Additional space was built in the Leased Premises which allowed the Company to reconfigure its existing space and to move all of its employees in Port Washington into contiguous space. The Company and the Affiliate amended the Lease for the space on October 23, 2003 and April 26, 2004. Effective on the occupancy date of the new space, as of May 1, 2004, the Affiliate leased additional square footage in the Leased Premises to the Company. The total space leased by the Company is currently 37,108 square feet. The Lease provides that, effective May 1, 2004, the rent payable by the Company shall be an aggregate annual rent of $580,174 over a ten year term, plus expenses related to real estate taxes, utilities and maintenance which are paid directly to the entities to whom payment must be made. 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, the Company has early termination rights which it 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, the Company would pay to the Affiliate the rent that would otherwise by payable by the Company 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.
Additionally, the Company leases office and/or warehouse space through its subsidiaries in Little Rock, Arkansas; Tulsa, Oklahoma; Portland, Maine; Miramar, Florida; Latham, New York; and Dallas, Texas. The aggregate annual rental payments for leased space in Little Rock are approximately $194,000; for leased space in Tulsa approximately $24,000; for Miramar approximately $142,000; for Portland approximately $120,000; for Latham approximately $383,000; and for Dallas approximately $168,000. The Company intends to move its current office space in Dallas to a less costly space in Dallas and has delivered a notice of termination to the landlord of the Dallas space, effective January 31, 2005.
In addition, Health Card rents a two family house in Port Washington, New York (near the Company’s offices) from P.W. Capital, LLC, (a company affiliated with Health Card’s former Chairman and current director of the Board) which is used for out-of-town employees. Health Card evaluated the cost of hotels for these individuals and determined it was more cost efficient to rent the house at an annual rate of $66,000. For the same reasons, Health Card rents two houses from Living In Style, LLC, an entity owned by three of Health Card’s executive officers. Pursuant to leases dated May 1, 2002 and expiring April 30, 2007, Health Card paid an aggregate of $133,000 in rent for these two facilities during the fiscal year ended June 30, 2004. The annual rent for each of the facilities increases by 5% per year.
The audited Consolidated Financial Statements include the accounts of Health Card and its wholly owned subsidiaries, PAI, PMP, Centrus, IPA, Specialty, Contracts, PBM Tech, NMHCmail, Integrail, Portland Professional Pharmacy and Portland Professional Pharmacy Associates (collectively “Ascend”), and Inteq Corp. and Inteq TX Corp. (collectively “Inteq”). Also included are the accounts of Funding. Unless the context otherwise requires, references herein to the “Company” or “Health Card” refer to the Company and its subsidiaries on a consolidated basis. The results of operations and balance sheet of the Company’s acquisitions and subsidiaries have been included in the consolidation as of the effective date that the Company acquired or established the entity as follows: PAI - July 20, 2000, PMP - March 5, 2001, Centrus and Funding - January 29, 2002, NMHCmail - September 1, 2002, Integrail - November 1, 2002, Ascend - July 31, 2003, and Inteq - April 1, 2004. All material intercompany balances and transactions have been eliminated in the consolidation.
Health Card derives its revenue from the provision of comprehensive pharmacy benefit management services to sponsors of prescription benefit plans. Substantially all of the services Health Card provides to its sponsors are related to pharmacy benefit programs and services. Health Card also recognizes administrative fees and earns rebates at the time of claims adjudication.
The amount of rebates recognized as reductions to revenue or cost of claims is based on estimates tied to actual claims data. Health Card processes its rebate claims either direct with the drug manufacturers, through its wholly-owned subsidiary, Specialty, for which it receives administrative fees, or through a third party rebate administrator. Effective July 1, 2001, Health Card has entered into an agreement with a third party administrator to handle all of its consolidated rebate claims which it does not otherwise submit direct to the drug manufacturers.
Credit risk relating to the rebates receivable is evaluated based on the financial strength of the rebate administrator and the drug manufacturers plus Health Card’s collection history. The drug manufacturers contracted with are primarily Fortune 500 companies and Health Card has not had a history of write-offs related to rebate receivables. Health Card does not believe a credit risk reserve is necessary.
Revenue increased $77.8 million, or approximately 14%, from $573.3 million for the fiscal year ended June 30, 2003, to $651.1 million for the fiscal year ended June 30, 2004. Revenue recognized for contracts recorded on a gross revenue basis was $648.5 million for the fiscal year ended June 30, 2004 and $572.0 million for the fiscal year ended June 30, 2003. Revenue recognized for contracts recorded on a net revenue basis was $2.6 million for the fiscal year ended June 30, 2004 and $1.3 million for the fiscal year ended June 30, 2003. The specific terms of the contracts that Health Card enters into with its sponsors will determine whether Health Card recognizes the gross revenue related to the cost of the prescriptions filled. For those contracts that Health Card recognizes net revenue, there is no impact on gross profit since neither the prescription revenue nor the related costs of the prescriptions is recorded. Health Card includes in revenue only those co-payments collected in its mail order facility in Miramar, Florida. For the twelve months ended June 30, 2004, there were approximately $2.3 million of co-payments included in revenue versus zero for the twelve months ended June 30, 2003. Co-payments retained by pharmacies on prescriptions filled for Health Card’s members and not included in Health Card’s revenue were $203.4 million and $168.5 million, for the twelve months ended June 30, 2004 and 2003, respectively.
Cost of claims increased $61.6 million, or approximately 12%, from $525.5 million for the fiscal year ended June 30, 2003, to $587.1 million for the fiscal year ended June 30, 2004. Ascend and Inteq accounted for $28.4 million, of the net increase. New sponsors and the growth in existing sponsors accounted for $144.8 million of the increase. This increase was partially offset by the three factors described in the previous paragraph, namely, the loss of sponsors which reduced cost of claims by $89.1 million, the recognizing of a certain contract on a net revenue basis which reduced cost of claims by $9.0 million, and an increase of $13.5 million in gross rebates received, which is treated as a reduction in cost of claims. As a percentage of revenue, cost of claims decreased from 91.7% to 90.2% for the fiscal years ended June 30, 2003 and June 30, 2004, respectively. The same factors contributed to the declining costs as a percentage of revenue. The major sponsor, which terminated its contract, is a managed care organization. Industry-wide, managed care clients have a greater cost of claims, and consequently a lower gross margin, than other types of business in the PBM industry. The new business the Company brought on during the fiscal year ended June 30, 2004, for the most part was not managed care, so consequently the cost of claims on the new business was lower than on the business it replaced. In addition, the contracts recognized on a net revenue basis decrease the overall Company costs as a percentage of revenue due to the cost not being recognized on the contracts recorded on the net revenue basis.
Gross profit increased from $47.8 million for the fiscal year ended June 30, 2003 to $64.0 million for the fiscal year ended June 30, 2004; a $16.2 million, or 34%, increase. In addition to the revenue volume increase described above, Ascend and Inteq accounted for $4.9 million, or 30%, of the increase. The increase in rebates (and administrative fees related to the collection of rebates) after accounting for the amount of rebates that are shared with sponsors, accounted for another $5.5 million, or 34%. The balance of the increase relates to the margins on the new business that replaced the lost business and growth in the existing business from additional services provided. Gross profit, as a percentage of revenue, increased from 8.3% to 9.8% for the twelve months ended June 30, 2003 and June 30, 2004, respectively. The contracts the Company recognizes on a net revenue basis have the effect of improving the gross margin as a percent of revenue due to the lower revenue base. The new activities at NMHCmail and Ascend also led to an increase in gross profit percentage, year-over-year. Partially offsetting the impact of the net revenue and new activities, the Company has seen some decline in profit margins due to competitive pressures.
For the fiscal year ended June 30, 2004, the Company earned other income, net, of approximately $40,000. For the fiscal year ended June 30, 2003, the Company incurred other expense, net, of approximately $804,000. The components of the approximate $844,000 increase in other income, net were an approximate $506,000 decrease in interest expense, an approximate $342,000 increase in interest income, slightly offset by an approximate $4,000 reduced gain on assets sold. The primary reasons for the net increase in income were 1) interest expense declined due to the reduced borrowings under the Company’s revolving credit facility due to increasing profitability and additional cash flow from operations (see Item 1, “Description of Business-Recent Acquisitions and Developments,” and Note 3 to the Consolidated Financial Statements comprising Item 8 hereof), and 2) interest income increased due to the interest portion of a settlement, with an outside party, related to past due rebates owed to the Company, and excess cash balances related to some of the Company’s acquisitions. The Company entered into a new sale leaseback with an unrelated third party in November 2003. This led to an approximate $35,000 gain on the sale of assets during the twelve months ended June 30, 2004. The total gain from this transaction was approximately $147,000 which was recorded as deferred revenue and is being recognized over the life of the lease, which is thirty-six (36) months. (See Note 11 to the Consolidated Financial Statements comprising Item 8 hereof.) This gain was offset by approximately $41,000 related to assets written-off when Ascend moved to a new facility in Portland.
The effective tax rate decreased from 41.8% for the twelve months ended June 30, 2003 to 41.0% for the twelve months ended June 30, 2004. The main reason for the decrease was a decline in the Company’s federal statutory rate.
There were three other charges recorded to determine income (loss) available to common stockholders related to the New Mountain Transaction. These include: (i) series A preferred stock cash dividends - approximately $1,596,000. The preferred stock provides for an initial cash dividend equal to 7% of the investment amount (currently $80 million), which decreases to 3.5% after the fifth anniversary of issuance (See Note 2 to the Consolidated Financial Statements comprising Item 8 hereof.). The dividend of approximately $1,596,000 represents the amount accrued and paid for the days from the closing of the New Mountain Transaction on March 19, 2004 to June 30, 2004; (ii) beneficial conversion feature - $80 million. This non-recurring, non-cash charge represents the difference between the fair market value of the Company’s common stock on the date of the closing of the New Mountain Transaction and the effective conversion price of $11.29, and which is limited to the $80 million purchase price for the series A preferred stock; and (iii) accretion of transaction expenses - approximately $135,000. Certain transaction costs related to the New Mountain transaction of approximately $4.7 million are deducted from net proceeds and the carrying value of the series A preferred stock. These transaction costs are accreted to the series A preferred stock carrying value over the ten-year life of the series A preferred stock investment. The approximate $135,000 charge represents the accretion from March 19, 2004 to June 30, 2004.
After deducting these three charges from net income there was a net loss available to common stockholders of approximately $73.8 million for the twelve months ended June 30, 2004. Since there was a loss, diluted EPS for the twelve months ended June 30, 2004 equals basic EPS of ($11.14).
*Diluted weighted average number of shares assumes the conversion of the 6,957 shares of redeemable convertible preferred stock and dilutive common stock options and warrants.
Revenue increased $113.4 million, or approximately 25%, from $459.83 million for the fiscal year ended June 30, 2002, to $573.27 million for the fiscal year ended June 30, 2003. Revenue recognized for contracts recorded on a gross revenue basis was $459.4 million for the fiscal year ended June 30, 2002 and $572.0 million for the fiscal year ended June 30, 2003. Revenue recognized for contracts recorded on a net revenue basis was $0.5 million for the fiscal year ended June 30, 2002 and $1.3 million for the fiscal year ended June 30, 2003. The specific terms of the contracts that Health Card enters into with its sponsors will determine whether Health Card recognizes the gross revenue related to the cost of the prescriptions filled. For those contracts that Health Card recognizes net revenue, there is no impact on gross profit since neither the prescription revenue nor the related costs of the prescriptions is recorded. Of the $113.4 million increase in revenue in fiscal 2003, $156.0 million was due to the inclusion of revenues from Centrus, since it was acquired on January 29, 2002 and included a full fiscal year in 2003 compared to a little over five months in the fiscal year ended June 30, 2002. This increase due to Centrus is a net amount and reflects the fact that one major sponsor terminated their contract effective December 31, 2002 and a new major sponsor was added in April 2003. Another $38.5 million of the overall gross revenue increase was due to revenue related to new sponsors or new services offered during fiscal 2003 unrelated to Centrus’ customers and excluding contracts recorded on a net revenue basis. Also, $19.6 million of the increase was from other existing sponsors as a result of several factors including higher charges relating to increased cost of pharmaceuticals, new drugs, plan participant growth and an increase in the average number of claims per plan participant. These increases were partially offset by non-Centrus revenue decreases related to three factors: 1) the termination of existing customer contracts throughout the fiscal year including one major sponsor which terminated their contract effective June 30, 2002, leading to a reduction in revenue of approximately $82.9 million, 2) there was one contract during the twelve months ended June 30, 2003 that the Company recognized on a net revenue basis that was recognized on a gross revenue basis during the twelve months ended June 30, 2002. Due to a change in the contract terms effective November 1, 2002, this customer’s revenue was recognized on a net basis from that point. The revenue impact of this change was a year over year reduction of gross revenue of approximately $15.6 million, and 3) rebates payable to the Company’s non-Centrus sponsors increased by $2.2 million for the twelve months ended June 30, 2003 as compared to the twelve months ended June 30, 2002. Since these rebates are treated as a reduction in revenue, this led to a reduction in the overall year-over-year revenue increase.
Cost of claims increased $100.7 million, or approximately 24%, from $424.8 million for the fiscal year ended June 30, 2002, to $525.5 million for the fiscal year ended June 30, 2003. Centrus accounted for $151.6 million, of the net increase. This increase was partially offset by the three factors described in the previous paragraph, namely, the loss of sponsors which reduced cost of claims by $77.7 million, the recognizing of a certain contract on a net revenue basis which reduced cost of claims by $15.6 million, and. an increase of $1.7 million in gross rebates received, which is treated as a reduction in cost of claims. The balance of the increase in cost of claims is related to the increased revenue as described above related to both new and existing sponsors. As a percentage of revenue, cost of claims decreased from 92.4% to 91.7% for the fiscal years ended June 30, 2002 and June 30, 2003, respectively. The same factors contributed to the declining costs as a percentage of revenue. The two major sponsors, which terminated their contracts, are managed care organizations. Industry-wide, managed care clients have a greater cost of claims, and consequently a lower gross margin, than other types of business in the PBM industry. While not all of the revenue associated with these two sponsors was replaced by new business, the new business, for the most part was not managed care, so consequently the cost of claims on the new business was lower than on the business it replaced. In addition, the contracts recognized on a net revenue basis decrease the overall Company costs as a percentage of revenue due to the cost not being recognized on the contracts recorded on the net revenue basis. The decline in cost of claims as a percentage of revenue was moderated by the higher cost of claims on the Centrus book of business, which serves managed care clients primarily. Centrus’ cost of claims for the fiscal year ended June 30, 2003 ran about 6 - 9 percentage points greater than the rest of the Company’s business, and since Centrus accounted for 49% of the Company’s revenue in the fiscal year, this impacted the overall cost of claims percentage.
For the fiscal year ended June 30, 2002, the Company incurred other expense, net, of approximately $502,000. For the fiscal year ended June 30, 2003, the Company incurred other expense, net, of approximately $804,000. The components of the approximate $302,000 increase in net expense were an approximate $84,000 increase in interest expense, an approximate $270,000 decrease in interest income, offset by an approximate $52,000 additional gain on assets sold during the fiscal year ended June 30, 2002. The primary reasons for the net increase in expense were 1) the interest expense incurred on the Company’s revolving credit facility and on the Note Offering to finance the acquisition of Centrus and Integrail (see Item 1, “Description of Business-Recent Acquisitions”, and Notes 3 and 7 to the Consolidated Financial Statements comprising Item 8 hereof), and 2) the reduction in interest income since all cash balances go towards paying off the revolving credit facility. Partially offsetting the increase in other expense was an approximate $52,000 increase in deferred gain on the sale of assets related to a sale/leaseback transaction, which gain of approximately $459,000 was recorded as deferred revenue and is being recognized over the life of the lease, which is thirty-six (36) months. (See Note 11 to the Consolidated Financial Statements comprising Item 8 hereof.)
The effective tax rate increased from 39.4% for the fiscal year ended June 30, 2002 to 41.8% for the fiscal year ended June 30, 2003. The increase stemmed primarily from an increase in the state tax rate as more of the Company’s income has been allocated to higher taxed states.
The Company’s primary cash requirements are for capital expenditures and operating expenses, including cost of pharmaceuticals, software and hardware upgrades and the funding of accounts receivable. Effective July 2003, the Company requires cash to carry inventory in its mail order facility and specialty pharmacy. The Company also requires cash for potential acquisitions of other pharmacy benefit management companies or of companies providing related services. As of June 30, 2004, the Company had a working capital deficit of $27.7 million as compared to a working capital deficit of $32.6 million as of June 30, 2003. The primary reason for the improvement in working capital was the profitability generated by the Company during the fiscal year ended June 30, 2004. The cash flow generated from operations - $23.9 million, plus the net proceeds of the New Mountain transaction - $24.0 million, plus the proceeds the Company received upon the exercise of stock options - $7.0 million, plus the repayment of affiliate loans - $2.8 million, were used to fund the acquisitions of Inteq - $29.1 million and PPP - $3.7 million (see Item 1, "Description of Business - Recent Acquisitions and Developments" and Note 3 to Consolidated Financial Statements comprising Item 8 hereof), repay the Company’s credit facility - $15.6 million, purchase capital assets - $7.4 million, pay preferred dividends - $1.6 million and pay additional consideration related to the Centrus acquisition - $2.0 million. The Company’s acquisitions have increased goodwill and other intangible assets which are long term assets, while decreasing working capital. The Company has now acquired six companies since July 2000 utilizing primarily cash. This has had the effect of increasing the Company’s working capital deficits until sufficient profitability is generated to pay back the cost of the acquisitions.
Historically, the timing of the Company’s accounts receivable and 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 sponsors on the one hand, and the Company’s pharmacy network on the other hand. These terms generally lead to the Company’s payments to participating pharmacies being slower than its corresponding collections from plan sponsors. The Company believes that this situation is not unusual in the pharmacy benefit management industry and expects 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, the Company could require additional working capital financing. The Company has put in place a $40 million revolving credit facility for acquisitions and working capital financing. However, if such terms of trade were to change materially, and/or if the Company were unable to obtain additional working capital financing, there could be a material adverse effect on the Company’s business, financial condition, or results of operations.
Three of these financial covenants are based upon the EBITDA (earnings before interest, taxes, depreciation and amortization) generated by the Company over specified periods of time. These covenants, EBITDA for the current fiscal quarter, interest coverage ratio, and debt service coverage for the previous twelve months, are evaluated by the Lender as a measure of the Company’s liquidity and its ability to meet all of its obligations under the Facility. EBITDA is presented as cash flow from operations plus or minus the net changes in assets and liabilities and the changes in certain non-cash reconciling items from net cash from operations to net income over the reported periods. While EBITDA is not a measure of financial performance nor liquidity under U.S. generally accepted accounting principles, it is provided as information for investors for analysis purposes in light of the financial covenants referred to above. EBITDA is not meant to be considered a substitute or replacement for net income as prepared in accordance with U.S. generally accepted accounting principles. The reconciliation from net cash from operations to EBITDA is as follows (see Consolidated Statement of Cash Flows comprising Item 8 hereof for more details):
The Company has entered into various capital lease transactions for hardware and software. The Company has also assumed various capital leases through its acquisitions. The principal balance of all capital leases as of June 30, 2004 was approximately $340,000.
The Company has entered into various real estate operating leases with both related and unrelated parties. The Company has entered into various operating leases with unrelated third parties for office equipment. These leases have different payment terms and expirations dates. The Company also entered into two sale-leaseback operating leases of certain fixed assets (principally computer hardware and externally developed software) one with an affiliate of the Company’s former Vice Chairman. See Note 11 to the Consolidated Financial Statements comprising Item 8 hereof for a further description of these various real estate and operating leases.
The shareholders of the Inteq Group are eligible to receive additional consideration of up to $4,200,000, if certain financial targets are met over the first year. Of this potential amount, $3,000,000 was deposited into escrow at the time of closing. As of June 30, 2004, $955,000 has been earned and will be released from escrow on September 30, 2004.
Following the completion of the tender offer, and assuming the exercise of 330,000 options and warrants held by Mr. Brodsky, which occurred in April 2004, New Mountain Partners owned securities at March 19, 2004 that were initially convertible into approximately 64% of the Company’s issued and outstanding common stock and prior to conversion of the series A preferred stock were entitled to cast that number of votes that is equal to approximately 60% of the Company’s aggregate voting power. Following the closing of the New Mountain Transaction, New Mountain Partners were entitled to and did nominate and elect 60% of the members of the Company’s board of directors.
The Company used the remaining proceeds from the issuance and sale of the series A preferred stock of approximately $24 million, excluding expenses related to the closing of the New Mountain Transaction, for the Inteq Acquisition (See Item 1, “Description of Business-Recent Acquisitions”, and Note 3 to the Consolidated Financial Statements comprising Item 8 hereof) and working capital purposes.
The series A preferred stock provides for an initial annual cash dividend equal to 7% of the investment amount, which decreases to 3.5% after the fifth anniversary of issuance. The series A preferred stock is convertible into common stock at a price of $11.50 per share of common stock, or an aggregate of approximately 7 million shares of the Company’s common stock.
The series A preferred stock may be redeemed at the Company’s option subsequent to the fourth anniversary of its issuance, subject to certain conditions. After the tenth anniversary of the issuance of the series A preferred stock, each holder of shares of series A preferred stock may require the Company to redeem all or a part of that holder’s shares of series A preferred stock.
* Includes an $80,000 non-recurring, non-cash charge for a beneficial conversion feature related to the New Mountain transaction.
Management does not believe that inflation has had a material adverse impact on Health Card’s net income for the three most recent fiscal years.
Since January 1, 2000, all services provided by the Company have been on a fee for services basis. Under the fee for service arrangement, the Company is paid by its sponsors for the Company’s contractually agreed upon rates based upon actual claims adjudicated, plus a fixed transaction fee.
Health Card includes in revenue only those co-payments collected from individual members by its mail order facility in Miramar, Florida. Co-payments retained by pharmacies on the remainder of the prescriptions filled for Health Card’s members are not included in Health Card’s reported revenue. Health Card discloses these amounts parenthetically on the face of its Consolidated Statement of Income.
Health Card maintains allowances for doubtful accounts for estimated losses resulting from the liability of its sponsors to make required payments. If the financial condition of Health Card’s sponsors were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances may be required.
In assessing the recoverability of the Company’s goodwill and other intangibles, the Company must make assumptions regarding estimated future cash flows and other factors to determine the fair value of the respective assets. If these estimates or their related assumptions change in the future, the Company may be required to record impairment charges for these assets not previously recorded. On July 1, 2001 the Company adopted Statement of Financial Accounting Standards No. 142, “Goodwill and Other Intangible Assets,” and will be required to analyze its goodwill for impairment issues on a periodic basis thereafter. To date, the Company has not recorded any impairment losses related to goodwill and other intangible assets.