Our corporate headquarters consists of approximately 37,000 square feet of office space located at 26 Harbor Park Drive in Port Washington, New York (the “Leased Premises”). NMHC subleases the Leased Premises from BFS Realty, LLC, an affiliate of a former Chairman (the “Affiliate”) pursuant to a lease dated November 1, 2001, as amended to date (the “Lease”). The Affiliate leases the Leased Premises from the Nassau County Industrial Development Agency (“NCIDA”) pursuant to a lease that was entered into by NCIDA and the Affiliate in December 2004, which expires in December 2015.
We conduct our PBM operations from the following locations: Arkansas, California, Florida, New York and Pennsylvania. Our Specialty Service operation which supports the delivery of certain medications to individuals with chronic or genetic diseases and disorders is located in Maine. The aggregate annual rental payments for our leased PBM and Specialty Service segments approximated $1,587,000.
In addition, we rent two houses from Living In Style, LLC, an entity owned partially by Tery Baskin, an executive officer, and James Bigl, a former Chairman of the Board, which is used for out-of-town employees when they are visiting our Port Washington, New York headquarters. During the fiscal year ended June 30, 2006, we evaluated the cost of local hotels for these individuals and determined it was more cost efficient to rent the house. Pursuant to leases dated May 1, 2002 and expiring April 30, 2007, we paid an aggregate of $147,000 in rent for these two facilities during the fiscal year ended June 30, 2006. The annual rent for each of the facilities increases by 5% per year.
The following selected financial data has been derived from our audited financial statements. The selected financial data should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the audited consolidated financial statements, including notes thereto. All amounts are in thousands, except per share amounts.
(1) Reference is made to Item 1 hereof, (Description of Business),
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.
With the acquisition and significant growth of Ascend, we have two reportable segments, PBM and Specialty Pharmacy. The PBM segment includes the sale of traditional prescription drugs to our clients and their participants, either through our nationwide network of pharmacies or our mail service pharmacy. The Specialty Pharmacy segment includes the sale of higher margin specialty pharmacy products and services for the treatment of chronic and potentially life-threatening diseases.
Both the PBM and Specialty Pharmacy segments operate in the United States and its territories.
Participant co-payments are not recorded as revenue. Under our client contracts, the pharmacy is solely obligated to collect the co-payments from the participants. Under client contracts, we do not assume liability for participant co-payments in pharmacy transactions. As such, we do not include participant co-payments to pharmacies in revenue or cost of claims. For the fiscal years ended June 30, 2006, 2005 and 2004, excluded from our revenue and cost of claims was approximately $321,055, $280,946 and $203,420, respectively, of participant co-payments to pharmacies. If the above amounts were included in our revenue and cost of claims, our operating income, net income, consolidated balance sheets and statements of cash flows would not have been affected.
We evaluate client contracts to determine whether we act as a principal or as an agent in the fulfillment of prescriptions through our retail pharmacy network. We act as a principal in most of our transactions with clients and revenues are recognized at the prescription price (ingredient cost plus dispensing fee) negotiated with clients, as well as our administrative fees (“Gross Reporting”). Gross reporting is appropriate because we (a) have separate contractual relationships with clients and with pharmacies, (b) are responsible to validate and economically manage a claim through our claims adjudication process, (c) commit to set prescription prices for the pharmacy, including instructing the pharmacy as to how that price is to be settled (co-payment requirements), (d) manage the overall prescription drug relationship with the patients, who are participants of clients’ plans, and (e) have credit risk for the price due from the client. In instances where 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 only record 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. As we’re not the principal in these transactions, drug ingredient cost is not included in our revenues or in our cost of claims. As such, there is no impact to our gross profit. Whether revenues are recorded on either a gross or net basis, we record the gross amount billed in accounts receivable and the related claims payable to pharmacies on our balance sheets.
The pharmacy benefit management industry is intensely competitive, generally resulting in continuous pressure on our gross profit as a percentage of total revenue. In recent years, industry consolidation and dramatic growth in managed healthcare have led to increasingly aggressive pricing of pharmacy benefit management services. Given the pressure on all parties to reduce healthcare costs, we expect this competitive environment to continue for the foreseeable future.
Fiscal Year Ended June 30, 2006 Compared to Fiscal Year Ended June 30, 2005
The $62.3 million, or 7.8%, increase in revenue during fiscal 2006 is primarily the result of i) $59.2 million inclusion of revenues from PCN, which we acquired on March 7, 2005, ii) increase in co-payment revenue from Mail Service of approximately $3.3 million due to higher sales volume and iii) increase in revenue from Specialty Service of $3.6 million due to higher sales volume. These increases were offset by $1.5 million of additional credit memos issued to various customers and a $2.3 million reduction in non-PCN business.
Cost of claims increased $57.6 million, or approximately 8.1%, from $713.9 million for the fiscal year ended June 30, 2005 to $771.5 million for the fiscal year ended June 30, 2006. This increase is primarily the result of i) $52.9 million inclusion of cost of claims from PCN, which we acquired on March 7, 2005, ii) increases in cost of claims from Specialty Service of $3.5 million related to higher sales volumes and iii) $0.5 million write-down of obsolete inventory from our Mail Service facility in Miramar, Florida. As a percentage of revenue, cost of claims increased from 89.2% to 89.4% for the fiscal years ended June 30, 2005 and June 30, 2006, respectively.
Selling, general and administrative expenses increased $8.1 million, or approximately 11.9%, from $67.8 million for the fiscal year ended June 30, 2005 to $75.9 million for the fiscal year ended June 30, 2006. This increase is primarily the result of i) $3.6 million related to the PCN acquisition, ii) $3.2 million of compensation expense primarily related to the expensing of employee stock options, beginning July 1, 2005, in accordance with Financial Accounting Standards Board (“FASB”) statement No. 123(R) and iii) $2.8 million related to investments in our information systems’ infrastructure and continual upgrading/maintenance of our adjudication system. These items were partially offset by a $1.7 million reduction in legal settlements which primarily related to our settlement of the Midwest Health Plan lawsuit during August 2005 which was accrued for as of June 30, 2005.
Other income, net decreased $0.3 million, or approximately 22.2%, from $1.5 million for the fiscal year ended June 30, 2005 to $1.2 million for the fiscal year ended June 30, 2006. The decrease primary relates to the recognition of a $1.7 million non-recurring gain from an insurance claim which represented the excess of the insurance proceeds over the carrying value of the assets covered by the claim during the fiscal year ended June 30, 2005. This item was partially offset by increased interest income earned on our higher cash balances throughout fiscal 2006. In addition, we aggregate rebates for an unrelated third party and charge such third party interest on advances we make to them for their rebates. For the fiscal year ended June 30, 2006, we earned $0.5 million in interest income from this unrelated third party.
Income before the provision for income taxes decreased $3.7 million, or approximately 18.3%, from $20.4 million for the fiscal year ended June 30, 2005 to $16.7 million for the fiscal year ended June 30, 2006. The decrease relates to the $4.7 million increase in our gross profit primarily offset by the $8.1 million increase in our selling, general and administrative expense as noted above.
Our effective tax rate was 42.1% for the fiscal year ended June 30, 2006 as compared to 39.3% for the fiscal year ended June 30, 2005. The increase in the effective tax rate for the fiscal year ended June 30, 2006 primarily resulted from the expensing of employee stock options in accordance with FASB statement No. 123(R). This compensation expense for incentive stock options, which is not deductible for income tax purposes, increased our effective tax rate by approximately 4%.
Net income decreased $2.7 million, or approximately 22.0%, from $12.4 million for the fiscal year ended June 30, 2005 to $9.7 million for the fiscal year ended June 30, 2006. The decrease primarily relates to the $2.6 million compensation charge, net of its income tax benefit, primarily related to the expensing of employee stock options in accordance with FASB statement No. 123(R). This decrease was further caused by the increase in selling, general and administrative expenses, offset by the increase in our gross profits.
After deducting these two charges from net income, there remained net income available to common stockholders of $3.6 million for the fiscal year ended June 30, 2006 as compared to $6.3 million for the fiscal year ended June 30, 2005.
Cost of claims increased $126.8 million, or approximately 21.6%, from $587.1 million for the fiscal year ended June 30, 2004 to $713.9 million for the fiscal year ended June 30, 2005. PCN accounted for $21.7 million, of the net increase, while Inteq accounted for another $35.2 million. New clients and the growth in existing clients accounted for $140.9 million of the increase. This increase was partially offset by the loss of clients which reduced cost of claims by $71.0 million (including a $1.1 million adjustment for previous pharmacy claims). As a percentage of revenue, cost of claims decreased from 90.2% to 89.2% for the fiscal years ended June 30, 2004 and June 30, 2005, respectively. The contracts that we recognized on a net revenue basis decreased our overall costs as a percentage of revenue due to the cost not being recognized on the contracts recorded on the net revenue basis. In addition, the receipt of an additional $12.9 million in co-payments from Mail Service resulted in a lower cost of claims as a percent of revenue, since no additional cost of claims are incurred related to these fees.
Selling, general and administrative expenses as a percent of revenue increased from 7.8% for the fiscal year ended June 30, 2004 to 8.5% for the fiscal year ended June 30, 2005. The main reasons for the increase were the impact of recognizing more contracts on a net revenue basis.
Income before the provision for income taxes increased approximately $6.9 million, or 51.1%, from approximately $13.5 million, for the fiscal year ended June 30, 2004, to approximately $20.4 million for the fiscal year ended June 30, 2005. The primary factors leading to this increase were the rises in gross profit and other income, offset by the increase in selling, general and administrative expenses related to the activities of the new entities we acquired.
The effective tax rate decreased from 41.0% for the year ended June 30, 2004 to 39.3% for the year ended June 30, 2005. The main reason for the decrease was a reduction in our state income taxes.
* Diluted weighted average number of shares assumes the conversion of the 6,957 shares of redeemable convertible preferred stock and dilutive common stock options and warrants.
While cash flow from operating and investing activities excluding the impact of the PCN acquisition are not measures of financial performance under GAAP, they are provided as information for investors for analysis purposes in evaluating the effect of the PCN acquisition on cash flow from operating and investing activities. Cash flow from operating and investing activities excluding the impact of the PCN acquisition is not meant to be considered a substitute or replacement for cash flow from operating and investing activities as prepared in accordance with GAAP. The reconciliation from cash flow from operating and investing activities to cash flow from operating and investing activities excluding the impact of the PCN acquisition, is as follows:
Net cash provided by financing activities was $1.5 million for the fiscal year ended June 30, 2006 as compared to net cash used in financing activities of $2.3 million for the fiscal year ended June 30, 2005. This increase of $3.8 million is primarily the result of a $2.3 million cash inflow, which represented the excess tax benefits from the exercise of employee stock option in accordance with FASB statement No. 123(R), which we’ve adopted July 1, 2005. The increase was further caused by a $0.7 million increase related to additional proceeds from the exercise of employee stock options, higher pay downs of capital lease obligations of $0.3 million and the payment of closing costs of $0.5 million in connection with our line of credit.
We calculate and use EBITDA and EBITDA per adjusted prescription as indicators of our ability to generate cash from our reported operating results. These measurements are used in concert with net income and cash flows from operations, which measure actual cash generated in the period. In addition, we believe that EBITDA and EBITDA per adjusted prescription are supplemental measurement tools used by analysts and investors to help evaluate overall operating performance and the ability to incur and service debt and make capital expenditures. EBITDA does not represent funds available for our discretionary use and is not intended to represent or to be used as a substitute for net income or cash flows from operations data as measured under GAAP. The items excluded from EBITDA but included in the calculation of our reported net income are significant components of our consolidated statements of income, and must be considered in performing a comprehensive assessment of our overall financial performance. EBITDA, and the associated year-to-year trends, should not be considered in isolation. Our calculation of EBITDA may not be consistent with calculations of EBITDA used by other companies.
EBITDA per adjusted prescription is calculated by dividing EBITDA by the adjusted prescription volume for the period. This measure is used as an indicator of our EBITDA performance on a per-unit basis, providing insight into the cash-generating potential of each prescription. EBITDA per adjusted prescription reflects the level of efficiency in the business and is affected by changes in prescription volumes between retail and mail, as well as the relative representation of brand-name, generic and specialty drugs.
(2) Includes Inteq’s operating results commencing April 1, 2004, the date of acquisition. Includes Ascend’s operating results commencing July 31, 2003, the date of acquisition.
(3) Estimated adjusted prescription volume equals the Mail Service prescriptions multiplied by 3, plus retail prescriptions. These Mail Service prescriptions are multiplied by 3 to adjust for the fact that they include approximately 3 times the amount of product days supplied compared with retail prescriptions.
We lease offices and warehouse space throughout the United States under various operating leases. The Company also leases pill dispensing and counting devices for use in its mail service pharmacy, as well as computer equipment for use in its various offices.
In addition, we rent two houses from Living In Style, LLC, an entity partially owned by Tery Baskin, an executive officer of the Company, and Bert Brodsky, a former Chairman of the Board, which is used for out-of-town employees. We evaluated the cost of hotels for these out-of-town employees and determined that it was more cost efficient to rent the houses.
As an approved PDP sponsor for 2007, we intend to commence offering Medicare Part D pharmacy benefits to employer groups on January 1, 2007, subject to entering into a formal agreement with CMS during the fourth quarter of 2006. This will be the first time we are a direct contractor to the federal government and subject to the rules, regulations and enforcement authority of the federal government over its contractors. In addition, under regulations established by CMS governing participation in the Medicare Part D program, our subsidiary, NMHC Group Solutions, must be a risk-bearing entity regulated under state insurance laws and must obtain licensure as a domestic insurance company prior to entering into a formal contract with CMS. NMHC Group Solutions has been approved to operate as a risk-bearing entity in its domicile state, Delaware, and has filed applications for licensure in the 49 other states and Washington D.C., and Puerto Rico. We are at various stages with these applications in the ancillary states as some states are considering our application, others we have not heard back from and others have been withdrawn for failure to meet certain requirements. We expect to operate under a three year wavier granted by CMS for these other states and territories. We have currently committed over $6.3 million in a cash account in connection with CMS requirements. As we become licensed as a risk-bearing entity in additional states, we expect to deposit an additional $8 million in the near future to fulfill statutory requirements in various states.
Following the completion of the tender offer, New Mountain Partners owned securities at March 19, 2004 that were initially convertible into approximately 64% of our issued and outstanding common stock and prior to conversion of the series A preferred stock were entitled to cast that number of votes that is equal to approximately 60% of our aggregate voting power. Following the closing of the New Mountain transaction, New Mountain Partners was entitled to and did nominate and elect 60% of the members of our board of directors.
The series A preferred stock provides for an initial annual cash dividend equal to 7% of the investment amount, which decreases to 3.5% after the fifth anniversary of issuance. The series A preferred stock is convertible into common stock at a price of $11.50 per share of common stock, or an aggregate of 6,956,522 shares of our common stock.
The series A preferred stock may be redeemed at our option subsequent to the fourth anniversary of its issuance, subject to certain conditions. After the tenth anniversary of the issuance of the series A preferred stock, each holder of shares of series A preferred stock may require us to redeem all or a part of that holder’s shares of series A preferred stock.
Revenue Recognition Our revenue primarily consists of sales of prescription drugs, together with any associated administrative fees, to clients and participants, either through our nationwide network of pharmacies, our mail service pharmacy or our specialty pharmacy. We enter into a fee for service (per claim charges) arrangement with our clients for the payment of administrative fees. Under the fee for service arrangement, we are paid by our clients for our contractually agreed upon rates based upon actual claims adjudicated plus a fixed transaction fee. Revenue related to the sales of prescription drugs by our nationwide network of pharmacies, our mail service pharmacy or specialty pharmacy, is recognized when the claims are adjudicated and the prescription drugs are shipped. Co-payment revenue recognized during the fiscal years ended June 30, 2006, 2005 and 2004 was $18,423, $15,134 and $2,274, respectively. Claims are adjudicated at the point-of-sale using our on-line processing system. To date, our mail service pharmacy primarily fills prescriptions for our plan clients. Revenue from these intercompany sales is eliminated in consolidation. Specialty pharmacy revenues represent revenues from the sale of primarily biopharmaceutical drugs and are reported at the net amount billed to third-party payors, patients and others. Approximately 48% of revenues from our specialty pharmacy are from prescriptions filled for our plan clients. Revenue from these intercompany sales is eliminated in consolidation. The remaining 52% of revenues from our specialty pharmacy are recognized at the point of shipment.
We evaluate client contracts using the indicators of Emerging Issues Task Force (“EITF”) No. 99-19, “Reporting Gross Revenue as a Principal vs. Net as an Agent,” to determine whether we act as a principal or as an agent in the fulfillment of prescriptions through the retail pharmacy network. We act as a principal in most of our transactions with clients and revenues are recognized at the prescription price (ingredient cost plus dispensing fee) negotiated with clients, as well as our administrative fees (“Gross Reporting”). Gross reporting is appropriate because we (a) have separate contractual relationships with clients and with pharmacies, (b) are responsible to validate and economically manage a claim through our claims adjudication process, (c) commit to set prescription prices for the pharmacy, including instructing the pharmacy as to how that price is to be settled (co-payment requirements), (d) manage the overall prescription drug relationship with the patients, who are participants of clients’ plans, and (e) have credit risk for the price due from the client. In instances where 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 only records their 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. As we are not the principal in these transactions, drug ingredient cost is not included in our revenues or in our cost of claims. Whether revenues are recorded on either a gross or net basis, we record the gross amount billed in accounts receivable and the related claims payable to pharmacies on our balance sheets.
Allowance for Doubtful Accounts We maintain an allowance for doubtful accounts for estimated losses resulting from the liability of our clients to make required payments. If the financial condition of our clients were to deteriorate, resulting in an impairment of their ability to make payments, an additional allowance may be required.
Goodwill Our goodwill represents the excess of the acquisition costs over the fair value of the net tangible and identifiable intangible assets acquired that has been allocated to goodwill from our various business acquisitions. We test our goodwill for impairment on an annual basis, or whenever events, such as a protracted decline in our stock price or other changes in circumstances, indicate that the carrying amount may not be recoverable, using a two-step fair-value based test. The most recent assessment of goodwill impairment for each of our designated reporting units was performed as of June 30, 2006, and the recorded goodwill was determined not to be impaired.
$2,278 and non-current net deferred tax liabilities of $7,784. The net deferred tax assets assume sufficient future earnings for their realization, as well as the continued application of currently anticipated tax rates. We periodically consider whether or not we should record a valuation allowance to reduce our deferred tax assets to the amount that is more likely than not to be realized. While we have considered future taxable income and ongoing tax planning strategies in assessing the need for the valuation allowance, in the event we were to determine that we would be able to realize our deferred tax assets in the future in excess of our net recorded amount, an adjustment to the deferred tax asset would increase income in the period such determination was made. Likewise, should we determine that we would not be able to realize all or part of our net deferred tax asset in the future, an adjustment to the deferred tax asset would be charged to income in the period such determination was made. Based on our assessment as of June 30, 2006, a valuation allowance is not required against our deferred tax assets.
We use an expected stock-price volatility assumption that is based on the historical volatility of the underlying stock which is obtained from public data sources. This approach is used as a predictor of future realized and implied volatilities and is directly related to stock option valuation. For stock option grants issued during the fiscal year ended June 30, 2006, we used a weighted-average expected stock-price volatility of 60.6% based upon the implied volatility at the time of issuance.
On November 10, 2005, FASB issued FASB Staff Position SFAS 123(R)-3 “Transition Election Related to Accounting for Tax Effects of Share-Based Payment Awards.” We have elected to adopt the alternative transition method provided in the FASB Staff Position for calculating the tax effects of stock-based compensation pursuant to FASB statement No. 123(R). The alternative transition method includes simplified methods to establish the beginning balance of the additional paid-in capital pool (“APIC pool”) related to the tax effects of employee stock-based compensation, and to determine the subsequent impact of the APIC pool and consolidated statements of cash flows of the tax effects of employee stock-based compensation awards that are outstanding upon adoption of FASB statement No. 123(R).
Tax positions that meet the more-likely-than-not recognition threshold at the effective date of FIN 48 may be recognized or, continue to be recognized, upon adoption of FIN 48. The cumulative effect of applying the provisions of FIN 48 shall be reported as an adjustment to the opening balance of retained earnings for that fiscal year. FIN 48 will apply to fiscal years beginning after December 15, 2006, with earlier adoption permitted. We are currently evaluating the impact FIN 48 will have on our consolidated financial statements when it becomes effective for us in fiscal 2008 and are unable, at this time, to quantify the impact, if any, to retained earnings at the time of adoption.