,000 ($1,027,000 net of tax). During 2001, we prepaid $50 million of our Term A loans and recorded an extraordinary charge of $602,000 ($372,000 net of tax). The Term B loan has a maturity of six years and will amortize 1% in years one through four, 25% in year five and 71% in year six. The capital stock of most of our existing and subsequently acquired domestic subsidiaries has been pledged as collateral for the credit facility.
During 2000, we received $2,397,000 to restructure an existing interest rate swap agreement in conjunction with a prepayment of the Term A loans. We recognized $1,500,000 ($926,000 net of tax) against interest expense as an ordinary gain related to the prepayment of debt and the remaining $897,000 has been deferred and is being amortized over the remaining term of the loans. Interest expense was reduced by $199,000 during both 2002 and 2001 and $50,000 during 2000.
During 1999, we entered into an interest rate lock related to our offering of $250 million Senior Notes. Upon issuance of the Senior Notes, we received $2,135,000, which is being amortized against interest expense over the term of the Senior Notes. Interest expense was reduced by $205,000, $206,000 and $286,000 during 2002, 2001 and 2000, respectively.
Effective January 1, 2001, we adopted FAS 133, “Accounting for Derivative Instruments and Hedging Activities,” as amended by FAS 137 and 138 (“FAS 133”). FAS 133 requires all derivative financial instruments, such as interest rate swaps, to be recognized as either assets or liabilities in the statement of financial position and measured at fair value. The adoption of FAS 133 did not have a material effect on our financial statements, but did reduce other comprehensive income during 2001 by $3,589,000, net of taxes, in the accompanying Consolidated Statement of Changes in Stockholders’ Equity due to a cumulative effect of change in accounting principle of $612,000 as of January 1, 2001, and additional deferred losses recorded during 2001 of $2,977,000.
We use interest rate swap agreements to manage our interest rate risk on future variable interest payments. At December 31, 2002, we have two swap agreements to fix the variable interest rate payments on approximately $150 million of our debt under our credit facility. Under one of our swap agreements, we agree to receive a variable rate of interest on the notional principal amount of approximately $100 million based upon a three month LIBOR rate in exchange for payment of a fixed rate of 6.25% per annum. The notional principal amount will decrease to $60 million in April 2003 and to $20 million in April 2004 until maturing in April 2005. On October 1, 2002, we entered into a second swap agreement to fix the variable rate interest payments on an additional $50 million of debt under our credit facility. Under this swap agreement, which matures in September 2003, we agree to receive a variable rate of interest on the notional principal of $50 million based upon a three month LIBOR rate in exchange for payment of a fixed rate of 1.66% per annum.
Our present interest rate swap agreements are cash flow hedges which require us to pay fixed-rates of interest, and which hedge against changes in the amount of future cash flows associated with variable interest obligations. Accordingly, the fair value of our swap agreement, $5,786,000 and $5,798,000, pre-tax, at December 31, 2002 and 2001, respectively, is reported on the balance sheet in other liabilities. The related deferred loss on our swap agreements, $3,585,000 and $3,589,000, net of taxes, at December 31, 2002 and 2001, respectively, are deferred in shareholders’ equity as a component of other comprehensive income. This deferred loss is then recognized as an adjustment to interest expense over the same period in which the related interest payments being hedged are recorded in income. The loss associated with the ineffective portion of this agreement is immediately recognized in income. For the years ended December 31, 2002 and 2001, the losses on the ineffective portion of our swap agreement were not material to the consolidated financial statements.
A reconciliation of the statutory federal income tax rate and the effective tax rate follows (the effect of foreign taxes on the effective tax rate for 2000, 1999 and 1998 is immaterial):
At December 31, 2002 and 2001, the net current deferred tax asset is $25,686 and $16,368, respectively, and the net long-term deferred tax liability, included in other liabilities is $80,514 and $42,853, respectively.
For the year ended December 31, 2002, approximately 50% of our pharmaceutical purchases were through one wholesaler. We believe other alternative sources are readily available and that no other concentration risks exist at December 31, 2002.
During September 2000, we sold our Albuquerque, New Mexico property and building for $7,806,000. These assets were then leased back from the purchaser over a period of ten years with the option to extend the terms up to an additional ten years. The resulting lease is being accounted for as an operating lease, and the resulting deferred gain of $4,136,000 is being amortized over the ten-year life of the lease.
In May 2001, we announced a two-for-one stock split of our Common Stock for stockholders of record on June 8, 2001, effective June 22, 2001. The split was effected in the form of a dividend by issuance of one share of Common Stock for each share of Common Stock outstanding. The earnings per share and the weighted average number of shares outstanding for basic and diluted earnings per share for all years presented have been adjusted for the stock split.
Treasury shares are carried at first in, first out cost. As of December 31, 2002, we have repurchased a total of 5,803,000 shares of our Common Stock under the stock repurchase program that we announced on October 25, 1996, of which, 2,046,000 shares were repurchased during 2002. Approximately 3,818,000 shares have been reissued in connection with employee compensation plans through December 31, 2002. In February 2002, our Board of Directors approved an increase in our stock repurchase program from 5,000,000 shares (adjusted for the June 2002 two for one stock split) to 6,500,000 shares. In July 2002, our Board of Directors approved an increase in the stock repurchase program from 6,500,000 shares to 10,000,000 shares. There is no limit on the duration of the program. Additional purchases, if any, will be made in such amounts and at such times as we deem appropriate based upon prevailing market and business conditions, subject to restrictions on stock repurchases contained in our bank credit facility and the Indenture under which our Senior Notes were issued.
Employee stock purchase plan. We offer an employee stock purchase plan that qualifies under Section 423 of the Internal Revenue Code and permits all employees, excluding certain management level employees, to purchase shares of our Common Stock. Participating employees may elect to contribute up to 10% of their salary to purchase common stock at the end of each monthly participation period at a purchase price equal to 85% of the fair market value of our Common Stock as of either the beginning or the end of the participation period, whichever is lower. During 2002, 2001 and 2000, approximately 63,000, 34,000 and 64,000 shares of our Common Stock were issued under the plan, respectively. Our Common Stock reserved for future employee purchases under the plan is 319,809 at December 31, 2002.
Deferred compensation plan. We maintain a non-qualified deferred compensation plan (the “Executive Deferred Compensation Plan”) that provides benefits payable to eligible key employees at retirement, termination or death. Benefit payments are funded by a combination of contributions from participants and us. Participants may elect to defer up to 50% of their base earnings and 100% of specific bonus awards. Participants become fully vested in our contributions on the third anniversary of the end of the plan year for which the contribution is credited to their account. For 2002, our contribution was equal to 6% of each qualified participant’s total annual compensation, with 25% being allocated as a hypothetical investment in our Common Stock and the remaining being allocated to a variety of investment options. We have chosen to fund our liability for this plan through investments in trading securities, which primarily consists of mutual funds (see Note 1). We incurred approximately $3,781,000, $2,090,000 and $89,000 of compensation expense in 2002, 2001 and 2000, respectively. At December 31, 2002, 18,182 shares of our Common Stock have been reserved for future issuance under the plan.
We are organized on the basis of services offered and have determined that we have two reportable segments: PBM services and non-PBM services. We manage the pharmacy benefit within an operating segment that encompasses a fully integrated PBM service. The remaining operating service lines (Specialty Distribution Services, Phoenix, Specialty self-injectibles in 2002 and Express Scripts Infusion Services in 2001 and 2000) have been aggregated into a non-PBM reporting segment. On June 12, 2001, we announced that we entered into an agreement with Option Care, Inc. to sell substantially all of the assets of our Infusion Services business, and we discontinued our acute home infusion services.
The following table presents information about the reportable segments as of and for the years ended December 31:
(1) Includes the acquisition of Phoenix Marketing Group effective February 25, 2002, National Prescription Administrators and certain related entities effective April 12, 2002 and Managed Pharmacy Benefits, Inc. effective December 20, 2002.
(2) As a result of our adoption of EITF 02-16, certain amounts have been reclassified from revenues to cost of revenues (see Note 1).