Ten of our eleven satellite offices, with a total of 55,000 square feet, are under leases that expire over terms through August 2013 and the other office is under a month-to-month lease. We believe that suitable space on commercially reasonable terms will be available as required.
(1) Certain reclassifications were made to prior year amounts to conform to current year presentation. Specifically, certain selling, general and administrative expenses, such as third-party commissions, client and member services costs, and information technology costs have been reclassified to direct expenses. Amounts reclassified from selling, general and administrative expense to direct expense were $13.9 million, $11.2 million, $7.5 million and $5.3 million for the years ended December 31, 2005, 2004, 2003 and 2002, respectively. We believe this presentation better reflects the nature of these costs as being more indicative of the direct effort to manage and process our client revenue. These changes have no impact on our previously reported revenue, total operating expenses or operating income.
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 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 approximately 3%, 6% and 9% of our revenue in the years ended 2006, 2005 and 2004, respectively. Individuals are the major purchasers of these programs.
Our PBM segment provides our clients access to a contracted, non-exclusive national network of more than 58,000 pharmacies. We provide our clients’ members with timely and accurate benefit adjudication, while controlling pharmacy spending trends through customized plan designs, 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.
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 $477.0 million, $279.2 million and $213.0 million, for the years ended December 31, 2006, 2005 and 2004, respectively. Our operating and net income, consolidated balance sheets and statements of cash flows would not have been affected.
We have supported the growth of our PBM segment through acquisitions.
interest beginning after twelve months and ending after fifteen months from closing at specified amounts based on the financial performance of EBRx. On February 6, 2007, we acquired the minority ownership interest in the parent of EBRx through the acquisition of a separate entity and transferred the shares in the operating subsidiary to HCEM. The transaction resulted in a cash payment of $30.3 million prior to the repayment of related transaction debt and accrued interest.
The acquisition of EBRx also provided for an additional contingent payment of up to $3.0 million subject to performance based standards including certain specified client retention and gross profit criteria for the twelve months ended December 31, 2006. The contingent consideration earned in 2006 was $2.4 million.
On June 18, 2004, we acquired 100% of the common stock of MHS for a cash payment of $37.3 million and 100,739 shares of our common stock valued at $1.5 million. In addition, we agreed to issue $4.0 million principal amount of non-negotiable promissory notes, warrants to purchase up to 300,000 shares of our common stock at an exercise price of $15.45 per share, and to pay $2.0 million in cash, all subject to performance-based standards and certain revenue and gross profit criteria attributable to MHS. The acquisition of MHS was accounted for using the purchase method of accounting, and we recorded goodwill of approximately $30.4 million and intangible assets of $8.4 million. In July 2005, subject to the various revenue and gross profit performance requirements, we paid the additional contingent cash consideration in a total amount of $6.2 million and issued 100,000 common stock warrants at an exercise price of $15.45 per share. Also, in July 2006, subject to the various revenue and gross profit performance requirements, we issued an additional 100,000 common stock warrants at an exercise price of $15.45 per share. Each of these warrant issuances were valued at $1.0 million and were recognized as additional goodwill as a component of the acquisition accounting. The remaining 100,000 warrants remain potentially issuable subject to future revenue and gross profit performance based requirements.
We have successfully integrated MHS and EBRx into our financial, organizational, management and technology structure. As a result, we achieved cost savings from the consolidation of certain corporate activities and the elimination of certain duplicate components of our corporate operations. We expect to integrate the operations of R/xx in 2007.
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 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 the extent and timing of marketing campaigns funded by these three companies and the success they achieve. Correspondingly, these companies are compensated with an increasing percentage of total program revenue, which is accounted for as direct expenses by us. All of the insurance and service features included in our programs are supplied by third-party insurance companies or other vendors, and the programs are distributed through an independent, licensed and non-affiliated insurance agency.
The primary determinant of revenue recognition for the supplemental benefits segment is monthly program enrollment. In general, program revenue is recognized based on the number of members enrolled in each reporting period multiplied by the applicable monthly fee for their specific membership program. The program revenue recognized by us includes the cost of membership features supplied by others, including the insurance components. Revenue from program payments received, and related direct expenses, is deferred to the extent that they are applicable to future periods or to any refund guarantee we offer.
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. The PBM revenue increased 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.
Gross margins, calculated as segment revenue less segment direct expense, in the PBM segment are generally predictable based on client contract terms and vendor/supplier contracts. Other 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. None have materially changed in 2006 in a manner that would meaningfully affect current or anticipated results. In 2006, composite gross margin percentages were reduced by the addition of several new large contracts including Wellmark Blue Cross Blue Shield of Iowa, which are more competitively priced due to their size. These decreases were somewhat offset by gross margin improvements resulting from an increased level of generic substitution and higher network discount rates.
Gross margins in the supplemental benefits segment are generally consistent on a per transaction basis. During 2006, we enhanced one of our telemarketing programs and modified one of our contracts with a partner. Both of these changes had a positive impact on our 2006 gross margin when compared to our 2005 gross margin.
Revenue. Revenue from operations for year ended December 31, 2005 was $694.5 million, consisting of $650.9 million generated from the PBM segment and $43.6 million from the supplemental benefits segment. The PBM revenue increased by $175.7 million, including: $165.1 million of revenue from increased prescription volume, which includes increases associated with a full year of activity on the State of Louisiana contract, a full year
Direct expenses for year ended December 31, 2004 were $471.9 million, consisting of $436.3 million and $35.6 million attributable to the PBM and supplemental benefit segments, respectively. The direct expenses of $627.2 million and $471.9 million for years ended December 31, 2005 and 2004 represented 95.1% of operating expenses for each of the respective periods.
Gross margins in the supplemental benefits segment are generally consistent on a per transaction basis. Gross margin dollars remained relatively unchanged in 2005 from 2004.
Selling, General and Administrative. For the year ended December 31, 2005, selling, general and administrative expenses increased by approximately $8.1 million over the prior year to $32.5 million or 4.9% of operating expenses. This increase was primarily associated with PBM segment growth and the related sales and marketing initiatives, and new client implementations.
Selling, general and administrative expenses for the year ended December 31, 2005, of $32.5 million consisted of $17.1 million in compensation and benefits, which includes $1.2 million in non-cash compensation, $2.8 million in professional fees and technology service costs, $3.3 million in facility costs, $2.2 million in travel expenses, $1.7 million in insurance and other corporate expenses, $0.2 million for product endorsement and marketing, $1.3 million in other expenses, which includes $0.7 million in recruitment and temporary help, and $3.9 million in depreciation and amortization.
Other Income. Other income was $87,000 for the year ended December 31, 2005. In the second quarter of 2004, we reached a legal settlement related to litigation initiated by us on December 3, 2002. The terms of the settlement are confidential; however, the net proceeds from the settlement constitute the significant portion of the $2.1 million in other income reported in the 2004 statement of operations.
Income Tax Expense. The effective income tax rate of 36.4% in 2005 and 37.7% in 2004 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 2004, in particular, due to interest income earned on federally tax exempt investments.
Net Cash Provided by (Used in) Financing Activities. Net cash provided by financing activities for the year ended December 31, 2006 was $5.7 million compared to cash used in financing activities of $4.8 million in 2005. In 2006, we repaid $12.5 million in notes payable and received proceeds of $8.8 million from the exercise of options and Employee Stock Purchase Plan purchases. In addition, we received an income tax payable benefit of $10.5 million from the exercise of stock options and restricted stock awards and incurred $1.1 million from all other financing activities. In 2005, we repaid $14.0 million in notes payable and received proceeds of $9.2 million from the exercise of options, warrants and ESPP purchases.
Trade accounts receivable are recorded at the invoiced amount and do not bear interest. The allowance for accounts receivable is our best estimate of the amount of probable credit losses in our existing accounts receivable. We determine the allowance based on historical write-off experience by industry and regional economic data. We review our allowance for accounts receivable monthly. Past due balances over 90 days and over a specified amount are reviewed individually for collectibility. All other balances are reviewed on a pooled basis by type of receivable. Account balances are charged off against the allowance when we feel it is probable the receivable will not be recovered. We do not have any off-balance-sheet credit exposure related to our customers.
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 capitalization at the date of valuation. For the purposes of performing this impairment test, our business segments are our reporting units. If the carrying amount exceeds the fair value, the second step of the goodwill impairment test is 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, 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.
In September 2006, the SEC issued Staff Accounting Bulletin No. 108, Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements (“SAB 108”). SAB 108 requires that public companies utilize a “dual-approach” to assessing the quantitative effects of financial misstatements. This dual approach includes both an income statement focused assessment and a balance sheet focused assessment. The guidance in SAB 108 must be applied to annual financial statements for fiscal years ending after November 15, 2006. The adoption of SAB 108 did not have a material impact on our financial condition, results of operations or cash flows.