Our offices are located in approximately 19,700 square feet of office space in Rockville, Maryland under a sublease that expires on May 30, 2004. Our subsidiaries lease a total of approximately 10,000 square feet under leases which expire in the first quarter of 2003. We believe that our office space is adequate for our existing needs and that suitable additional space on commercially reasonable terms will be available as required.
The following selected financial data has been derived from the audited financial statements of the Company and its predecessor companies. 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.
- -------------- (1) Reflects the formation of HealthExtras, Inc. and the Reorganization as if those events had taken place at the beginning of the period, except that no effect is given to the investment by Capital Z Healthcare Holding Corp. in HealthExtras prior to May 27, 1999.
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - ------- ---------------------------------------------------------------
We have established a nationwide network of over 50,000 retail pharmacies. In general, self-insured employers and managed care organizations contract with us to access our negotiated retail pharmacy network rates, participate in certain rebate arrangements with manufacturers based on formulary design and the other care enhancement protocols in our system. Under these contracts, we have an independent obligation to pay network retail pharmacies for the drugs dispensed and accordingly have assumed that risk independent of our customers. Pharmacy benefit claim payments from our health plan sponsors are recorded as revenues, and reflect prescription costs to be paid to retail pharmacies are recorded as direct expenses.
We have made two acquisitions in order to generate increased revenues and scale in the pharmacy benefit management business. The revenues from this business segment are now larger than those of the health and disability segment and are growing at a higher rate as well. On November 14, 2001, we completed the acquisition of an 80% interest in Catalyst for an aggregate purchase price of approximately $14.3 million. Consideration for the transaction consisted of $10.4 million in cash, $8.9 million of which was payable at December 31, 2001, and the remainder consisted of the assumption of debt and the issuance of common stock. The acquisition of Catalyst was accounted for using the purchase method of accounting. The excess of the purchase price paid over the net fair value of identifiable assets and liabilities of Catalyst was recorded as goodwill.
Effective November 1, 2000, we completed the acquisition of IPM for an aggregate purchase price of approximately $9.2 million. Consideration for the transaction consisted of approximately 95% cash and the remainder in newly issued common stock. The acquisition of IPM was accounted for using the purchase method of accounting.
We anticipate being able to generate competitive and operational efficiencies as a result of the Catalyst acquisition by:
We generate a significant portion of our revenue from the sale of membership programs which provide disability insurance benefits. To date, we have primarily focused on the distribution of our programs to customers of our financial institution partners. Christopher Reeve is featured prominently in our marketing campaigns for these programs.
Revenue is generated by payments for program benefits and payments from certain business partners related to new member enrollments. For program benefits, revenue reflects the numbers of individuals enrolled as well as the price level of the benefits selected. The factors which most directly effect this business include customer acquisition costs, the cost of the benefits provided relative to the fee charged, the level of compensation shared with our business partners and the attrition rate in our membership base. Over the past year we have generated lower average fees while facing increasing direct costs for benefits provided and the compensation shared with our partners. Accordingly we are evaluating opportunities to maintain the profitability of this business segment while shifting more of the up front customer acquisition cost risk to our business partners.
The primary determinant of HealthExtras' program revenue recognition is monthly program enrollment and payments from business partners 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 fee collected from the member or paid by the marketing partner for their specific membership program. The program revenue recognized by HealthExtras includes the cost of the membership benefits, which are supplied by others, including the insurance components. Payments from business partners related to new member enrollments are recorded as revenue to the extent of related direct expenses, which to date have exceeded payments from business partners.
Operating expenses for the year ended December 31, 2000, totaled $64.0 million. Direct expenses of $24.3 million, consisted of $19.8 million in benefit costs, warrant charges and fees payable to our distribution partners for our supplemental health and disability products and $4.5 million in direct costs associated with pharmacy benefit services, consisting largely of reimbursements to network pharmacies. These direct expenses represented 38.0% of operating expenses for the period. For the year ended December 31, 2000, HealthExtras incurred $31.2 million in product development and marketing expenses, or 49.0% of total operating expenses. The primary component of the expenditures related to direct sales activities including telemarketing, direct mail and statement inserts. The expenses for these direct sales activities were approximately $26.1 million. In addition, the Company incurred approximately $1.1 million in product endorsement costs, and $4.0 million in other product development and marketing related expenses. General and administrative expenses for the year totaled $8.5 million or 13.0% of total operating expenses, $8.0 million of which was related to the Company's supplemental health and disability segment while the remaining $448,000 was related to the management of pharmacy benefits. These expenses included $4.2 million in compensation and benefits, $653,000 in professional fees, $467,000 in facility costs, $308,000 in telephone and software costs, $380,000 in other personnel costs, $274,000 in travel expenses, and $702,000 in depreciation and amortization. Interest income for the period was approximately $2.1 million.
Management's Discussion and Analysis of the Financial Condition and Results of Operations discusses the Company's consolidated financial statements. The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. The most significant accounting estimates made by the Company in preparing its financial statements include the following:
The Company records direct expense for the fair market value of common stock warrants earned or expected to be earned by a marketing partner. The Company estimates the value of the warrants at each balance sheet date using an appropriate equity-pricing model with assumptions consistent with those used in preparing the Company's fair value stock option compensation disclosures. Direct expense is based on the number of warrants expected to be issued, which is determined based on an estimate of annualized revenues as defined under the agreement with the marketing partner.
Rebate revenues earned under arrangements with manufacturers are recognized as they are earned in accordance with contractual agreements and recorded as a reduction of direct expenses and a reduction of revenue if the Company has agreed to share a portion of the manufacturers rebates with the plan sponsors. Manufacturers rebates are based on estimates, which are subject to final settlement with the contracted party.
Intangible assets related to the November 2001 acquisition of Catalyst were recognized under the provisions of FASB Statement No. 141 (FAS 141) (described below). Accordingly, a portion of the excess purchase price was assigned to intangible assets that were recognizable apart from goodwill. This estimated fair value and the weighted average useful-life of the intangible assets are based on income-method valuation calculations, performed by an independent consulting firm. These calculations are in the process of being finalized; thus the allocation of the purchase price to intangible assets is subject to refinement. The remaining useful life of intangible assets will be evaluated periodically and adjusted as necessary to match expected period that the assets are expected to provide economic benefits.
Emerging Issues Task Force Issue No. 01-9, "Accounting for Consideration Given by a Vendor to a Customer or a Reseller of the Vendor's Products" ("EITF 01-9") will be effective for the Company in 2002. EITF 01-9 will change the way the Company recognizes the cost of consideration provided to a marketing partner under a warrant agreement. This consideration is currently recognized as a direct expense in the consolidated statements of operations and comprehensive loss. Effective January 1, 2002, the Company will begin to recognize the cost of this consideration as a reduction of revenue from the marketing partner. Financial statements from prior periods presented for comparative purposes must be reclassified to comply with these provisions.
On October 3, 2001 the FASB issued FASB Statement No. 144 (FAS 144), Accounting for the Impairment or Disposal of Long-Lived Assets. The objectives of FAS 144 are to address significant issues relating to the implementation of FASB Statement No. 121 (FAS 121), Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of, and to develop a single accounting model, based on the framework established in FAS 121, for long-lived assets to be disposed of by sale, whether previously held and used or newly acquired. FAS 144 supersedes FAS 121, however it retains the fundamental provision of FAS 121 for (1) the recognition and measurement of the impairment of long-lived assets to be held and used and (2) the measurement of long-lived assets to be disposed of by sale. FAS 144 will be effective for the Company in 2002. Implementation of FAS 144 is not expected to have any effect on the Company's financial statements.
The limited history of operating our business means that our business prospects are subject to a great deal of uncertainty and risks. Our changing strategic emphasis creates additional industry and competitive uncertainty.
We have incurred operating losses since our inception. Even if we achieve profitability, we may not be able to maintain profitability in the future. In addition, as our business model evolves, we expect to introduce a number of new products and services that may or may not be profitable for us.
The pharmacy benefit management industry is relatively consolidated and dominated by large companies with significant resources. Many of the large pharmacy benefit management companies are owned by large companies, including pharmaceutical manufacturers, which can provide them with significant purchasing power and other advantages, which we do not have. Competitors in this industry include other pharmacy benefit management companies, drug retailers, physician practice management companies, and insurance companies/health maintenance organizations. We may also experience competition from other sources in the future. Pharmacy benefit management companies compete primarily on the basis of price, service, reporting capabilities and clinical services. In most cases, the competitors referenced above are large, profitable and well-established companies with substantially greater financial and marketing resources than our resources. The significant majority of our PBM revenues are generated by our twenty largest plan sponsors. The loss of any of these significant customers could have an adverse affect on our revenues and profitability.
If we do not manage our growth effectively, we may not be able to operate profitably - -----------------------------------------------------------------------------
Our growth strategy, if successful, will result in further expansion of our PBM operations. We can achieve profitable operations, however, only if we are able to manage our growth effectively. Our growth in operations has placed significant demands on our management and other resources, which is likely to continue. Under these conditions, it is important for us to retain our existing management, including those from Catalyst, and to attract, hire and retain additional highly skilled and motivated officers, managers and employees.
A significant majority of all of our supplemental health program sales is attributable to two marketing partner relationships. The relationships with JCPenney and American Express provide us with access to customer leads resulting in sales to individual consumers. These relationships directly or indirectly were responsible for 62% and 17% of our supplemental health and disability segment revenues for 2001. If we lose one or more of these marketing relationships and are unable to replace them with other marketing outlets, our access to potential customers would decline and sales and revenue would suffer.
A significant percentage of our membership growth during 2001 was attributable to telemarketing sales. These sales involve a much higher percentage of monthly rather than annual sales than was our previous experience. The combination of these has resulted in higher initial cancellation rates and reduced enrollment persistency.
The loss of our relationship with Christopher Reeve to promote our programs could significantly impair our brand recognition and, thus, our ability to sell our programs - -------------------------------------------------------------------------------
Our agreement for Christopher Reeve to promote our programs currently expires in July 2005. The loss of the Christopher Reeve identification with our programs, upon termination of our contract or otherwise, could significantly reduce our ability to sell our programs.
If we lose our relationships with our benefit providers, we could have difficulty meeting demand for the products and services included in the programs we sell - --------------------------------------------------------------------------------
* changes in acceptance levels for our supplemental benefit program by consumers;
If we fail to comply with all of the various and complex laws and regulations governing our products and marketing techniques, we could be subject to fines, additional licensing requirements or the inability to market in particular jurisdictions - -------------------------------------------------------------------------------
One of the means by which the Company markets its programs is telemarketing, which it generally outsourced to third parties. Telemarketing has become subject to an increasing amount of Federal and state regulation as well as general public scrutiny 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. 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 the Company's current or future operations. Compliance with these regulations is generally the shared responsibility of the Company, its sub-contractors and its marketing partners. The Company maintains operational controls to ensure that its marketing practices conform with applicable state and federal regulations.
Regulation of the sale of insurance over the Internet and of electronic commerce generally is unsettled, and future laws, regulations and interpretations could hinder our ability to offer programs over the Internet - ----------------------------------------------------------------------------
The distribution of our programs including an insurance component over the Internet subjects us to additional risk as most insurance laws and regulations have not been modified to clarify or amend their application to Internet transactions. Currently, many state insurance regulators and legislators are exploring the need for specific regulation of insurance sales over the Internet. Such regulation could dampen the growth of the Internet as a means of providing insurance services. Moreover, the application of laws governing general commerce on the Internet remains largely unsettled, even in areas where there has been some legislative action. It may take years to determine whether and how existing laws such as those governing insurance, intellectual property, privacy and taxation apply to the Internet. In addition, the growth and development of the market for electronic commerce may prompt calls for more stringent consumer protection laws and regulations that may impose additional burdens on companies conducting business over the Internet.
Licensure. Many states have licensure or registration laws governing certain types of ancillary healthcare organizations, including preferred provider organizations, third party administrators and utilization review organizations. These laws differ significantly from state to state, and the application of such laws to the activities of pharmacy benefit managers is often unclear. We have registered under such laws in those states in which we have concluded such registration is required.
If we experience failures of, or capacity constraints in, our systems or the systems of third parties on which we rely, sales of our programs likely would be reduced and our reputation could be damaged - ---------------------------------------------------------------------------
If we are unable to safeguard the security and privacy of our program members' information, our reputation would be damaged and we could be subject to litigation and liability - --------------------------------------------------------------------------------
Our audited Financial Statements are contained in a separate section of this Annual Report on Form 10-K on pages through, attached hereto.