Our offices are located in approximately 19,700 square feet of office space in Rockville, Maryland under a sublease that expires on May 30, 2004. Our subsidiaries lease a total of approximately 25,400 square feet under three leases that expire in March 2003, February 2006, and October 2011. We believe that our office space is adequate for our existing needs and that suitable additional space on commercially reasonable terms will be available as required.
- -------------- (1) Reflects the formation of HealthExtras, Inc. as if those events had taken place at the beginning of the period, except that no effect is given to the investment by Capital Z Healthcare Holding Corp. in HealthExtras prior to May 27, 1999.
This Form 10-K may contain forward-looking statements (see "Certain Factors That May Affect Future Operating Results or Stock Prices") within the meaning of Section 21E of the Securities Exchange Act of 1934, as amended. These forward-looking statements involve a number of risks and uncertainties. We undertake no obligation to revise any forward-looking statements in order to reflect events or circumstances that may arise after the date of this report. Readers are urged to carefully review and consider the various disclosures made in this report and in our other filings with the Securities and Exchange Commission that attempt to advise interested parties of the risks and factors that may affect our business.
HealthExtras is a provider of PBM services and supplemental benefits. The Company's clients include managed-care organizations, self-insured employers, third party administrators, as well as individual customers. The PBM segment now generates the significant majority of our revenues and is expected to be the primary source of growth and profit potential in years ahead. The acquisitions of International Pharmacy Management, Inc. ("IPM"), Catalyst Rx ("Catalyst") and PNNC have contributed significantly to the growth of our PBM business.
On November 14, 2001, the Company acquired an 80% interest in Catalyst for an aggregate purchase price of approximately $14.3 million. Consideration for the transaction consisted of $10.4 million in cash, $8.9 million of which was payable at December 31, 2001, and the remainder consisted of the assumption of debt and the issuance of common stock. The acquisition of Catalyst was accounted for using the purchase method of accounting. The $9.1 million excess of the purchase price paid over the net fair value of identifiable assets and liabilities of Catalyst was recorded as goodwill.
The Company has completed the initial steps of integrating PNNC that are necessary for HealthExtras to operate as a single, combined company. We intend to operate with a combined financial, organizational and management structure so that all of our customers, employees and suppliers have access to a consistent and reliable organizational infrastructure. Over the next several quarters the Company expects to complete additional integration steps around data processing platforms and other technology systems.
Revenue from program payments received, and related direct expenses, are deferred to the extent that they are applicable to future periods or to any refund guarantee we offer. HealthExtras has committed to minimum premium volumes with respect to the insurance features of its programs supplied by others. In the event that there were insufficient members to utilize the minimum premium commitment, the differential would be expensed by the Company with out any related revenue. The Company believes that current enrollment trends will allow the minimum future commitments at December 31, 2002, to be fully utilized by current enrollment levels.
REVENUE. Revenue from operations for the year ended December 31, 2002, was $248.4 million, compared to $118.2 million for the year ended December 31, 2001. The PBM segment contributed $135.4 million of this revenue increase, while the supplemental benefits segment decreased by $5.2 million. Total revenue for the year ended increased 289% and decreased 7.3% in the PBM segment and the supplemental benefits segment, respectively. The PBM increase was principally due to the Catalyst acquisition on November 14, 2001, which increased revenues by $115.2 million from 2001 to 2002. Of the $115.2 million, $49.8 million is attributed to new business for Catalyst in 2002. Due to the Company's adoption of Emerging Issues Task Force Issue No. 01-9, "Accounting for Consideration Given by a Vendor to a Customer or a Reseller of the Vendors Products" ("EITF 01-9"), revenues and direct expenses for 2001 have been retroactively reduced by $6.2 million in the comparative financial statements. For more information about the adoption of EITF 01-9, see Note 2 of the Notes to Consolidated Financial Statements.
SELLING, GENERAL AND ADMINISTRATIVE. Selling, general and administrative expenses for the year ended December 31, 2002, totaled $35.5 million or 14.5% of operating expenses, $7.0 million of which was related to the Company's PBM segment, while the remaining $28.5 million related to the management of the supplemental benefits segment. These expenses include $4.1 million for creative development, product endorsement and market research, $12.6 million in direct marketing, $8.2 million in compensation and benefits, $1.3 in professional fees, insurance and taxes, $2.8 million in other expenses, $1.4 million in facility costs, $826,000 in travel expenses and $1.7 million in depreciation and amortization and $2.7 million related to the impairment of and write-off of fixed assets.
INTEREST INCOME (EXPENSE) NET. Interest expense, net for the year ended December 31, 2002, was approximately $(82,000) compared to interest income, net of $1.1 million for the year ended December 31, 2001. This was principally due to lower invested balances, interest rates and interest on borrowings initiated in 2002. Interest expense on borrowings for 2002 was $319,000.
INCOME TAX BENEFIT. Through 2001, the Company maintained a full valuation allowance against the Company's deferred tax assets due to the uncertainly as to their ultimate realization. In the fourth quarter of 2002, as a result of the Company's current and projected profitability, the Company recognized approximately a $10.2 million tax benefit principally resulting from the Company releasing the valuation allowance for its deferred tax asset. See Note 7 to the Notes to Consolidated Financial Statements for further information.
NET INCOME (LOSS). Net income for the year ended December 31, 2002, was $13.5 million compared to a $(6.8) million net loss in 2001. As a percentage of revenue, net income increased from (5.6)% to 5.4%.
SELLING, GENERAL AND ADMINISTRATIVE. Selling, general and administrative expenses for the year ended December 31, 2001, totaled $38.5 million of 30.5% of operating expenses, $3.7 million of which was related to the Company's PBM segment, while the remaining $34.8 million related to the management of supplemental benefits segment. These expenses include $5.8 million for creative development, product endorsements, and market research, $21.4 million in direct marketing, $6.1 million in compensation and benefits, $1.1 million in professional fees, insurance and taxes, $1.0 million in other fees, $843,000 million in facility costs, $466,000 in travel expenses and $1.8 million in depreciation and amortization.
NET LOSS. Net loss for the year ended December 31, 2001, was $6.8 million compared to a $17.4 million net loss in 2000. As a percentage of revenue, net loss decreased from 39.2% in 2000 to 5.6% in 2001.
Operating expenses of the segments exclude $2.4 million and $7.7 million in corporate overhead that was not allocated by management in assessing segment performance for the years ended December 31, 2001 and 2000, respectively.
CASH USED IN INVESTING ACTIVITIES. Cash used in investing activities for 2002 was $33.5 million compared to approximately $589,000 during 2001. The increase is primarily attributed to the $19.6 million paid in cash for the PNNC acquisition and related costs and the $12.1 million paid to satisfy the Catalyst acquisition promissory notes.
CASH FROM FINANCING ACTIVITIES. Cash provided by financing activities for 2002 was approximately $18.0 million compared to $6.7 million at December 31, 2001. In January 2002, the Company arranged for a line of credit for $5.0 million to support the working capital requirements of the Company's acquisition of Catalyst. In March 31, 2002, the Company arranged an $8.0 million revolving credit facility. In April 2002, the Company repaid the outstanding principal of $4.5 million on the credit facility previously arranged in January 2002. The Company repaid the remaining outstanding principal of $8.0 million in the fourth quarter of 2002. In December 2002, the
Company arranged to an $18.0 million revolving credit facility. At December 31, 2002, the outstanding balance on the credit facility was $18.0 million. All principal and accrued interest is due to the bank on May 31, 2004.
In 2000 and 2001, the Company recorded as direct expense the fair market value of common stock warrants earned, or expected to be earned by a distributor. The Company estimated the value of the warrants at each balance sheet date using an equity-pricing model with assumptions consistent with those used in preparing the Company's fair value stock option compensation disclosures. Direct expense was based on the number of warrants expected to be issued, which is determined based on an estimate of annualized revenues as defined under the agreement with the distributor. Effective January 1, 2002, the Company adopted EITF 01-9, which was issued in November 2001. The Company's adoption of EITF 01-9 resulted in changing the way the Company recognizes the cost of consideration provided to a distributor under a warrant agreement. Effective January 1, 2002, the charge for this consideration was recorded as a reduction to revenue from the distributor rather than as a charge to direct expense, as reflected in prior periods. To comply with EITF 01-9, the non-cash warrant expenses of $6.2 million and $255,000 for 2001 and 2000, respectively from prior years have been reclassified as a reduction to revenue from the distributor.
Intangible assets related to the acquisitions of Catalyst, and PNNC were recognized under the provisions of FASB Statement No. 141 ("FAS 141"). Accordingly, a portion of the excess purchase price was assigned to intangible assets that were recognizable apart from goodwill. This estimated fair value and the weighted average useful-life of the intangible assets are based on income-method valuation calculations, performed by an independent consulting firm. The remaining useful life of intangible assets will be evaluated periodically and adjusted as necessary to match the period that the assets are expected to provide economic benefits.
The Company adopted Statement of Financial Accounting Standards No. 142, Goodwill and Other Intangible Assets ("FAS No. 142"), and discontinued the amortization of goodwill and indefinite-lived intangible assets effective January 1, 2002. The Company completed its initial adoption impairment testing of goodwill and concluded that no impairment of goodwill exists. The Company performed a similar test as of December 31, 2002, and concluded that no impairment of goodwill exists.
The Company records deferred tax assets and liabilities based on temporary differences between the financial statement and the tax bases of assets and liabilities using enacted tax rates in effect in the year in which the differences are expected to reverse. In 2000 and 2001, the Company maintained a full valuation allowance against the Company's deferred tax assets due to the uncertainty as to their ultimate realization. In the fourth quarter of 2002, as a result of the Company's current and projected profitability, the Company recognized approximately $10.2 million in tax benefits principally resulting from the Company releasing the full valuation allowance for its deferred tax asset.
In December 2002, the FASB issued SFAS No. 148, "Accounting for Stock-Based Compensation - Transition and Disclosure, an amendment of FASB Statement No. 123", to provide alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. In addition, SFAS No. 148 amends the disclosure requirements of SFAS No. 123 to require prominent disclosures in both annual and interim financial statements about the method of accounting for stock-based employee compensation and the effect of the method used on reported results. The application of the transition provisions of SFAS No. 148 is effective for fiscal years ending after December 15, 2002. The application of the disclosure requirements is effective for financial reports for interim periods beginning after December 15, 2002. We are currently evaluating the impact of SFAS No. 148 on our financial position, results of operations and liquidity.
In November 2002, the FASB issued FASB Interpretation (FIN) No. 45, "Guarantor's Accounting and Disclosure Requirements for Guarantees Including Indirect Guarantees of Indebtedness of Others", which elaborates on the disclosures to be made by a guarantor in its interim and annual financial statements about its obligations under certain guarantees that it has issued. It also clarifies that 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 initial measurement provisions of FIN No. 45 are applicable on a prospective basis to guarantees issued or modified after December 31, 2002, irrespective of the guarantor's fiscal year end. The disclosure requirements are effective for financial statements of interim or annual periods ending after December 15, 2002. As of December 31, 2002, there is no impact on the Company's financial statements as a result of the issuance of FIN 45.
Our growth strategy, if successful, will result in further expansion of our PBM operations. We can maintain profitable operations, however, only if we are able to manage our growth effectively. Our growth in operations has placed significant demands on our management and other resources, which is likely to continue. Under these conditions, it is important for us to retain our existing management, including those from Catalyst and PNNC, and to attract, hire and retain additional highly skilled and motivated officers, managers and employees.
If we do not effectively manage and integrate our acquisition of PNNC our business prospects could be damaged - ----------------------------------------------------------------------------
If we lose one or more of our distribution relationships, our access to potential customers would decline and sales and revenues would suffer - ----------------------------------------------------------------------------
A significant percentage of our membership growth during 2002 was attributable to telemarketing sales. These sales involve a much higher percentage of monthly rather than annual sales than was our previous experience. The combination of these has resulted in higher initial cancellation rates and reduced enrollment persistency. Moreover, it is possible that FTC rule regarding a national "do-not-call" registry could adversely affect telemarketing sales.
The loss of our relationship with Christopher Reeve to promote our programs could significantly impair our brand recognition and, thus, our ability to sell our Supplemental Benefits programs - ------------------------------------------------------------------------------
Our agreement for Christopher Reeve to promote our programs currently expires in July 2005. The loss of the Christopher Reeve identification with our programs, upon termination of our contract or otherwise, could significantly reduce the distribution of our programs.
If we lose our relationships with our benefit providers, we could have difficulty meeting demand for the products and services included in our programs - -------------------------------------------------------------------------------
Complex laws, rules and regulations of each of the 50 states and the District of Columbia pertaining to insurance impose strict and substantial requirements on insurance coverage sold to consumers and businesses. Compliance with these laws, rules and regulations can be arduous and imposes significant costs. The underwriter of the insurance benefits included in HealthExtras programs is responsible for obtaining and maintaining regulatory approvals for those benefits. If the appropriate regulatory approvals for the insurance benefits included in the programs are not maintained, we would have to stop including those benefits. An independent licensed insurance agency is responsible for the solicitation of insurance benefits involved in the programs.
Our pharmacy benefit management business must comply with a range of State and Federal regulatory requirements - -------------------------------------------------------------------------------
Various forms of legislation and government regulations affect or could affect providers of pharmacy benefit management services. Among the most prominent forms of such regulation are the following:
Consumer Protection Legislation. Most states have consumer protection laws that generally prohibit payments and other broad categories of conduct deemed harmful to consumers. These statutes may be enforced by the states and, in fact, have been the basis for state investigations and at least one multi-state settlement relating to financial incentives provided by drug manufacturers to retail pharmacies in connection with drug switching programs. We believe that we do not have contractual relationships with drug manufacturers and retail pharmacies that include the features that have been viewed adversely by enforcement authorities. However, no assurance can be given that we will not be subject to scrutiny or challenge under one or more of these laws.
Discount Drug Card Regulation. Several states recently have enacted laws and/or promulgated or proposed regulations regulating the selling, marketing, promoting, advertising or distributing of discount drug cards for cash purchases. Such laws and regulations provide generally that any person may bring an action for damages or injunction for violations.
If we are unable to safeguard the security and privacy of our program members' information, our reputation would be damaged and we could be subject to litigation and liability - -------------------------------------------------------------------------------
A significant barrier to electronic commerce and online communications has been the need for secure transmission of confidential information over the Internet. Our ability to secure the transmission of confidential information over the Internet is essential in maintaining consumer confidence in our service. In addition, because we handle confidential and sensitive information about our program members, any security breaches would damage our reputation and could expose us to litigation and liability. We cannot guarantee that our systems will prevent security breaches.