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”). We sublease the Leased Premises from BFS Realty, LLC, an affiliate of former Chairman Bert E. Brodsky (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.
The Lease provides that, effective May 1, 2004, the rent payable by us shall be an aggregate annual rent of $594,678 over a ten year term, plus expenses related to real estate taxes, utilities and maintenance. Annual rent increases will be based upon the Consumer Price Index plus 2.5% subject to a maximum annual cap of 3.5%. The Lease expires ten years from the occupancy date of May 1, 2004. In addition, we have early termination rights which we may exercise by delivery of a notice to the Affiliate 60 days prior to the end of the April 30, 2009 lease year. In consideration of such early termination rights, we would pay to the Affiliate the rent that would otherwise be payable by us to the Affiliate for the succeeding 30 months, and subject to adjustments if the Affiliate is able to lease the Leased Premises to another party during said 30 month period.
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 $2,091,000 for the fiscal year ended June 30, 2007.
In addition, we rented two houses from Living In Style, LLC, an entity partially owned by Tery Baskin, a former executive officer of the Company, and a former Chairman of the Board and CEO, which was used for out-of-town employees. Pursuant to leases dated May 1, 2002 which expired April 30, 2007, we paid an aggregate of $128,000 in rent for these two facilities during the fiscal year ended June 30, 2007. Upon their expiration, we did not renew the lease for these two houses.
The following selected financial data has been derived from our audited consolidated 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 share amounts.
During the fiscal year ended June 30, 2007, we identified various errors which resulted in a reduction of our operating income of approximately $211. These various errors consisted of the following:
Rebate Error. During the preparation of our Quarterly Report on Form 10-Q for the period ended September 30, 2006 (“First Quarter 10-Q”)) we determined that we incorrectly recognized $1,017 of rebate revenue during the fiscal year ended June 30, 2006. The error primarily related to an adjustment recorded during the fourth quarter of fiscal 2006 regarding a duplicate rebate payment made to a single customer in a prior period; however, management subsequently discovered that the duplicate payment of $1,032 had already been refunded by the customer. This duplicate payment was reflected as a reduction in our liability as of June 30, 2006 to this customer when it should not have been. Subsequent to the filing of our First Quarter 10-Q, we identified additional errors approximating $456. The net impact of errors relating to our rebate payable balances to customers resulted in a net decrease of approximately $1,473 of our rebate revenue and operating income for the fiscal year ended June 30, 2007 (the “Rebate Error”).
Claims Payable to Pharmacies. Based upon a review of our claims payable to pharmacies, we identified approximately $1,523 of liabilities incorrectly processed during prior periods. The components of the $1,523 are as follows: i) $1,099 of claims that should have been reversed into income during a prior period but were reflected as a liability as of June 30, 2006 and June 30, 2005, ii) approximately $407 of claims that were shown as a reduction to our claims payable balance when they should not have been and should have been written off during prior periods, and iii) approximately $831 of claims that should have been reversed during a prior period along with a corresponding net receivable of $831 from a former customer that should have been written off during that same prior period (note that item iii results in no net impact to our operating results).
Accounting for Leases. We conducted a review of our leases and noted that the accounting treatment for various leases was not in accordance with SFAS No. 13, “Accounting for Leases”. As a result, we identified leases that were originally accounted for as operating leases when they should have been accounted for as capital leases. The change in the accounting treatment for various leases resulted in a $584 net increase of our operating income and was recorded during the quarter ended September 30, 2006 (the “Lease Error”). In addition, the change in accounting treatment for various leases resulted in $4,762 increase in our property and equipment and a $4,178 increase in our capital lease obligations.
With the acquisition and significant growth of Ascend, we have two reportable segments, PBM and Specialty Service. The PBM segment includes the sale of traditional prescription drugs to our customers and their participants, either through our nationwide network of pharmacies or our Mail Service pharmacy. The Specialty Service 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 Service segments operate in the United States and several of its territories.
The PBM 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 PBM services. Given the pressure on all parties to reduce healthcare costs, we expect this competitive environment to continue for the foreseeable future.
Cost of claims decreased $179,721, or 23.3%, from $771,487 for the fiscal year ended June 30, 2006 to $591,766 for the fiscal year ended June 30, 2007. This decrease is primarily the result of a decrease in the amount of adjusted prescriptions as noted above. As a percentage of revenue, cost of claims decreased from 89.4% to 87.1% for the fiscal years ended June 30, 2006 and 2007, respectively.
Gross profit decreased $4,051 or 4.4%, from $91,366 for the fiscal year ended June 30, 2006 to $87,315 for the fiscal year ended June 30, 2007. This decrease is primarily the result of a $5,909 reduction in rebate revenue from our PBM segment (exclusive of the $1,473 Rebate Error as defined and discussed above) due to the current trends in negotiations with our customers. This decrease is partially offset by (i) $443 increase in gross profit from our PBM segment, exclusive of rebates, (ii) $1,365 increase in gross profit from our Specialty Service segment, and (iii) $50 net increase which consists of $1,523 relating to the Claims Payable Error as defined and discussed above offset by $1,473 relating to the Rebate Error. Primarily due to the changes in our customer mix, gross profit, as a percentage of revenue, increased from 10.6% for the fiscal year ended June 30, 2006 to 12.9% for the fiscal year ended June 30, 2007.
of various financial transactions in conjunction with the filings of our First Quarter 10-Q and the Quarterly Report on Form 10-Q for the period ended December 31, 2006 (“Second Quarter 10-Q”), settlements of various legal proceedings as well as an increase in our insurance premiums, (iii) $1,236 increase in information-technology costs, which includes a $657 impairment loss related to the cancellation of various capitalized projects during the fourth quarter of fiscal 2007, (iv) $1,880 increase in bad debt expense (inclusive of the $831 Claims Payable Error), of which $1,152 was incurred during the fourth quarter of fiscal 2007, and (v) $371 of net increases in other selling, general and administrative expenses. These increases were offset by $584 related to the Lease Error as defined and discussed above.
Our effective tax rate was 92.9% for the fiscal year ended June 30, 2007 as compared to 42.1% for the fiscal year ended June 30, 2006. The increase in the effective tax rate primarily resulted from lower pre-tax income combined with the effects of expensing stock options in accordance with Statement of Financial Accounting Standards No. 123 (revised 2004), “Share-Based Payment”, (“SFAS 123R”), offset by a $439 reversal of a prior state tax reserve as the related statute of limitations expired during the fiscal year ended June 30, 2007.
In addition, there were two charges against net income available to common stockholders related to the New Mountain Transaction (see “Commitments and Contingencies”). The first of these charges relates to series A preferred stock cash dividends, which amounted to $5,600 for both fiscal years ended June 30, 2007 and 2006. The series A preferred stock provides for an initial cash dividend equal to 7% of the investment amount (currently $80,000), which decreases to 3.5% after the fifth anniversary of issuance, March 19, 2009. The dividends of $5,600 represent the amount accrued and paid for the fiscal year ended June 30, 2006. The dividends of $5,600 represent the amount accrued for the fiscal year ended June 30, 2007. However, $1,396 of this dividend was not paid until July 3, 2007. The second charge is for the accretion of transaction expenses which was $475 for both fiscal years ended June 30, 2007 and 2006.
Revenue increased $62,261 or 7.8%, from $800,592 for the fiscal year ended June 30, 2005 to $862,853 for the fiscal year ended June 30, 2006. The specific terms of the contracts that we enter into with our customers will determine whether we recognize the gross revenue related to the cost of the prescriptions filled. For those contracts that we only recognize net revenue, there is no impact on our gross profit since neither the prescription revenue nor the related costs of the prescriptions is recorded. 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 sheet. We include in revenue only those co-payments earned from Mail Service. For the fiscal year ended June 30, 2006, there was $18,423 of co-payments included in revenue as compared to $15,134 for the fiscal year ended June 30, 2005. Co-payments retained by pharmacies on prescriptions filled for our participants and not included in our revenue were $321,055 and $280,946, for the fiscal years ended June 30, 2006 and 2005, respectively. Under our customer contracts, the pharmacy is solely obligated to collect the co-payments from the participants. As such, we do not include participant co-payments to pharmacies in our revenue or our cost of claims.
The $62,261 or 7.8%, increase in revenue during the fiscal year ended June 30, 2006 is primarily the result of (i) $59,176 inclusion of revenues from PCN, which we acquired on March 7, 2005, (ii) increase in co-payment revenue from Mail Service of $3,288 due to higher sales volume, and (iii) increase in revenue from Specialty Service of $3,618 due to higher sales volume. These increases were offset by $1,537 of additional credit memos issued to various customers and a $2,284 reduction in non-PCN business.
Cost of claims increased $57,604 or 8.1%, from $713,883 for the fiscal year ended June 30, 2005 to $771,487 for the fiscal year ended June 30, 2006. This increase is primarily the result of (i) $52,888 inclusion of cost of claims from PCN, which we acquired on March 7, 2005, (ii) increases in cost of claims from Specialty Service of $3,455 related to higher sales volumes, and (iii) $476 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.
Gross profit increased $4,657 or 5.4%, from $86,709 for the fiscal year ended June 30, 2005 to $91,366 for the fiscal year ended June 30, 2006. This increase is primarily the result of (i) $6,288 related to the PCN acquisition and (ii) increase in volume of claims from our Mail Service pharmacy which resulted in additional gross profit of $1,000. These increases were partially offset by (i) $1,537 of additional credit memos issued to various customers, (ii) $476 write-down of obsolete inventory from our Mail Service facility in Miramar, Florida, and (iii) reduction in non-PCN business. Gross profit, as a percentage of revenue, decreased from 10.8% to 10.6% for the fiscal years ended June 30, 2005 and June 30, 2006, respectively.
Selling, general and administrative expenses increased $8,066 or 11.9%, from $67,786 for the fiscal year ended June 30, 2005 to $75,852 for the fiscal year ended June 30, 2006. This increase is primarily the result of (i) $3,641 related to the PCN acquisition, (ii) $3,204 of compensation expense primarily related to the expensing of employee stock options, beginning July 1, 2005, in accordance with SFAS 123R, and (iii) $2,912 related to investments in our information systems’ infrastructure and continual upgrading/maintenance of our claims adjudication system. These items were partially offset by a $1,702 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.
Selling, general and administrative expenses as a percent of revenue increased from 8.5% for the fiscal year ended June 30, 2005 to 8.8% for the fiscal year ended June 30, 2006.
Other income, net decreased $331 or 22.2%, from $1,489 for the fiscal year ended June 30, 2005 to $1,158 for the fiscal year ended June 30, 2006. The decrease primary relates to the recognition of a
Net income decreased $2,724 or 22.0%, from $12,381 for the fiscal year ended June 30, 2005 to $9,657 for the fiscal year ended June 30, 2006. The decrease primarily relates to the $2,600 compensation charge, net of its income tax benefit, primarily related to the expensing of employee stock options in accordance with SFAS 123R. This decrease was further caused by the increase in selling, general and administrative expenses, offset by the increase in our gross profit.
Our primary cash requirements are for capital expenditures and operating expenses, including cost of pharmaceuticals, software and hardware upgrades, funding of accounts receivable and inventory in our Mail Service and Specialty Service pharmacies. We have acquired eight companies since July 2000 utilizing primarily cash. This has had the effect of increasing our working capital deficits until sufficient profitability is earned to offset these deficits. As of June 30, 2007 and 2006, we had working capital deficits of $3,383 and $7,098, respectively.
Net cash provided by operating activities was $3,172 for the fiscal year ended June 30, 2007 as compared to $7,658 for the fiscal year ended June 30, 2006. This decrease of $4,486 is primarily the result of (i) $13,580 increase in restricted cash primarily attributable to a $5,665 increase in our statutory, capital and surplus requirements in connection with our PDP and an additional deposit of $9,400 required from a customer, (ii) $28,280 decrease in rebates payable to customers, (iii) $1,801 decrease in income taxes payable and other current liabilities, (iv) $2,312 decrease in claims payable to pharmacies, (v) $2,744 increase in accounts receivable, and (vi) $1,295 increase in prepaid expense and other current assets. These decreases were partially offset by (i) $15,028 decrease in rebates receivable, (ii) $19,307 increase in trade and other payables and accrued expenses, and (iii) $12,092 increase in customer deposits payable. This decrease was further caused by $901 of net changes in other operating activities.
Historically, the timing of our collections of accounts receivable and payments of accounts payable has generally been a net source of cash from operating activities. This is the result of the terms of trade in place with plan customers on the one hand, and our pharmacy network on the other hand. These terms generally lead to our payments to participating pharmacies being slower than our corresponding collections from plan customers. We believe that this situation is not unusual in the PBM industry and expect to operate on similar terms for the foreseeable future. However, there can be no assurance that such terms of trade will continue in the future and, if they were to change materially, we could require additional working capital financing. If such terms of trade were to change materially, and/or if we were unable to obtain additional working capital financing, there could be a material adverse effect on our business, financial condition, or results of operations. Although we have a $65,000 revolving credit facility, we currently cannot borrow the full amount under this credit facility and we may be limited, or unable, to borrow under this credit facility in the future. We are currently in the process of exploring alternative financing arrangements so we can fully access any funds as needed.
Net cash used in financing activities was $4,323 for the fiscal year ended June 30, 2007 as compared to net cash provided by financing activities of $1,502 for the fiscal year ended June 30, 2006. This decrease of $5,825 is primarily the result of (i) additional payments of $2,630 towards our capital lease obligations, (ii) $2,557 reduction in the proceeds from the exercise of stock options, and (iii) $2,034 reduction in the excess tax benefit from the exercise of stock options. These decreases were offset by the Company not paying $1,396 of dividends on the series A preferred stock for the quarter ended June 30, 2007 until July 3, 2007.
On January 28, 2005, we entered into a five-year $65,000 line of credit with a syndicate of commercial banks led by JPMorgan. Subject to certain conditions, the line of credit may be increased by an aggregate of $35,000. Depending on the timing and dollar amount of each loan request, we can either borrow at a spread above LIBOR, the overnight Federal Funds rate or JPMorgan’s prime rate. As of June 30, 2007, the spread is 1.50% for LIBOR and Federal Funds loans and 0.50% for prime rate loans. The line of credit contains various covenants that, among other things, require us to maintain certain financial ratios, which are consolidated net worth, consolidated fixed charge ratio and consolidated debt to EBITDA (earnings before interest, taxes, depreciation and amortization) ratio. The consolidated fixed charge ratio and the consolidated debt to EBITDA ratio are evaluated by JPMorgan as a measure of our liquidity and our ability to meet all of our obligations under the credit facility. As of and for the year ended June 30, 2007, there was no principal balance outstanding under the line of credit, and we were in compliance with the aforementioned financial covenants. Although we have a $65,000 revolving credit facility, we currently cannot borrow the full amount under this credit facility and we may be limited, or unable, to borrow under this credit facility in the future. As of June 30, 2007, we were able to borrow approximately $39,000 under the credit facility. If we are in compliance with the consolidated fixed charge ratio, we can then borrow up to 2.5 times the Company’s consolidated EBITDA for the preceding twelve months less consolidated debt, as defined in the credit facility. Based on our financial performance, we may not be in compliance with the aforementioned financial covenants during fiscal year 2008. We are currently in the process of exploring alternative financing arrangements so we can fully access any funds as needed.
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.
risk. This change in PDP offerings may allow us to decrease the capital and surplus amounts maintained in our restricted cash accounts.
We entered into an amended and restated preferred stock purchase agreement, dated as of November 26, 2003, with New Mountain Partners, L.P. (the “purchase agreement”). Pursuant to the purchase agreement, we agreed, subject to various conditions, to issue to New Mountain Partners a total of 6,956,522 shares of the series A preferred stock at a purchase price of $11.50 per share, for aggregate proceeds of approximately $80,000. On March 19, 2004, we completed the sale of the series A preferred stock to New Mountain Partners and used approximately $49,000 of the proceeds of the sale of the series A preferred stock to purchase, pursuant to a tender offer, 4,448,900 shares of our outstanding common stock at $11.00 per share (collectively, the “New Mountain Transaction”).
We used the remaining proceeds from the issuance and sale of the series A preferred stock of approximately $24,000, excluding expenses related to the closing of the New Mountain Transaction, for the Inteq acquisition and working capital purposes. See Item 8 hereof (Note 4 - Business Acquisitions) for descriptions of the various acquisitions that have been consummated in the last 3 years.
Subject to certain conditions, the liquidation value of the series A preferred stock is the greater of $11.50 per share plus all unpaid dividends, whether or not declared, or the amount that would be payable to a holder of the series A preferred stock if the series A preferred stock was converted into common stock immediately prior to the liquidation.
The preparation of consolidated financial statements requires companies to include certain amounts that are based on management’s best estimates and judgments. In preparing the consolidated financial statements, we reviewed our accounting policies and believe that these accounting policies are appropriate for a fair presentation of our financial position, results of operations and cash flows. Several of these accounting policies contain estimates, the most significant of which are discussed below. Actual results may differ from those estimates, and it is possible that future results of operations for any particular period could be materially affected by the ultimate actual results.
We describe below what we believe to be our critical accounting policies. (Also see 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.)
Revenue Recognition. Our revenue primarily consists of sales of prescription drugs, together with any associated administrative fees, to customers and participants, either through our nationwide network of pharmacies, our Mail Service pharmacy or our Specialty Service pharmacy. We enter into a fee for service (per claim charges) arrangement with our customers for the payment of administrative fees. Under the fee for service arrangement, we are paid contractually agreed upon rates from our customers 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 our Specialty Service pharmacy is recognized when the claims are adjudicated and the prescription drugs are shipped.
We evaluate customer contracts using the indicators of 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 our retail pharmacy network. We act as a principal in most of our transactions
Allowance for Doubtful Accounts. We estimate the allowance for doubtful accounts for our PBM and Specialty Service business based upon a variety of factors including the age of the outstanding receivables, trends of cash collections and bad debt write-offs, and the payor’s collection history. When circumstances related to specific collection patterns change, estimates of the recoverability of receivables are adjusted.
Property and Equipment. We state property and equipment at cost, less accumulated depreciation and amortization. We calculate depreciation using the straight-line method for assets with useful lives ranging from 3 to 8 years or, with respect to equipment under capital leases and leasehold improvements, we amortize them on a straight-line basis over the shorter of the lease term or the assets’ useful lives.
Internal Use Software. We invest heavily in developing software in order to enhance our operations as well as meet the needs of our customers. We apply the provisions of the American Institute of Certified Public Accountants Statement of Position (“SOP”) 98-1, “Accounting for the Costs of Computer Software Developed or Obtained for Internal Use.” Under this SOP, certain costs of computer software developed or obtained for internal use are capitalized and amortized on a straight-line basis over three years. Costs for general and administrative expenses, overhead, maintenance and training, as well as the cost of software coding that does not add functionality to the existing system, are expensed as incurred. Reductions, if any, in the carrying value of capitalized software development costs to net realizable value are expensed.
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, 2007, and the recorded goodwill was determined not to be impaired.
Income Taxes. We account for income taxes in accordance with SFAS No. 109, “Accounting for Income Taxes.” This statement establishes financial accounting and reporting standards for the effects of income taxes that result from an enterprise’s activities during the current and preceding years. It requires an asset and liability approach for financial accounting and reporting of income taxes. As of June 30, 2007, we have current net deferred tax assets of $1,913 and non-current net deferred tax liabilities of $8,780. 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, 2007, a valuation allowance is not required against our deferred tax assets.
With regard to the weighted-average option life assumption, we consider the exercise behavior of past grants and model the pattern of aggregate exercises. For stock options granted during the fiscal year ended June 30, 2007, we used an expected option life assumption of 5.5 years.
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 will be reported as an adjustment to the opening balance of retained earnings in the fiscal year. In May 2007, the FASB issued FASB Staff Position (“FSP”) No. FIN 48-1, “Definition of Settlement in FASB Interpretation No. 48, an amendment of FASB Interpretation (FIN) No. 48, Accounting for Uncertainty in Income Taxes” (“FSP No. FIN 48-1”). FSP No. FIN 48-1 provides guidance on how to determine whether a tax position is effectively settled for the purpose of recognizing previously unrecognized tax benefits.
Information with respect to this item is contained in our audited consolidated financial statements and financial statement schedules listed in the index on page of this Annual Report on Form 10-K and is incorporated herein by reference.