HealthExtras provides pharmacy benefit management services, referred to as PBM, and supplemental benefit programs. Our PBM segment, which operates primarily under the brand name Catalyst Rx, accounted for approximately 99%, 97% and 94% of our revenue in the years ended 2007, 2006 and 2005, respectively, and is expected to be the primary source of our growth and profits in the future. Our PBM clients include more than 1,000 self-insured employers, including state and local governments, managed care organizations, third-party administrators, referred to as TPAs, and unions, who contract with us to administer the prescription drug component of their overall health benefit programs. Our PBM segment revenue increased by 50% to $1.8 billion in 2007 from $1.2 billion in 2006. During 2007, we initiated services with several new PBM clients. As a result, total claims processed increased to 41.5 million in 2007 from 29.3 million in 2006. In particular, beginning July 1, 2007, we commenced providing PBM services to the States of Maryland and Ohio, which together were responsible for 2.0 million claims and accounted for approximately 9% of our total revenue for the year. Also, beginning July 1, 2006, we commenced providing PBM services to over 1.0 million members of Wellmark Blue Cross Blue Shield of Iowa. For the year ended December 31, 2007, this client was responsible for 10.9 million claims and accounted for approximately 20% of our total revenue for 2007.
We also offer supplemental benefit programs developed by us, under the brand name HealthExtras, which include lump sum accidental disability benefits, accidental death and dismemberment benefits, and emergency accident and sickness medical reimbursement benefits. We contract with insurance companies to underwrite the insurance components of these programs. As a result, the financial responsibility for the payment of claims resulting from a qualifying event covered by the insurance features of our programs is borne by the third-party insurers. Our supplemental benefits segment accounted for 1%, 3% and 6% of our revenue in 2007, 2006 and 2005, respectively. Individuals are the major purchasers of these programs
Our PBM segment provides our clients access to a contracted, non-exclusive national network of approximately 60,000 pharmacies. We provide our clients’ members with timely and accurate benefit adjudication, while controlling pharmacy spending trends through customized plan designs, clinical programs, physician orientation programs, and member education. We use an electronic point-of-sale system of eligibility verification and plan design information, and offers access to rebate arrangements for certain branded pharmaceuticals. When a member of one of our clients presents a prescription or health plan identification card to a retail pharmacist in our network, the system provides the pharmacist with access to online information regarding eligibility, patient history, health plan formulary listings, and contractual reimbursement rates. The member generally pays a co-payment to the retail pharmacy and the pharmacist fills the prescription. We electronically aggregate pharmacy benefit claims, which include prescription costs plus our claims processing fees, for consolidated billing and payment. We receive payments from clients, make payments of amounts owed to the retail pharmacies pursuant to our negotiated rates, and retain the difference, including claims processing fees.
Pharmacy benefit claim payments from our clients are recorded as revenue, and prescription costs to be paid to pharmacies are recorded as direct expenses. Under our network contracts, we generally have an independent obligation to pay pharmacies for the drugs dispensed and, accordingly, have assumed that risk independent of our clients. When we administer pharmacy reimbursement contracts and do not assume a credit risk, we record only our administrative or processing fees as revenue. Rebates earned under arrangements with manufacturers are recorded as a reduction of direct expenses. The portion of manufacturer rebates due to clients is recorded as a reduction of revenue.
If we had included co-payments in our reported revenue and direct expenses, it would have resulted in an increase in our reported PBM revenue and direct expenses of $635.6 million, $477.0 million and $279.2 million, for the years ended December 31, 2007, 2006 and 2005, respectively. Our operating and net income, consolidated balance sheets and statements of cash flows would not have been affected.
On December 16, 2005, we acquired the common stock of EBRx, Inc. (“EBRx”). The acquisition was structured as a merger between our wholly-owned subsidiary, HCEM Corp., and the parent company of EBRx, with the former parent as the surviving entity following the merger. Consideration consisted of a cash payment of $27.9 million and $0.8 million in related transaction costs. HCEM was funded by us with a $4.0 million equity investment and the remaining consideration was provided in the form of subsidiary debt. As contemplated by the original structure and terms of the transaction, a separate entity owned by former owners of EBRx and its management team, purchased a 20% ownership interest in the parent of EBRx through a $1.0 million equity investment, on January 3, 2006.
Based on management’s best estimate, including our valuation report of the allocation of the purchase price to the net assets acquired, the acquisition of EBRx resulted in goodwill of $56.1 million and customer relationship intangibles of $8.5 million and non-competition agreements of $0.3 million. The customer relationship intangibles are being amortized on a straight-line basis over an 11-year life and the non-competition agreements are being amortized on a straight-line basis over a 3-year life.
In 2006, certain MHS business lines were consolidated into our financial, management and technology platform. Accordingly, the remaining warrant issuance was based on a combination of MHS’ actual results and pro-forma calculations of revenue and gross profit performance. As a result, in July 2007, 55,000 warrants were issued at an exercise price of $15.45 per share. This additional consideration resulted in additional goodwill of approximately $546,000 based on the value of the warrants at the date of acquisition.
Our supplemental benefits segment generates revenue from the sale of supplemental benefit programs, which include lump sum accidental disability benefits, accidental death and dismemberment benefits, and emergency accident and sickness medical reimbursement benefits. In recent periods, our supplemental benefits programs have been marketed and sold to individuals primarily by three nationally-recognized companies, which incur the marketing expenses. Accordingly, our supplemental benefit revenue from new members is primarily dependent on
Revenue. Revenue from operations for the year ended December 31, 2007 was approximately $1.9 billion, consisting of over $1.8 billion generated from the PBM segment and $27.5 million from the supplemental benefits segment. PBM revenue increased over the comparable period in 2006 by $601.0 million, including $558.1 million from increased prescription volume, which includes new clients since the prior year including State of Maryland and State of Ohio as well as the increase associated with a full year of the R/xx operations; $18.2 million from an increase in unit prices; and $24.7 million from the proportionate amount of prescription costs paid by the plan sponsor. Total claims processed increased to approximately 41.5 million in 2007 from approximately 29.3 million in 2006. Contributors to the increase in revenue and prescription volume were our contracts with Wellmark Blue Cross Blue Shield of Iowa, covering over 1.0 million members, which commenced on July 1, 2006, and the States of Maryland and Ohio, together covering over 0.3 million members, which commenced on July 1, 2007. These contracts generated 29% of our consolidated revenue in 2007. Supplemental benefits segment revenue for 2007 decreased by $14.4 million from the comparable period in 2006. This decrease was primarily a result of reduced billings attributable to the previously disclosed conversion of the supplemental benefits marketing partner relationships, as well as our decreased emphasis on this line of business. Our revenue from operations for the year ended December 31, 2006 was approximately $1.3 billion, consisting of $1.2 billion generated from the PBM segment and $41.9 million from the supplemental benefits segment.
Selling, General and Administrative. For the year ended December 31, 2007, selling, general and administrative expenses increased by approximately $7.6 million over the prior year to $54.0 million or 3.0% of operating expenses. This increase was primarily associated with our PBM segment growth and the associated personnel and vendor costs to serve and implement new clients.
Revenue. Revenue from operations for the year ended December 31, 2006 was $1.3 billion, consisting of $1.2 billion generated from the PBM segment and $41.9 million from the supplemental benefits segment. PBM revenue increased over the comparable period in 2005 by $578.2 million, including $510.2 million from increased prescription volume, which includes increases associated with the Wellmark Blue Cross Blue Shield of Iowa contract, a full year of EBRx operations and two months of R/xx operations; $43.4 million from an increase in unit prices; and $24.6 million from the proportionate amount of prescription costs paid by the plan sponsor. Total claims processed increased to approximately 29.3 million in 2006 from approximately 17.1 million in 2005. A significant contributor to the increase in revenue and prescription volume was a new contract with Wellmark Blue Cross Blue Shield of Iowa covering over 1.0 million members, which commenced on July 1, 2006. This contract generated 13.9% and 13.5% of our PBM and total revenue, respectively. The supplemental benefits revenue for 2006 remained largely unchanged from 2005. Revenue for year the ended December 31, 2005 was $694.5 million, consisting of approximately $650.9 million and $43.6 million attributable to the PBM and supplemental benefits segments, respectively.
Direct Expenses. Direct expenses for the year ended December 31, 2006 were $1.2 billion, consisting of $1.1 billion in direct expenses from the PBM segment and $27.6 million in direct expenses from the supplemental benefits segment. PBM segment direct expenses increased over the comparable period in 2005 by $555.0 million, while the supplemental benefits segment direct expenses decreased by approximately $5.3 million. The PBM segment’s increase in direct expenses is related to the $578.2 million increase in PBM revenue. The decrease in direct expenses in the supplemental benefits segment was largely a result of a modest decrease in membership and the negotiation of lower costs for certain of the benefits in our programs.
Minority Interest. EBRx is majority owned by us and 20% owned by investors affiliated with EBRx’s former parent. The minority interest for 2006 represents 20% of the earnings of EBRx for the year.
Income Tax Expense. The effective income tax rates of 39.1% in 2006 and 36.4% in 2005 represent the combined federal and state income tax rates adjusted as necessary based on the particular jurisdictions where we operate. The tax rate in 2005 was lower than in 2006, in particular due to interest income earned on federally tax exempt investments and an increase in 2006 in our effective state income tax rate reflective of our expansion into additional state jurisdictions.
Our sources of funds are usually cash flows from operating activities. We have in the past raised funds by borrowing on bank debt and selling equity in the capital markets to fund acquisitions. During the last several years we generated positive cash flow from operations and anticipate similar results in 2008 and the foreseeable near-term future. Cash and cash equivalents and marketable securities at December 31, 2007 were $124.6 million. At December 31, 2007, we had available a $50.0 million revolving credit facility with no outstanding borrowings.
Net Cash Provided by Operating Activities. Our operating activities generated $54.6 million of cash from operations in 2007, a $2.2 million increase from the $52.4 million generated in 2006. This $54.6 million in cash provided by operating activities in 2007 reflects $39.3 million in net income, plus $12.7 million in non-cash charges and $2.6 million net increase in working capital and other assets and liabilities. This $2.6 million net increase in working capital was primarily due to a $54.2 million increase in accounts receivable and $5.2 million increase in income tax receivable offset by a $64.1 million increase in accounts payable and other current liabilities. The cash provided by operating activities of $52.4 million in 2006 reflects net income of $31.6 million, plus $11.4 million in non-cash charges, and a net $9.4 million decrease in working capital and other assets and liabilities.
Net Cash Used in Investing Activities. Net cash used in investing activities for the year ended December 31, 2007 was $38.4 million compared to $36.5 million in 2006. During 2007, we had $3.7 million in capital expenditures and net purchases of $1.4 million in marketable securities. The acquisition of our remaining 20% minority ownership interest resulted in a cash payment of $30.3 million, of which $1.3 million was attributable to the minority interest and approximately $29.0 million was recorded as additional purchase price. Also, additional contingent consideration and other payments of approximately $5.1 million relating to prior business acquisitions were paid during 2007. The current period also reflects $1.0 million of cash provided upon the repayment of a note receivable as well as $1.0 million resulting from the lifting of restrictions on certain cash deposits. Net cash used in investing activities for the year ended December 31, 2006 consisted primarily of $5.7 million in capital expenditures (net of proceeds from sales of property and equipment of $1.0 million), purchases of $14.5 million in marketable securities net of maturities and payments of $16.3 million, net of cash acquired, for business acquisitions, of which $15.9 million was used to acquire R/xx.
Net Cash Provided by Financing Activities. Net cash provided by financing activities for the year ended December 31, 2007 was $15.3 million compared to $5.7 million in 2006. In 2007, we purchased $1.4 million of
The following table reflects our current contractual commitments as of December 31, 2007 (in thousands):
At December 31, 2007, we had available a $50.0 million revolving credit facility with no outstanding borrowings.
Management’s Discussion and Analysis of the Financial Condition and Results of Operations discusses our consolidated financial statements. Preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying notes. Our estimates and assumptions are based upon a combination of historical information and various other assumptions believed to be reasonable under the particular circumstances. Actual results could differ from those estimates. Certain of the accounting policies which most impact our consolidated financial statements and that require management to make difficult, subjective or complex judgments are described below. (See also Note 2, “Summary of Significant Accounting Policies,” to our consolidated financial statements included in Part II, Item 8 of this Annual Report on Form 10-K).
Member co-payments are not recorded as revenue. Under our client contracts, the pharmacy is solely obligated to collect the co-payments from the members. Under client contracts, we do not assume liability for member co-payments in pharmacy transactions. As such, we do not include member co-payments to pharmacies in revenue or direct expenses.
Revenue from supplemental benefit programs and related direct expenses, principally marketing and processing fees and the cost of the benefits provided to program members, are initially deferred during the period in which a program member is entitled to obtain a refund, generally 90 days. If a member requests a refund, we retain any interest earned on funds held during the refunded membership period. Total revenue and direct expenses attributable to the initial deferral are recognized subsequent to the end of the initial deferral period. After the initial deferral period, revenue is recognized as earned and direct expenses as incurred.
We account for our intangible assets under Statement of Financial Accounting Standards (“SFAS”) No. 142, Goodwill and Other Intangible Assets. Under SFAS No. 142, we do not have any intangible assets with indefinite lives. We do have other intangible assets subject to amortization and these assets are amortized over 5 months to 20 years, depending on each intangible asset’s estimated useful life.
We account for our goodwill under SFAS No. 142. Under SFAS No. 142, goodwill is not amortized, but it is tested for impairment at least annually. Each year, we test for impairment of goodwill according to a two-step approach. In the first step, we test for impairment of goodwill by estimating the fair values of its reporting units using the present value of future cash flows approach, subject to a comparison for reasonableness to its market
From time to time we issue warrants to purchase shares of our common stock under arrangements with our business partners or as consideration in acquisitions. We are required to estimate the fair value of such warrants for purposes of recording these transactions in our consolidated financial statements upon achieving a measurement date. Such estimates require judgments regarding, among other things, expected term, risk-free interest rates and common stock volatility.
In September 2006, the FASB issued SFAS No. 157, Fair Value Measurements, which addresses how companies should measure fair value when they are required to use a fair value measure for recognition or disclosure purposes under generally accepted accounting principles. SFAS No. 157 applies to financial statements that are issued for fiscal years beginning after November 15, 2007 and to interim periods within those fiscal years. We are required to adopt SFAS No. 157 on January 1, 2008. Our adoption of SFAS No. 157 is not expected to have a material impact on our financial condition, results of operations or cash flows.
In February 2007, the FASB issued SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities, which permits reporting entities to elect to measure many financial instruments and certain other items at fair value that are not currently required to be measured at fair value. This election is irrevocable. SFAS No. 159 will be effective in the first quarter of fiscal 2008. Our adoption of SFAS No. 159 is not expected to have a material impact on our financial condition, results of operations or cash flows.
In December 2007, the FASB issued SFAS No. 141 (revised 2007), Business Combinations (“SFAS No. 141 (R)”). SFAS No. 141(R) establishes principles and requirements for how an acquirer in a business combination recognizes and measures in its financial statements the identifiable assets acquired, the liabilities assumed and any controlling interest in the acquiree at the acquisition date fair value. SFAS No. 141(R) will significantly change the accounting for business combinations in a number of areas including the treatment of contingent consideration, pre-acquisition contingencies and transaction costs. In addition, any changes in an acquired entity’s deferred tax assets and uncertain tax positions after the measurement period will impact income tax expense. SFAS No. 141(R) also includes a substantial number of new disclosure requirements. SFAS No. 141(R) is effective for fiscal years beginning after December 15, 2008 with early application prohibited. We will adopt SFAS No. 141(R) beginning in the first quarter of fiscal 2009 and will change our accounting treatment for business combinations on a prospective basis.
We are subject to interest rate risk on our short-term investments. We do not expect our financial position, results of operations or cash flows to be affected to any significant degree by a sudden change in market interest rates.
We operate our business within the United States and Puerto Rico and execute all transactions in U.S. dollars and, therefore, we have no foreign exchange risk.