Sixteen of our twenty-six satellite offices, with a total of 260,000 square feet, are under leases that expire over terms through 2023 and the other offices are under month-to-month leases. We believe that suitable space on commercially reasonable terms will be available to us as required.
We provide our clients access to a contracted, non-exclusive national network of approximately 65,000 pharmacies. Our primary business is to provide our clients and their 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 we offer 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, including applicable claims processing fees, and make payments of amounts owed to the retail pharmacies pursuant to our negotiated rates. Total claims processed, excluding administrative services only (ASO) claims, increased to 92.5 million in 2011 from 69.7 million in 2010. ASO claims were 45.2 million and 0.5 million in 2011 and 2010, respectively. Our revenue increased by approximately 42% to $5.3 billion in 2011 from $3.8 billion in 2010.
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. In limited instances, when we administer pharmacy reimbursement contracts and do not substantially assume a credit risk, we record only our administrative or processing fees as revenue. Rebates earned under arrangements with manufacturers or third-party intermediaries are predominately recorded as a reduction of direct expenses. The portion of manufacturer or third-party intermediary rebates due to clients is recorded as a reduction of revenue.
Member co-payments to pharmacies are not recorded as revenue or direct expenses. We incur no obligations for co-payments to pharmacies and have never made such payments. Under our pharmacy agreements, the pharmacy is solely obligated to collect the co-payments from the members. If we had included co-payments in our reported revenue and direct expenses, it would have resulted in an increase in our reported revenue and direct expenses of approximately $1.8 billion, $1.0 billion and $0.8 billion for the years ended December 31, 2011, 2010 and 2009, respectively. Our operating and net income, consolidated balance sheets and statements of cash flows would not have been affected.
The purchase price of CHII was largely determined on the basis of management’s expectations of future earnings and cash flows, resulting in the recognition of goodwill. Management’s allocation of the purchase price to the net assets acquired resulted in goodwill of $366.5 million, acquired technology of $11.3 million with an estimated useful life of 5.5 years, customer relationship intangibles of $133.0 million with an estimated useful life of 13 years, and other contract intangibles related to an administrative support services agreement with the seller of $44.9 million with an estimated useful life of 8 years. Goodwill related to this acquisition is deductible for tax purposes. The goodwill recognized is primarily attributable to the workforce of the acquired business and the operating synergies expected to be realized after our acquisition of CHII.
The acquisition was accounted for as a purchase, and accordingly, the results of CHII operations are included in our consolidated financial statements since the date of acquisition.
On January 25, 2011, we acquired NLBP, LLC, or “NLBP”, an Arizona limited liability company which has developed an electronic clinical messaging platform, for $6.2 million in cash.
The acquisition was accounted for as a purchase, and accordingly, the results of FutureScripts operations are included in our consolidated financial statements since the date of acquisition.
The purchase price of inPharmative was largely determined on the basis of management’s expectations of future earnings and cash flows, resulting in the recognition of goodwill. Management’s final allocation of the purchase price to the net assets acquired resulted in goodwill of $12.6 million, customer relationships of $3.2 million with an estimated useful life of 12 years, technology software of $0.7 million with an estimated useful life of 3 years, and trade name intangibles of $0.5 million with an estimated useful life of 20 years. Goodwill related to this acquisition is deductible for tax purposes.
We entered into a purchase agreement on December 16, 2011, whereby we made an initial capital contribution of $5.0 million to Script Relief LLC, a Delaware corporation, in exchange for a 19.9% ownership interest. Script Relief operates a direct to consumer pharmacy benefit business including discount card offerings and associated activities. We have evaluated this transaction and have determined that Script Relief is a variable interest entity and that we are the primary beneficiary because our underlying PBM and pharmacy contracts represent its key business operations and we have the power to direct these activities. As a result, we consolidate Script Relief in our consolidated financial statements and separately disclose the amounts attributable to our non-controlling interests, which were recorded at fair value as of the date of the purchase agreement. The carrying amount of the assets and liabilities, and the impact of the operating results of this consolidated variable interest entity were not material to our consolidated financial statements for the year ended December 31, 2011. Under the purchase agreement, upon the achievement of certain milestones, we may be required to make an additional $5.0 million capital contribution within twelve months in exchange for additional ownership interests. Additionally, beginning December 2012 and through April 2016, we have the right to purchase all of the outstanding interests owned by the other equity member. The purchase of the outstanding interests is at our sole discretion and is subject to a contractually-defined purchase price. If we elect to exercise this call option, it does contain a minimum purchase price of $50.0 million which could be increased based on operating performance. There are no other terms that would require us to provide additional financial support to the variable interest entity. Under the accounting guidance, subsequent changes in our ownership interest while maintaining control will be accounted for as an equity transaction.
Revenue. Revenue from operations for the years ended December 31, 2011 and 2010 was approximately $5.3 billion and $3.8 billion, respectively. Revenue increased over the comparable period in 2010 by $1.5 billion. Total claims processed, excluding administrative services only (ASO) claims, increased to 92.5 million in 2011 from 69.7 million in 2010. ASO claims were 45.2 million and 0.5 million in 2011 and 2010, respectively. Our increase in revenue and prescription volume in 2011 was primarily due to our initiation of services with several new PBM clients, as well as our current year acquisition of Catalyst Rx Health Initiatives, Inc. (“CHII”), formerly known as Walgreens Health Initiatives, Inc., which contributed revenue of $0.6 billion in 2011, and the full year effect of our prior year acquisitions of FutureScripts and inPharmative, which contributed incremental revenue of $0.6 billion. Also, for the years ended December 31, 2011 and 2010, acquisition related intangible amortization expense of $12.9 million and $2.7 million, respectively, for customer contracts related to PBM agreements has been included as an offset to revenue.
Direct Expenses. Direct expenses for the years ended December 31, 2011 and 2010 were approximately $5.0 billion and $3.5 billion, respectively. Direct expenses increased by $1.5 billion over the comparable period in 2010 primarily due to the $1.5 billion increase in overall revenue. Direct expenses for 2011 and 2010 represented 96.3% and 97.2% of total operating expenses for the respective periods. Additionally, rebates earned under arrangements with manufacturers or third-party intermediaries are predominately recorded as a reduction of direct expenses. For the years ended December 31, 2011 and 2010, adjustments made to these rebate receivable estimates from prior periods reduced direct expenses by $4.8 million and $4.8 million, respectively.
Gross margin is calculated as revenue less direct expenses. Factors that can result in changes in gross margins include generic substitution rates, changes in the utilization of preferred drugs with higher discounts and changes in the volume of prescription dispensing at lower-cost network pharmacies. Our gross margin increased to $307.9 million for the year ended December 31, 2011 from $234.2 million for the comparable period in 2010. Gross margin as a percentage of revenue was 5.8% and 6.2% for the years ended December 31, 2011 and 2010, respectively. In 2011, gross margin percentages were reduced primarily by the impact of CHII, FutureScripts and new client implementations and renewals. These decreases were somewhat offset by gross margin improvements resulting from an increased level of generic substitution and higher network discount rates.
Selling, General and Administrative Expenses. For the year ended December 31, 2011, selling, general and administrative expenses increased by $92.0 million over the prior year to $193.7 million, or 3.7% of operating expenses. For the year ended December 31, 2010, selling, general and administrative expenses was $101.7 million, or 2.8% of total 2010 operating expenses. The increase in selling, general and administrative expenses was primarily associated with incremental costs related to acquisitions, our growth and the associated personnel, facility and vendor costs to serve and implement new clients. For the year ended December 31, 2011, we incurred $47.7 million of CHII transaction and integration related costs.
Selling, general and administrative expenses of $193.7 million for the year ended December 31, 2011, consisted of $73.9 million in compensation and benefits, which includes $8.4 million in non-cash compensation, $65.5 million in professional fees, which includes $42.9 million of transition and integration related costs, $13.8 million in facility costs, $6.9 million in travel expenses, $3.8 million in insurance and other corporate expenses, $1.9 million in non-employee non-cash compensation expense, $2.5 million in recruitment and temporary help, $1.2 in other, which includes an offset of $5.3 million for the net adjustment to the fair value of contingent consideration, and $24.2 million in depreciation and amortization.
Selling, general and administrative expenses of $101.7 million for the year ended December 31, 2010, consisted of $50.0 million in compensation and benefits, which includes $5.5 million in non-cash compensation, $14.2 million in professional fees, which includes transaction related costs, $10.3 million in facility costs, $5.6 million in travel expenses, $3.4 million in insurance and other corporate expenses, $1.6 million in non-employee non-cash compensation expense, $1.1 million in recruitment and temporary help, $3.5 million in other, and $12.0 million in depreciation and amortization.
Interest and Other Income. Interest and other income decreased to $0.2 million for the year ended December 31, 2011 from $0.9 million for the year ended December 31, 2010. The decrease was primarily due to changes in our average balances and reductions in average market interest rates in short-term investments during the period.
Net Income. Net income for the year ended December 31, 2011 decreased by approximately $14.4 million over the same period in 2010 to $66.6 million. The decrease in net income was primarily a function of increased selling, general and administrative expenses related to our recent acquisitions.
Selling, General and Administrative Expenses. For the year ended December 31, 2010, selling, general and administrative expenses increased by $20.7 million over the prior year to $101.7 million, or 2.8% of operating expenses. For the year ended December 31, 2009, selling, general and administrative expenses was $81.0 million, or 2.9% of total 2009 operating expenses. The increase in selling, general and administrative expenses was primarily associated with our growth and the associated personnel, facility and vendor costs to serve and implement new clients, as well as incremental selling, general and administrative costs related to pursuing potential acquisitions.
Selling, general and administrative expenses of $81.0 million for the year ended December 31, 2009, consisted of $41.0 million in compensation and benefits, which includes $4.3 million in non-cash compensation, $8.2 million in professional fees and technology services, $9.7 million in facility costs, $2.9 million in travel expenses, $3.4 million in insurance and other corporate expenses, $2.2 million in non-employee non-cash compensation expense, $0.9 million in recruitment and temporary help, $3.0 million in other, and $9.7 million in depreciation and amortization.
Interest Expense. Interest expense increased to $3.0 million for the year ended December 31, 2010 from $0.6 million in the comparable period in 2009. The increase in interest expense was primarily attributable to the expense associated with our new credit facilities and the amortization of related debt financing costs.
Income Tax Expense. The effective income tax rates of 37.9% in 2010 and 2009 represent the combined federal and state income tax rates adjusted as necessary based on the particular jurisdictions where we operate.
On April 14, 2011, we amended and restated our existing senior credit facilities which were originally entered into on August 4, 2010, consisting of a revolving credit facility and term loan facility. The original term loan facility had a principal amount of $150.0 million and remains unchanged subsequent to the amendment. The original revolving credit facility had an aggregate revolving commitment of $200.0 million, and was subsequently amended
to increase that commitment to $400.0 million. Each of our revolving credit facility and our term loan facility matures on August 4, 2015. In addition to the revolving credit facility and term loan facility, our senior credit facilities permit us to incur up to $100.0 million in total principal amount of additional term loan or revolving loan indebtedness under the senior credit facilities. Our obligations under our senior credit facilities are fully and unconditionally guaranteed jointly and severally by us and certain of our U.S. subsidiaries currently existing or that we may create or acquire, with certain exceptions as set forth in our amended credit agreement, pursuant to the terms of a separate guarantee and collateral agreement.
During the year ended December 31, 2011, we cumulatively borrowed $609.0 million under our revolving credit facility and made $479.0 million of repayments. The outstanding balance under the revolving credit facility at December 31, 2011 was $130.0 million. The term loan facility balance at December 30, 2011 was $140.6 million and amortizes in nominal quarterly installments of $1.875 million on the last day of each calendar quarter, with such payments having commenced on December 31, 2010 until maturity, whereby the final installment of the term loan facility will be paid on the maturity date in an amount equal to the aggregate unpaid principal amount. We anticipate repaying the term loan and revolving credit facility through our operating cash flows.
Our operating activities generated $97.7 million of cash from operations in 2010, a $14.4 million decrease from the $112.1 million generated in 2009. This $97.7 million in cash provided by operating activities in 2010 reflects $81.0 million in net income, plus $27.4 million in non-cash charges and $10.7 million net decrease in cash from changes in working capital and other assets and liabilities. This $10.7 million net decrease in cash provided by changes in working capital, net of effects from acquisitions, was primarily due to changes in rebates receivable of $4.6 million, inventory of $0.2 million, rebates payable of $19.2 million and accrued expense and other liabilities of $28.3 million, offset by changes in accounts receivable of $5.5 million, income tax receivable of $1.1 million, accounts payable of $48.4 million and other assets of $8.0 million. The change in rebates payable and in accrued expenses and other liabilities reflects the temporary benefit in the timing of payments of these payables and liabilities. The change in accounts payable reflects the timing of payments of our accounts payable.
Net cash used in investing activities for the year ended December 31, 2010 was $240.3 million, compared to $21.5 million in 2009. The cash used in 2010 reflects expenditures of $239.9 million for business acquisitions, net of cash acquired, and $12.3 million in capital expenditures offset by investment sales of $11.9 million.
We anticipate continuing to generate positive operating cash flow which, combined with available cash resources, should be sufficient to meet our planned working capital, debt service, capital expenditures and operating expenses. However, there can be no assurance that we will not require additional capital. Even if such funds are not required, we may seek additional equity or debt financing. We cannot be assured that such financing will be available on acceptable terms, if at all, or that such financing will not be dilutive to our stockholders.
The following table reflects our current contractual commitments as of December 31, 2011 (in thousands):
consideration payments through 2014 associated with our acquisition of Catalyst Rx Health Initiatives, Inc., and (b) the potential future payments that may be made associated with our consolidated variable interest entity. See “Note 11. - Business Combinations” and “Note 12 - Variable Interest Entity”, respectively, of our consolidated financial statements for further discussion.
Management’s Discussion and Analysis of 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.
We recognize revenue from services provided to our clients for sales of prescription drugs either by pharmacies in our nationwide network or through our mail order facilities, and related claims processing fees. Revenue is recognized when the claims are adjudicated. Pharmacy claims are adjudicated at the point-of-sale using an on-line claims processing system. When we have a contractual obligation to pay a network pharmacy provider for benefits provided to our clients’ members, total payments from these clients, including administration and other fees, are recorded as revenue and payments to the network pharmacy provider, and the claim adjudication service costs are recorded as direct expenses. Generally, these contracts require us to assume the credit risk of our clients’ abilities to pay. In limited instances, when we administer pharmacy reimbursement contracts and do not assume credit risk, we record only the net revenue and the administrative or processing fees. Rebates earned under arrangements with manufacturers or third-party intermediaries are predominately recorded as a reduction to direct expenses. The portion of such rebates due to our clients is recorded as a reduction of revenue. Manufacturers’ or third-party intermediary rebates are based on estimates, which are subject to final settlement with the contracted party. We refine our estimates each period based on actual collection and payment experiences.
The Company estimates its rebates receivable and rebates payable based on the number and type of claims submitted, the rebate program terms with its clients, the Company’s rebate contracts with pharmaceutical manufacturers and third-party intermediaries, and other information that may be available. The amount of rebates actually received by the Company, and rebates paid to its clients, is impacted by a variety of factors, including the validation of claims data submitted by the Company and differences between estimated and actual rebatable products. As a result, the Company’s actual experience relative to rebates received by the Company, and rebates paid to its clients, may result in adjustments to the estimates made in prior periods.
During 2011, the Company had favorable adjustments to its prior estimates related to rebates receivable and rebates payable by $4.8 million and $2.2 million, respectively. During 2010, the Company’s favorable adjustment to its prior estimates related to rebates receivable and rebates payable were $4.8 million and $3.5 million, respectively. The impact of adjustments in rebates receivable and rebates payable estimates for the years ended December 31, 2009 were not material. Future adjustments to the amounts of rebates receivable and rebates payable outstanding are possible but are not expected to be material.
We do not have any intangible assets with indefinite lives. We do have other intangible assets subject to amortization, and these assets are amortized straight-line over 5 months to 20 years, depending on each intangible asset’s estimated useful life. The estimated fair value and the weighted average useful-life of the intangible assets are based on income-method valuation calculations. The remaining useful life of intangible assets is evaluated periodically and adjusted as necessary to match the period that the assets are expected to provide economic benefits.
Our goodwill is not amortized, but is tested for impairment at least annually. In the current year, we adopted a new Accounting Standards Updates (“ASU”) that allows for the goodwill impairment analysis to start with an assessment of qualitative factors to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount. If, after assessing the qualitative factors, we determine that it is more likely than not that the fair value of a reporting unit is less than its carrying amount, then we would perform a two-step impairment test.
In the first step of the impairment test, we would test for impairment of goodwill by estimating the fair values of our reporting units using a present value of future cash flows approach. Although we operate in one reportable segment, for the purposes of performing this impairment test under the accounting standards, we have identified three reporting units. If the carrying amount of the reporting unit exceeds the fair value, the second step of the goodwill impairment test would be performed to measure the amount of the impairment loss, if any. In the second step, the implied fair value of the goodwill is estimated as the fair value of the reporting unit used in the first step, less the fair values of all other net tangible and intangible assets of the reporting unit. If the carrying amount of the goodwill exceeds its implied fair market value, an impairment loss is recognized in an amount equal to that excess, not to exceed the carrying amount of the goodwill. In addition, the goodwill of a reporting unit is tested for impairment between annual tests if an event occurs or circumstances change that would more-likely-than-not reduce the fair value of a reporting unit below its carrying value.
The Company’s investments consist primarily of our investments in non-controlled companies and are recorded at cost. At December 31, 2011 and 2010, there were no identified events or changes in circumstances that had a significant adverse effect on the values of these investments. If there was evidence of a decline in value, which is other than temporary, the amounts would be written down to their estimated recoverable value. Also included in investments are auction rate securities, or “ARS”, which are classified as available-for-sale and are recorded at fair market value, with unrealized gains (losses), net of taxes, reported as a separate component of shareholders’ equity. Realized gains (losses) and amounts representing credit losses on these ARS’, of which there were none, are included in other income. For purposes of determining any credit loss, the Company assesses the fair value of its ARS under the single best-estimate approach. We continue to receive timely interest payments and there have been instances of recent redemptions of our auction rate securities by issuers at par; however, our ARS investments currently lack short-term liquidity and, therefore, are classified as non-current on our balance sheet.
Our deferred income taxes are determined based on the estimated future tax effects of differences between the financial statement and tax bases of assets and liabilities, given the provisions of enacted tax laws. Deferred income tax provisions and benefits are based on changes to the assets or liabilities from year to year. In providing for deferred taxes, we consider tax regulations of the jurisdictions in which we operate, estimates of future taxable income, and available tax planning strategies. If tax regulations, operating results or the ability to implement tax-planning strategies vary, adjustments to the carrying value of deferred tax assets and liabilities may be required. Valuation allowances, if any, are recorded related to deferred tax assets based on the “more-likely-than-not” criteria.
The outcome of any current or future litigation or governmental or internal investigations cannot be accurately predicted, nor can we predict any resulting penalties, fines or other sanctions that may be successfully sought by federal or state regulatory authorities. We record accruals for such contingencies to the extent that we conclude it is probable that a liability has been incurred and the amount of the loss can be reasonably estimated. No estimate of the possible loss or range of loss in excess of amounts accrued, if any, can be made at this time regarding current or future litigation, or penalties, fines or other sanctions because the inherently unpredictable nature of legal proceeding and sanctions may be exacerbated by various factors, including: (i) the damages sought in the proceedings are unsubstantiated or indeterminate: (ii) discovery is not complete: (iii) the proceeding is in its early stages; (iv) the matters present legal uncertainties; (v) there are significant facts in dispute; (vi) there are a large number of parties (including where it is uncertain how liability, if any, will be shared among multiple defendants); or (vii) there is a wide range of potential outcomes. Nevertheless, it is reasonably possible that the outcome of legal matters or sanctions may have a material adverse effect on our results of operations, financial position, and cash flows and may affect our reputation.