Six of the seven clinical and sales offices, with a total of 22,000 square feet, are under leases that expire over terms through October 2011 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.
HealthExtras provides pharmacy benefit management (“PBM”) services and supplemental benefit programs. Our PBM segment, which operates under the brand name “Catalyst Rx”, accounted for approximately 91%, 86% and 73% of our revenue in the years ended 2004, 2003 and 2002, respectively, and is expected to be the primary source of our growth and profits in the future. Our PBM clients include more than 1,000 self-insured employers, including state and local governments, third-party administrators (“TPAs”), and managed care organizations, who contract with us to administer the prescription drug component of their overall health benefit programs. Total claims processed increased to 12.8 million in 2004 from 9.0 million in 2003, respectively and our PBM segment revenue increased by 43.3% from 2003 to 2004.
Catalyst Rx provides its clients access to a contracted, non-exclusive national network of more than 53,000 pharmacies. Catalyst Rx’s services 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. Catalyst Rx uses 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.
On November 14, 2001, we acquired an 80% interest in Catalyst for an aggregate purchase price of approximately $14.3 million, consisting of $10.4 million in cash, the assumption of $1.6 million in liabilities and the issuance of 366,730 shares of common stock valued at $2.3 million. The acquisition of Catalyst was accounted for using the purchase method of accounting and resulted in $9.1 million of goodwill and $4.0 million of intangible assets.
We have successfully integrated IPM, Catalyst, and PNNC 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 are in the process of integrating MHS.
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 HealthExtras. 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.
Revenue. Revenue from operations for year ended December 31, 2004 was $521.3 million, consisting of $475.2 million generated from the PBM segment and $46.1 million from the supplemental benefits segment. The PBM revenue increased by $143.7 million, including $131.0 million of revenue from increased prescription volume, $8.9 million from the acquisition of MHS, and $16.2 million in increased unit prices, slightly offset by a reduction in revenue of $12.4 million due to increased member co-payments. Total claims processed increased to approximately 12.8 million in 2004 from approximately 9.0 million in 2003. A significant contributor to the increase in revenue and prescription volume was a new contract with the State of Louisiana, covering about 180,000 members, which commenced on July 1, 2004. This contract generated 13.0% and 11.8% of the Company’s PBM and total revenue, respectively. The supplemental benefits revenue decreased by $6.5 million, largely as a result of lower levels of coverage purchased and decreased membership. Revenue for year ended December 31, 2003 was $384.1 million, consisting of approximately $331.5 million and $52.6 million attributable to the PBM and supplemental benefits segments, respectively.
Gross margins in the PBM segment for year ended December 31, 2004 were 10.2%, or $48.3 million, compared to 8.8%, or $29.3 million, for year ended December 31, 2003. Gross margins for the supplemental benefits segment for year ended December 31, 2004 were 26.6%, or $12.3 million, compared to 25.8%, or $13.6 million for year ended December 31, 2003.
Gross margins in the PBM segment are generally predictable based on client contract terms and vendor/supplier contracts. 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 2004 in a manner that would meaningfully affect current or anticipated results. In the current year, gross margins were improved by an increased volume of higher margin workers compensation business resulting from the acquisition of the MHS business. This increase was largely offset in percentage terms by the addition of the State of Louisiana contract that has lower percentage margin contributions than our historical averages. Excluding these changes, there were no other significant factors that influenced reported gross margins in 2004 or indicate likely changes in the near future.
Gross margins in the supplemental benefits segment are generally consistent on a per transaction basis. Gross dollar margins have been declining as new enrollments, with lower gross dollar margins, offset attrition in membership under more profitable prior marketing arrangements. This gradual shift in business mix is likely to continue in the future but is not anticipated to accelerate.
Of the $35.6 million in selling, general and administrative expenses for the year ended December 31, 2004, $24.9 million related to the PBM segment, $4.5 million related to the supplemental benefits segment, and $6.2 million related to corporate overhead. Selling, general and administrative expenses included approximately $16.7 million in compensation and benefits, $5.5 million in commissions, other professional services, and insurance, $4.1 million in other expenses, $3.0 million in depreciation and amortization, $2.1 million for creative development, product endorsement and market research, $2.6 million in facility costs, and $1.6 million in travel expenses.
Interest Income. Interest income increased to $383,000 in the year ended December 31, 2004 from $155,000 in the prior year. The increase was primarily due to our higher average cash and cash equivalents balance during 2004 due to increased operating income and our sale of common stock in the fourth quarter of 2004.
Income Tax Expense. The effective income tax rates of 37.7% for both 2004 and 2003 represent the combined federal and state income tax rates adjusted as necessary based on the particular jurisdictions where the Company operates.
Revenue. The increase in revenue for 2003 was primarily related to the ongoing growth of our PBM revenue. Revenue growth in the PBM segment in 2003 was primarily attributable to a full year consolidation of the results of our acquired subsidiary, PNNC, and a significant overall increase in the number of pharmacy claim transactions processed. Total claims processed increased from approximately 4.8 million in 2002 to approximately 9.0 million in 2003. Revenue also increased due to modest increases in unit prices.
Revenue for the year ended December 31, 2003 was $384.1 million, consisting of $331.5 million generated from the PBM segment and $52.6 million from the supplemental benefits segment. PBM revenue increased by $149.3 million, including a $99.2 million increase from PNNC. Of the $99.2 million increase from PNNC, $17.8 million was attributable to revenue from new clients signed by PNNC in 2003. The remaining
Direct Expenses. Operating margins in the PBM segment were improved in 2003 through an increase in more profitable generic drug dispensing rates, consolidation of our claims processing systems to a single more cost-effective platform, the introduction of standardized pharmacy reimbursement contract rates across all our business units and more effective formulary compliance programs which result in increased margins from the use of preferred drugs.
The decrease in direct expenses in the supplemental benefits segment was largely a result of lower levels of coverage being purchased by new members. A modest decrease in membership and the negotiation of lower costs paid by us for certain of the benefits included in our programs (available for the first time in 2003) also contributed to the decrease.
Direct expenses for the year ended December 31, 2003 were $341.2 million, consisting of $302.2 million in direct expenses from the PBM segment and $39.0 million in direct expenses from the supplemental benefits segment. PBM segment direct expenses increased by $134.2 million, including a $89.1 million increase from PNNC. The remaining $45.1 million increase was directly related to the $50.1 million increase in revenue in 2003. This $45.1 million increase in related direct expenses was consistent with our anticipated PBM segment gross margin contribution of approximately 10% from increased prescription volume during 2003. Direct expenses for the year ended 2002 were $209.5 million, consisting of approximately $168.0 million and $41.5 million attributable to the PBM and supplemental benefit segments, respectively. The direct expenses of $341.2 million and $209.5 million for the years ended December 31, 2003 and 2002 represented 93.0% and 85.5% of operating expenses for the respective periods.
Selling, General and Administrative. From 2002 to 2003, selling, general and administrative expenses decreased by approximately $9.6 million. This decrease, as discussed above, was primarily a result of changing our marketing arrangements. In 2003, Company-funded direct marketing expenses for supplemental benefits were eliminated and resulted in an expense reduction of approximately $12.6 million. The offsetting increase in selling, general and administrative expenses was primarily associated with PNNC’s operations, personnel costs and other expenses being consolidated for the full calendar year.
Interest Income. Interest income decreased to $155,000 in the year ended December 31, 2003 from $286,000 in the prior year. The decrease in 2003 was due to lower interest rates in 2003 and increased average cash and cash equivalent balances in 2002 resulting from the sale of Company stock in the fourth quarter of 2001.
Interest Expense. Interest expense increased to $598,000 in the year ended December 31, 2003 from $368,000 in the year ended December 31, 2003. The increase was primarily due to the acquisition of PNNC and increased borrowings under the line of credit commencing in the fourth quarter of 2002.
Minority Interest. There was no minority interest charge in 2003. The $45,000 charge in 2002 represents the net income attributable to the 20% minority interest in Catalyst for the months of January and February 2002.
Segment operating information for 2003 and 2002 is as follows (in thousands):
Operating expenses of the segments exclude $5.4 million and $6.5 million in corporate overhead that was not allocated by management in assessing segment performance for the years ended December 31, 2003 and 2002, respectively.
Our sources of funds are usually the capital markets through the sale of equity, bank debt, and cash flows from operations. In November 2004, we received $54.8 million in net proceeds from the sale of shares in a public offering. During 2004 and 2003, we generated positive cash flow from operations and anticipate similar results in 2005 and thereafter. Cash and cash equivalents at December 31, 2004 were $67.1 million, an increase of $38.2 million from the end of 2003.
Net Cash Provided by Operating Activities. Our operating activities generated $12.0 million of cash from operations during 2004, a $11.4 million decrease from the $23.4 million of net cash provided in 2003. The decrease was primarily due to the timing of payments to vendors included in accounts payable, the timing of receipts from clients against accounts receivable, and a $6.3 million decrease in deferred tax assets in 2003.
Member co-payments are not recorded as revenue. Under our client contracts, the pharmacy is solely obligated to collect the co-payments from the members. Under client contracts, we do not assume liability for member co-payments in pharmacy transactions. As such, we do not include member co-payments to pharmacies in revenue or operating expenses.
The primary determinant of revenue recognition for the supplemental benefits segment is monthly program enrollment and, prior to October 2002, payments from certain distributors related to new member enrollments. 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 we recognize includes the cost of membership features supplied by others, including the insurance components. Direct program expenses consist of the costs that are a direct function of a period of membership and a specific set of program features. The coverage obligations of our benefit suppliers and the related expense are determined monthly, as are the remaining direct expenses.
Revenue from supplemental benefit programs and related direct expenses (principally marketing and processing fees and the cost of the benefits provided to program members) are initially deferred during the period in which a program member is entitled to obtain a refund (generally 90 days). If a member requests a refund, we retain any interest earned on funds held during the refunded membership period. Total revenue and direct expenses attributable to the initial deferral are recognized subsequent to the end of the initial deferral period. After the initial deferral period, revenue is recognized as earned and direct expenses as incurred.
The Company accounts for its goodwill under SFAS No. 142, “Goodwill and Other Intangible Assets.” Under SFAS No. 142, goodwill is not amortized, but it is tested for impairment at least annually. Each year, the Company tests for impairment of goodwill according to a two-step approach. In the first step, the Company tests 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. 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 2001, we recorded a full valuation allowance against our deferred tax assets due to the uncertainty as to their ultimate realization. In the fourth quarter of 2002, as a result of our profitability, we recognized $10.2 million in tax benefits principally resulting from releasing the full valuation allowance for our deferred tax asset. In 2004 and 2003, we recorded income tax expense of $9.9 million and $6.3 million, respectively. As we now have achieved sustained profitability, no additional valuation allowances are expected in the foreseeable future.
From time to time we have issued warrants to purchase shares of our common stock under arrangements with our business partners or as consideration in acquisitions. We are required to estimate the fair value of such warrants for purposes of recording these transactions in our financial statements upon achieving a measurement date. Such estimates require judgments regarding, among other things, expected term, risk-free interest rates and common stock volatility.
In January 2003, the FASB issued Interpretation No. 46, “Consolidation of Variable Interest Entities” (“FIN 46”). Until this interpretation, a company generally included another entity in its consolidated financial statements only if it controlled the entity through voting interests. FIN 46 requires a variable interest entity, as defined, to be consolidated by a company if that company is subject to a majority of the risk of loss from the variable interest entity’s activities or entitled to receive a majority of the entity’s residual returns. Certain provisions of FIN 46 were deferred until the period ending after March 15, 2004. The impact of FIN 46 and certain provisions effective after March 15, 2004, are not applicable to the accounting of our business and had no impact on the Company’s financial statements.
In December 2004, the FASB issued SFAS No. 123, Revised 2004 (“Statement 123(R)”), “Share-Based Payment”, which revised SFAS No. 123, “Accounting for Stock-Based Compensation”. This statement supercedes APB 25. The revised statement addresses the accounting for share-based payment transactions with employees and other third parties, eliminates the ability to account for share-based compensation transactions using APB 25 and requires that the compensation costs relating to such transactions be recognized in the consolidated statement of operations. The revised statement is effective as of the first interim period beginning after June 15, 2005. The Company will adopt the statement as required. Effective with the implementation of SFAS 123(R), the Company anticipates accelerating the vesting of certain options with little or no intrinsic value prior to July 1, 2005. Therefore, these options will not be expensed in the periods subsequent to July 1, 2005. It is estimated that the acceleration of the vesting of these options will eliminate approximately $5.0 million before income taxes on a prospective basis and that the Company will incur a one-time charge associated with the acceleration of vesting of approximately $1.5 million before income taxes. The Company expects to execute the indicated restructuring of its option plans no later than June 30, 2005.
Competition in our industry is intense and could reduce or eliminate our profitability.
If we lose key clients as a result of competitive bidding for contracts, consolidation of clients or otherwise, our business, profitability and growth prospects could suffer.
We depend on a limited number of clients for a significant portion of our revenue. Our top ten clients generated approximately 47%, and our top twenty clients generated approximately 58%, of the claims we processed in 2004, although no single client accounted for greater than 15% of all revenue. Our business, results of operations and financial condition could suffer if we were to lose one or more of our significant clients.
If we lose pharmacy network affiliations, our business, results of operations and financial condition could suffer.
We receive rebates from numerous pharmaceutical manufacturers based on the use of selected drugs by members of health plans sponsored by our clients, as well as fees for other programs and services. We believe our business, results of operations and financial condition could suffer if:
rebates decline due to the failure of our health plan sponsors to meet market share or other thresholds;
Over the next few years, as patents expire covering many brand name drugs that currently have substantial market share, generic products will be introduced that may substantially reduce the market share of these brand name drugs. Historically, manufacturers of generic drugs have not offered formulary rebates on their drugs. Our profitability could be adversely affected if the use of newly approved, brand name drugs added to formularies, does not offset any decline in use of brand name drugs whose patents expire.
If our business continues to grow rapidly and we are unable to manage this growth, our business, results of operations and financial condition could suffer.
Part of our growth strategy includes making acquisitions involving new markets and complementary products, services, technologies and businesses. If we are unable to overcome the potential problems and inherent risks related to such future acquisitions, our business, results of operations and financial condition could suffer. Our ability to continue to expand successfully through acquisitions depends on many factors, including our ability to identify acquisition prospects and negotiate and close transactions. Even if we complete future acquisitions:
we may experience difficulties maintaining the quality of products and services that acquired companies have historically provided;
we would be required to amortize the identifiable intangible assets of an acquired business, which will reduce our net income in the years following its acquisition, and we also would be required to reduce our net income in future years if we were to experience an impairment of goodwill or other intangible assets attributable to an acquisition.
In June 2004, we acquired MHS, which we are in the process of integrating into our business operations. There are risks associated with integrating and operating newly acquired businesses. We can give no assurance that we will successfully operate this new business in the future.
Our operations utilize an electronic network connecting approximately 53,000 retail pharmacies to process third-party claims. This system is provided by a third-party adjudication vendor. Because claims are adjudicated in real time, systems availability and reliability are key to meeting customers’ service expectations. Any interruption in real time service, either through systems availability or telecommunications disruptions can significantly damage the quality of service we provide. Our PBM services also depend on third-party proprietary software to perform automated transaction processing. There can be no assurance that our business will not be harmed by service interruptions or software performance problems.
Our contracts with retail pharmacies which participate in our network generally obligate us to make payments for prescription claims even if we are not reimbursed by our clients. If our clients delay their reimbursement payments or fail to make payments for prescription claims, it could have a material adverse effect on our business, results of operations and financial condition.
Among the legislation and government regulations that could affect us as a provider of PBM services are the following:
Anti-Remuneration Legislation. Anti-kickback statutes at the federal and state level prohibit an entity from paying or receiving any compensation to induce the referral of healthcare plan beneficiaries or the purchase of items or services for which payment may be made under healthcare plans. To our knowledge, these laws have not been applied to prohibit PBM companies from receiving amounts from pharmaceutical manufacturers in connection with pharmaceutical purchasing and formulary management programs or in connection with therapeutic substitution programs conducted by independent PBM companies nor have such laws been interpreted as prohibiting contractual relationships, such as we have with certain of our clients. However, we can make no assurances that such laws will not, in the future, be applied to restrict PBM activities and affect the way in which we conduct our business.
ERISA Regulation. The Employee Retirement Income Security Act of 1974, “ERISA,” regulates certain aspects of employee pension and health benefit plans, including self-funded corporate health plans with which we have agreements to provide PBM services. We believe that the conduct of our business generally is not subject to the fiduciary obligations of ERISA. However, other PBMs have disclosed publicly that they are defending private litigant lawsuits alleging that they are ERISA fiduciaries. On May 25, 2004, the U.S. District Court for the Southern District of New York accepted a class action settlement proposed by Medco. Pursuant to the settlement, Medco will pay $42.5 million into a settlement fund to be distributed to plan participants. Medco also agreed to change certain business practices aimed at increasing transparency around formulary decisions and therapeutic interchanges. There can be no assurance that the U.S. Department of Labor, which is the agency that enforces ERISA, or a private litigant would not assert that the fiduciary obligations imposed by ERISA apply to certain aspects of our operations.
Consumer Protection Legislation. Most states have consumer protection laws that generally prohibit payments and other broad categories of conduct deemed harmful to consumers. States and/or private litigants may enforce these statutes and both have put such statutes to use initiating lawsuits against PBMs. On April 26, 2004, Medco settled allegations that it engaged in unfair and deceptive acts with 20 states for $29 million. In addition, Medco agreed to change several of its business practices aimed at increasing transparency as to the existence and extent of manufacturer rebates and the reasons for therapeutic interchanges. We do not believe that we engage in conduct that has been identified as problematic in the Medco settlement agreement or that has been alleged as improper in other actions against PBMs under state consumer protection statutes. However, no assurance can be given that we will not be subject to scrutiny or challenge under one or more of these laws by the government enforcers or private litigants.
State laws that are more protective of medical information are not pre-empted by HIPAA. Therefore, to the extent states enact more protective legislation, we could be required to make significant changes to our business operations.
In addition, both Congress and state legislatures are expected to consider legislation to increase governmental regulation of managed care plans. Some of these initiatives would, among other things, require that health plan members have greater access to drugs not included on a plan’s formulary and give health plan members the right to sue their health plans for malpractice when they have been denied care. The scope of the managed care reform proposals under consideration by Congress and state legislatures and enacted by states to date vary greatly, and we cannot predict the extent of future legislation. However, these initiatives could greatly limit our business practices and impair our ability to serve our clients.
MMA creates a voluntary outpatient prescription drug benefit, which will provide both new risks and opportunities for PBMs to participate in the Medicare program, and possible increased competition.
There are many uncertainties presented by the Medicare Modernization Act, “MMA,” which is one of the reasons we opted not to participate under the interim endorsed drug discount card program, despite being selected as a national sponsor. We are considering bidding to become either a Prescription Drug Plan, “PDP,” or a fallback plan in one or more regions for the outpatient prescription drug benefit to begin January 1, 2006. Possible effects of the MMA include:
New opportunities for PBMs created by MMA may bring new entrants into the PBM industry, thereby increasing competition and impacting profitability.
We have experienced a greater reliance on monthly rather than annual sales and a reduction in program renewals as a result of reliance on telemarketing.
A significant percentage of our sales of supplemental benefit programs is attributable to telemarketing sales. These sales involve a much higher percentage of monthly rather than annual sales than was our previous experience. This has resulted in higher initial cancellation rates and a reduction in program renewals.
If we lose one or more of our marketing relationships, our access to potential customers would decline, and our business, results of operations and financial condition could suffer.
State insurance laws and regulations are complex and broad in scope and are subject to periodic modification as well as differing interpretations. There can be no assurance that insurance regulatory authorities in one or more states will not determine that the nature of our business requires us to be licensed under applicable insurance laws. A determination to that effect or that we or our business partners are not in compliance with applicable regulations could result in fines, additional licensing requirements or the inability to market our programs in particular jurisdictions. Such penalties could significantly increase our general operating expenses and harm our business, results of operations and financial condition. In addition, even if the allegations in any regulatory or legal action against us turn out to be false, negative publicity relating to any such allegation could result in a loss of consumer confidence and significant damage to our brand.
Telemarketing is one of the primary means by which our programs are marketed. Telemarketing has become subject to an increasing amount of Federal and state regulation in the past several years. For example, such regulation limits the hours during which telemarketers may call consumers and prohibits the use of automated telephone dialing equipment to call certain telephone numbers. The Federal Telemarketing and Consumer Fraud and Abuse Prevention Act of 1994 and FTC regulations prohibit deceptive, unfair or abusive practices in telemarketing sales.
Both the FTC and state attorneys general have authority to prevent certain telemarketing activities deemed by them to violate consumer protection. The FTC has adopted regulations which, beginning October 1, 2003, prohibit most telemarketers from calling a number listed on a National Do Not Call Registry. Violators are subject to a fine of up to $11,000 per violation. Under those FTC regulations, telemarketers can continue to call consumers with whom a company has an existing business relationship and consumers who request information about a company’s products can be called for three months. In addition, some states have enacted laws and others are considering enacting laws targeted directly at regulating telemarketing practices, and there can be no assurance that any such laws, if enacted, will not adversely affect or limit our current or future operations. While compliance with these regulations is generally the responsibility of the marketers and subcontractors, there can be no assurance that we would have no exposure to liability.