UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
x | QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended September 30, 2005. |
o | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from ____________ to _____________. |
Commission File Number: 0-20199
EXPRESS SCRIPTS, INC.
(Exact name of registrant as specified in its charter)
Delaware (State of Incorporation) | 43-1420563 (I.R.S. employer identification no.) |
13900 Riverport Dr., Maryland Heights, Missouri (Address of principal executive offices) | 63043 (Zip Code) |
Registrant’s telephone number, including area code: (314) 770-1666
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.
Yes X No __
Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).
Yes X No __
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).
Yes __ No X
Common stock outstanding as of September 30, 2005: | 145,633,623 | Shares |
EXPRESS SCRIPTS, INC.
INDEX
Part I Financial Information
Item 1. Financial Statements (unaudited)
a) Unaudited Consolidated Balance Sheet
b) Unaudited Consolidated Statement of Operations
c) Unaudited Consolidated Statement of Changes
in Stockholders’ Equity
d) Unaudited Consolidated Statement of Cash Flows
e) Notes to Unaudited Consolidated Financial Statements
Item 2. Management’s Discussion and Analysis of Financial
Condition and Results of Operations
Item 3. Quantitative and Qualitative Disclosures About
Market Risk
Item 4. Controls and Procedures
Part II Other Information
Item 1. Legal Proceedings
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
Item 3. Defaults Upon Senior Securities - (Not Applicable)
Item 4. Submission of Matters to a Vote of Security Holders - (Not Applicable)
Item 5. Other Information - (Not Applicable)
Item 6. Exhibits
Signatures
Index to Exhibits
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
EXPRESS SCRIPTS, INC. | |||||||
Unaudited Consolidated Balance Sheet | |||||||
September 30, | December 31, | ||||||
(in thousands, except share data) | 2005 | 2004 | |||||
Assets | |||||||
Current assets: | |||||||
Cash and cash equivalents | $ | 405,027 | $ | 166,054 | |||
Receivables, net | 1,002,422 | 1,057,222 | |||||
Inventories | 144,027 | 158,775 | |||||
Deferred taxes | 41,185 | 33,074 | |||||
Prepaid expenses and other current assets | 23,870 | 27,892 | |||||
Total current assets | 1,616,531 | 1,443,017 | |||||
Property and equipment, net | 169,421 | 181,166 | |||||
Goodwill, net | 1,708,332 | 1,708,935 | |||||
Other intangible assets, net | 222,953 | 245,270 | |||||
Other assets | 25,954 | 21,698 | |||||
Total assets | $ | 3,743,191 | $ | 3,600,086 | |||
Liabilities and Stockholders’ Equity | |||||||
Current liabilities: | |||||||
Claims and rebates payable | $ | 1,246,891 | $ | 1,236,775 | |||
Accounts payable | 350,343 | 322,885 | |||||
Accrued expenses | 255,417 | 231,695 | |||||
Current maturities of long-term debt | 22,056 | 22,056 | |||||
Total current liabilities | 1,874,707 | 1,813,411 | |||||
Long-term debt | 345,451 | 412,057 | |||||
Other liabilities | 189,889 | 178,304 | |||||
Total liabilities | 2,410,047 | 2,403,772 | |||||
Stockholders’ equity: | |||||||
Preferred stock, $0.01 par value per share, 5,000,000 shares authorized, | |||||||
and no shares issued and outstanding | - | - | |||||
Common Stock, 275,000,000 shares authorized, $0.01 par value; | |||||||
shares issued: 159,479,000 and 79,787,000, respectively; | |||||||
shares outstanding: 145,634,000 and 73,858,000, respectively | 1,595 | 798 | |||||
Additional paid-in capital | 465,722 | 467,353 | |||||
Unearned compensation under employee compensation plans | (7,806 | ) | (18,177 | ) | |||
Accumulated other comprehensive income | 9,785 | 8,266 | |||||
Retained earnings | 1,431,727 | 1,142,757 | |||||
1,901,023 | 1,600,997 | ||||||
Common Stock in treasury at cost, 13,845,000 and 5,929,000 | |||||||
shares, respectively | (567,879 | ) | (404,683 | ) | |||
Total stockholders’ equity | 1,333,144 | 1,196,314 | |||||
Total liabilities and stockholders’ equity | $ | 3,743,191 | $ | 3,600,086 | |||
See accompanying Notes to Unaudited Consolidated Financial Statements
EXPRESS SCRIPTS, INC.
Unaudited Consolidated Statement of Operations
Three Months Ended | Nine Months Ended | |||||||||||
September 30, | September 30, | |||||||||||
(in thousands, except per share data) | 2005 | 2004 | 2005 | 2004 | ||||||||
Revenues 1 | $ | 3,847,642 | $ | 3,767,690 | $ | 11,631,018 | $ | 11,175,010 | ||||
Cost of revenues 1 | 3,554,442 | 3,532,280 | 10,796,107 | 10,494,291 | ||||||||
Gross profit | 293,200 | 235,410 | 834,911 | 680,719 | ||||||||
Selling, general and administrative | 132,067 | 130,806 | 387,051 | 322,773 | ||||||||
Operating income | 161,133 | 104,604 | 447,860 | 357,946 | ||||||||
Other (expense) income: | ||||||||||||
Undistributed loss from joint venture | (633 | ) | (954 | ) | (1,928 | ) | (3,754 | ) | ||||
Interest income | 3,506 | 867 | 7,558 | 2,492 | ||||||||
Interest expense | (5,102 | ) | (4,248 | ) | (14,532 | ) | (37,118 | ) | ||||
(2,229 | ) | (4,335 | ) | (8,902 | ) | (38,380 | ) | |||||
Income before income taxes | 158,904 | 100,269 | 438,958 | 319,566 | ||||||||
Provision for income taxes | 57,210 | 38,352 | 149,988 | 122,266 | ||||||||
Net income | $ | 101,694 | $ | 61,917 | $ | 288,970 | $ | 197,300 | ||||
Basic earnings per share: | $ | 0.70 | $ | 0.41 | $ | 1.96 | $ | 1.28 | ||||
Weighted average number of common shares | ||||||||||||
Outstanding during the period - Basic EPS | 146,312 | 152,252 | 147,285 | 153,804 | ||||||||
Diluted earnings per share: | $ | 0.68 | $ | 0.40 | $ | 1.93 | $ | 1.26 | ||||
Weighted average number of common shares | ||||||||||||
Outstanding during the period - Diluted EPS | 148,858 | 154,354 | 149,651 | 156,142 | ||||||||
1Excludes estimated retail pharmacy co-payments of $1,413,332 and $1,363,991 for the three months ended September 30, 2005 and 2004, respectively, and $4,357,212 and $4,148,590 for the nine months ended September 30, 2005 and 2004, respectively. These are amounts we instructed retail pharmacies to collect from members. We have no information regarding actual co-payments collected.
See accompanying Notes to Unaudited Consolidated Financial Statements
EXPRESS SCRIPTS, INC. | |||||||||||||||||||||||||
Unaudited Consolidated Statement of Changes in Stockholders’ Equity | |||||||||||||||||||||||||
Number of Shares | Amount | ||||||||||||||||||||||||
(in thousands) | Common Stock | Common Stock | Additional Paid-in Capital | Unearned Compensation Under Employee Compensation Plans | Accumulated Other Comprehensive Income | Retained Earnings | Treasury Stock | Total | |||||||||||||||||
Balance at December 31, 2004 | 79,787 | $ | 798 | $ | 467,353 | $ | (18,177 | ) | $ | 8,266 | $ | 1,142,757 | $ | (404,683 | ) | $ | 1,196,314 | ||||||||
Comprehensive income: | |||||||||||||||||||||||||
Net income | - | - | - | - | - | 288,970 | - | 288,970 | |||||||||||||||||
Other comprehensive income: | |||||||||||||||||||||||||
Foreign currency | |||||||||||||||||||||||||
translation adjustment | - | - | - | - | 1,255 | - | - | 1,255 | |||||||||||||||||
Realized and unrealized gains | |||||||||||||||||||||||||
on derivative financial | |||||||||||||||||||||||||
instruments, net of taxes | - | - | - | - | 264 | - | - | 264 | |||||||||||||||||
Comprehensive income | - | - | - | - | 1,519 | 288,970 | - | 290,489 | |||||||||||||||||
Stock split in form of stock dividend | 79,724 | 797 | (797 | ) | - | - | - | - | - | ||||||||||||||||
Treasury stock acquired | - | - | - | - | - | - | (220,436 | ) | (220,436 | ) | |||||||||||||||
Changes in stockholders’ equity related | |||||||||||||||||||||||||
to employee stock plans | (32 | ) | (834 | ) | 10,371 | - | - | 57,240 | 66,777 | ||||||||||||||||
Balance at September 30, 2005 | 159,479 | $ | 1,595 | $ | 465,722 | $ | (7,806 | ) | $ | 9,785 | $ | 1,431,727 | $ | (567,879 | ) | $ | 1,333,144 |
See accompanying Notes to Unaudited Consolidated Financial Statements
EXPRESS SCRIPTS, INC. | |||||||
Unaudited Consolidated Statement of Cash Flows | |||||||
Nine Months Ended | |||||||
September 30, | |||||||
(in thousands) | 2005 | 2004 | |||||
Cash flows from operating activities: | |||||||
Net income | $ | 288,970 | $ | 197,300 | |||
Adjustments to reconcile net income to net cash | |||||||
provided by operating activities, excluding | |||||||
the effect of the acquisition: | |||||||
Depreciation and amortization | 59,625 | 50,477 | |||||
Non-cash adjustments to net income | 55,902 | 57,081 | |||||
Net changes in operating assets and liabilities | 126,565 | (1,582 | ) | ||||
Net cash provided by operating activities | 531,062 | 303,276 | |||||
Cash flows from investing activities: | |||||||
Purchases of property and equipment | (34,211 | ) | (33,387 | ) | |||
Acquisition, net of cash acquired, and investment in joint venture | (2,150 | ) | (331,136 | ) | |||
Repayment from (loan to) Pharmacy Care Alliance | 2,188 | (14,050 | ) | ||||
Other | (294 | ) | 103 | ||||
Net cash used in investing activities | (34,467 | ) | (378,470 | ) | |||
Cash flows from financing activities: | |||||||
Proceeds from long-term debt | - | 675,564 | |||||
Repayment of long-term debt | (16,556 | ) | (740,455 | ) | |||
(Repayment of) Proceeds from revolving credit line, net | (50,000 | ) | 50,000 | ||||
Treasury stock acquired | (219,949 | ) | (160,286 | ) | |||
Deferred financing fees | - | (6,036 | ) | ||||
Net proceeds from employee stock plans | 28,531 | 21,256 | |||||
Net cash used in financing activities | (257,974 | ) | (159,957 | ) | |||
Effect of foreign currency translation adjustment | 352 | 272 | |||||
Net increase (decrease) in cash and cash equivalents | 238,973 | (234,879 | ) | ||||
Cash and cash equivalents at beginning of period | 166,054 | 396,040 | |||||
Cash and cash equivalents at end of period | $ | 405,027 | $ | 161,161 |
See accompanying Notes to Unaudited Consolidated Financial Statements
EXPRESS SCRIPTS, INC.
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
Note 1 - Summary of significant accounting policies
Certain of our significant accounting policies are described below. Other financial statement note disclosures, normally included in financial statements prepared in conformity with generally accepted accounting principles, have been omitted from this Form 10-Q pursuant to the rules and regulations of the Securities and Exchange Commission. However, we believe the disclosures contained in this Form 10-Q are adequate to make the information presented not misleading when read in conjunction with the notes to the consolidated financial statements included in our Annual Report on Form 10-K for the year ended December 31, 2004 filed with the Securities and Exchange Commission on March 3, 2005. For a full description of our accounting policies, please refer to the Notes to Consolidated Financial Statements included in our Annual Report on Form 10-K for the year ended December 31, 2004.
We believe the accompanying unaudited consolidated financial statements reflect all adjustments (consisting of only normal recurring adjustments except as otherwise disclosed) necessary to present fairly the Unaudited Consolidated Balance Sheet at September 30, 2005, the Unaudited Consolidated Statements of Operations for the three and nine months ended September 30, 2005 and 2004, the Unaudited Consolidated Statement of Changes in Stockholders’ Equity for the nine months ended September 30, 2005, and the Unaudited Consolidated Statements of Cash Flows for the nine months ended September 30, 2005 and 2004. Operating results for the three and nine months ended September 30, 2005 are not necessarily indicative of the results that may be expected for the year ending December 31, 2005.
REVENUE RECOGNITION
Revenues from our pharmacy benefit management (“PBM”) segment are earned by dispensing prescriptions from our home delivery pharmacies, processing claims for prescriptions filled by retail pharmacies in our networks, and by providing services to drug manufacturers, including administration of discount programs (see also “—Rebate Accounting”).
Revenues from dispensing prescriptions from our home delivery pharmacies, which include the co-payment received from members of the health plans we serve, are recorded when prescriptions are shipped. At the time of shipment, our earnings process is complete: the obligation of our customer to pay for the drugs is fixed, and, due to the nature of the product, the member may not return the drugs nor receive a refund.
Revenues related to the sale of prescription drugs by retail pharmacies in our networks consist of the amount the client has contracted to pay us (which excludes the co-payment) for the dispensing of such drugs together with any associated administrative fees. These revenues are recognized when the claim is processed. When we independently have a contractual obligation to pay our network pharmacy providers for benefits provided to our clients’ members, we act as a principal in the arrangement and we include the total payments we have contracted to receive from these clients as revenue, and payments we make to the network pharmacy providers as cost of revenue in compliance with Emerging Issues Task Force (“EITF”) Issue No. 99-19, “Reporting Gross Revenue as a Principal vs. Net as an Agent.” When a prescription is presented by a member to a retail pharmacy within our network, we are solely responsible for confirming member eligibility, performing drug utilization review, reviewing for drug-to-drug interactions, performing clinical intervention, which may involve a call to the member’s physician, communicating plan provisions to the pharmacy, directing payment to the pharmacy and billing the client for the amount they are contractually obligated to pay us for the prescription dispensed, as specified within our client contracts. We also provide benefit design and formulary consultation services to clients. We have separately negotiated contractual relationships with our clients and with network pharmacies, and under our contracts with pharmacies we assume the credit risk of our clients’ ability to pay for drugs dispensed by these pharmacies to clients’ members. Our clients are not obligated to pay the pharmacies as we are primarily obligated to pay retail pharmacies in our network the contractually agreed upon amount for the prescription dispensed, as specified within our provider contracts. In addition, under most of our client contracts, we realize a positive or negative margin represented by the difference between the negotiated ingredient costs we will receive from our clients and the separately negotiated ingredient costs we will pay to our network pharmacies. These factors indicate we are a principal as defined by EITF 99-19 and, as such, we record ingredient cost billed to clients in revenue and the corresponding ingredient cost paid to network pharmacies in cost of revenues.
If we merely administer a client’s network pharmacy contracts to which we are not a party and under which we do not assume credit risk, we record only our administrative fees as revenue. For these clients, we earn an administrative fee for collecting payments from the client and remitting the corresponding amount to the pharmacies in the client’s network. In these transactions we act as a conduit for the client. Because we are not the principal in these transactions, drug ingredient cost is not included in our revenues or in our cost of revenues.
In retail pharmacy transactions, amounts paid to pharmacies and amounts charged to clients are always exclusive of the applicable co-payment. Under our pharmacy agreements, the pharmacy is solely obligated to collect the co-payment from the member based on the amount we advise them to collect. We have no information regarding actual co-payments collected. As such, we do not include member co-payments to retail pharmacies in our revenue or in our cost of revenue. Retail pharmacy co-payments, which we instructed retail pharmacies to collect from members, of $1.4 billion for the three months ended September 30, 2005 and 2004, and $4.4 billion and $4.1 billion for the nine months ended September 30, 2005 and 2004, respectively, are excluded from revenues and cost of revenues.
We bill our clients based upon the billing schedules established in client contracts. At the end of a period, any unbilled revenues related to the sale of prescription drugs that have been adjudicated with retail pharmacies are estimated based on the amount we will pay to the pharmacies and historical gross margin. Those amounts due from our clients are recorded as revenue as they are contractually due to us for past transactions. Adjustments are made to these estimated revenues to reflect actual billings at the time clients are billed; historically, these adjustments have not been material.
Certain implementation and other fees paid to clients upon the initiation of a contractual agreement are considered an integral part of overall contract pricing and are recorded as a reduction of revenue. Where they are refundable upon early termination of the contract, these payments are capitalized and amortized as a reduction of revenue on a straight-line basis over the life of the contract.
Revenues from our non-PBM segment, Pharma Business Solutions (“PBS”), are derived from the distribution of pharmaceuticals requiring special handling or packaging where we have been selected by the pharmaceutical manufacturer as part of a limited distribution network, the distribution of pharmaceuticals through Patient Assistance Programs where we receive a fee from the pharmaceutical manufacturer for administrative and pharmacy services for the delivery of certain drugs free of charge to doctors for their indigent patients, sample fulfillment and sample accountability services. Revenues earned by PBS include administrative fees received from pharmaceutical manufacturers for dispensing or distributing consigned pharmaceuticals requiring special handling or packaging and administrative fees for verification of practitioner licensure and distribution of consigned drug samples to doctors based on orders received from pharmaceutical sales representatives. We also administer sample card programs for certain manufacturers and include the ingredient costs of those drug samples dispensed from retail pharmacies in PBS revenues, and the associated costs for these sample card programs in cost of revenues. Because manufacturers are independently obligated to pay us and we have an independent contractual obligation to pay our network pharmacy providers for free samples dispensed to patients under sample card programs, we include the total payments from these manufacturers (including ingredient costs) as revenue, and payments to the network pharmacy provider as cost of revenue. These transactions require us to assume credit risk.
REBATE ACCOUNTING
We administer two rebate programs through which we receive rebates and administrative fees from pharmaceutical manufacturers. Rebates earned for the administration of these programs, performed in conjunction with claim processing and home delivery services provided to clients, are recorded as a reduction of cost of revenue and the portion of the rebate payable to customers is treated as a reduction of revenue. When we earn rebates and administrative fees in conjunction with formulary management services, but do not process the underlying claims, we record rebates received from manufacturers, net of the portion payable to customers, in revenue. We record rebates and administrative fees receivable from the manufacturer and payable to clients when the prescriptions covered under contractual agreements with the manufacturers are dispensed; these amounts are not dependent upon future pharmaceutical sales.
With respect to rebates based on actual market share performance, we estimate rebates and the associated receivable from pharmaceutical manufacturers quarterly based on our estimate of the number of rebatable prescriptions and the rebate per prescription. The portion of rebates payable to clients is estimated quarterly based on historical and/or anticipated sharing percentages and our estimate of rebates receivable from pharmaceutical manufacturers. These estimates are adjusted to actual when amounts are received from manufacturers and the portion payable to clients is paid.
With respect to rebates that are not based on market share performance, no estimation is required for the manufacturer billing amounts which are determinable when the drug is dispensed. We pay all or a contractually agreed upon portion of such rebates to our clients. The portion of rebates payable to clients is estimated based on historical and/or anticipated sharing percentages. These estimates are adjusted to actual when amounts are paid to clients.
COST OF REVENUES
Cost of revenues includes product costs, network pharmacy claims payments and other direct costs associated with dispensing prescriptions, including shipping and handling (see also “—Revenue Recognition” and “—Rebate Accounting”).
CASH AND CASH EQUIVALENTS
Cash and cash equivalents include cash on hand and investments with original maturities of three months or less. We have banking relationships resulting in certain cash disbursement accounts being maintained by banks not holding our cash concentration accounts. As a result, cash disbursement accounts carrying negative book balances of $164.0 million and $160.3 million (representing outstanding checks not yet presented for payment) have been reclassified to claims and rebates payable, accounts payable and accrued expenses at September 30, 2005 and December 31, 2004, respectively. This reclassification restores balances to cash and current liabilities for liabilities to our vendors which have not been defeased. No overdraft or unsecured short-term loan exists in relation to these negative balances.
RECEIVABLES
Based on our revenue recognition policies discussed above, certain claims at the end of a period are unbilled. Revenue and unbilled receivables for those claims are estimated each period based on the amount to be paid to network pharmacies and historical gross margin. Estimates are adjusted to actual at the time of billing. In addition, revenue and unbilled receivables for rebates based on market share performance are calculated quarterly based on an estimate of rebatable prescriptions and the rebate per prescription. These estimates are adjusted to actual when the number of rebatable prescriptions and the rebate per prescription have been determined and the billing to the manufacturers has been completed. Historically, adjustments to our estimates have been immaterial.
Included in receivables, net, as of September 30, 2005 and December 31, 2004, is an allowance for doubtful accounts of $38.7 million and $31.4 million, respectively. This increase is primarily due to additional reserves for receivables from our clients’ members.
As of September 30, 2005 and December 31, 2004, unbilled receivables were $655.9 million and $664.5 million, respectively. Unbilled receivables are billed to clients typically within 30 days of the transaction date based on the contractual billing schedule agreed upon with the client.
IMPAIRMENT OF LONG-LIVED ASSETS
We evaluate whether events and circumstances have occurred that indicate the remaining estimated useful life of long-lived assets, including intangible assets, may warrant revision or that the remaining balance of an asset may not be recoverable. The measurement of possible impairment is based on the ability to recover the balance of assets from expected future operating cash flows on an undiscounted basis. Impairment losses, if any, would be determined based on the present value of the cash flows using discount rates that reflect the inherent risk of the underlying business. Absent events or circumstances indicating an impairment of goodwill, we perform an annual goodwill impairment test during the fourth quarter. No impairments existed as of September 30, 2005 and December 31, 2004.
SELF-INSURANCE RESERVES
We maintain insurance coverage for claims that arise in the normal course of business. Where insurance coverage is not available, or, in our judgment, is not cost-effective, we maintain self-insurance reserves to reduce our exposure to future legal costs, settlements and judgments. Self-insured losses are accrued based upon estimates of the aggregate liability for the costs of uninsured claims incurred using certain actuarial assumptions followed in the insurance industry and our historical experience (see Note 8). It is not possible to predict with certainty the outcome of these claims, and we can give no assurances that any losses, in excess of our insurance and any self-insurance reserves, will not be material.
EMPLOYEE BASED COMPENSATION
We account for employee stock options in accordance with Accounting Principles Board No. (“APB”) 25, “Accounting for Stock Issued to Employees.” Under APB 25, we apply the intrinsic value method of accounting and, therefore, have not recognized compensation expense for options granted, because we grant options at a price equal to market value at the time of grant. During 1996, Financial Accounting Standard (“FAS”) No. 123, “Accounting for Stock-Based Compensation”, became effective for us. FAS 123 prescribes the recognition of compensation expense based on the fair value of options determined on the grant date. However, FAS 123 grants an exception that allows companies currently applying APB 25 to continue using that method. We have, therefore, elected to continue applying the intrinsic value method under APB 25. In December 2004, the Financial Accounting Standards Board (“FASB”) revised FAS 123 (“FAS 123R”), “Share-Based Payment”, which replaces FAS 123, “Accounting for Stock-Based Compensation”, and supersedes APB 25. FAS 123R will require compensation cost related to share-based payment transactions to be recognized in the financial statements. We will adopt FAS 123R using the modified prospective method beginning January 1, 2006 (see “New Accounting Guidance”).
The following table shows stock-based compensation expense included in net income and pro forma stock-based compensation expense, net income and earnings per share had we elected to record compensation expense based on the estimated fair value of options at the grant date for the three and nine months ended September 30, 2005 and 2004 (see also Note 7):
Three Months Ended September 30, | Nine Months Ended September 30, | ||||||||||||
(in thousands, except per share data) | 2005 | 2004 | 2005 | 2004 | |||||||||
Net income, as reported(1) | $ | 101,694 | $ | 61,917 | $ | 288,970 | $ | 197,300 | |||||
Less: Employee stock-based compensation expense determined using fair-value based method for stock-based awards, net of tax(2) | (2,340 | ) | 1,035 | (8,155 | ) | 2,387 | |||||||
Pro forma net income | $ | 99,354 | $ | 60,882 | $ | 280,815 | $ | 194,913 | |||||
Basic earnings per share | |||||||||||||
As reported | $ | 0.70 | $ | 0.41 | $ | 1.96 | $ | 1.28 | |||||
Pro forma | 0.67 | 0.40 | 1.91 | 1.27 | |||||||||
Diluted earnings per share | |||||||||||||
As reported | $ | 0.68 | $ | 0.40 | $ | 1.93 | $ | 1.26 | |||||
Pro forma | 0.66 | 0.39 | 1.87 | 1.25 |
(1) Net income, as reported, includes stock-based compensation expense for the three months ended September 30, 2005 and 2004 of $1,159 ($1,760 pre-tax) and $1,122 ($1,818 pre-tax), respectively, and for the nine months ended September 30, 2005 and 2004 of $5,748 ($9,022 pre-tax) and $3,860 ($6,252 pre-tax), respectively, related to restricted shares of Common Stock awarded to certain of our officers and employees.
(2) The increase in pro forma compensation expense is due to the forfeiture of options during 2004 which resulted in expense reductions of $283 and $3,473 during the three and nine months ended September 30, 2004, respectively.
NEW ACCOUNTING GUIDANCE
In June 2005, the FASB issued FAS 154, “Accounting Changes and Error Corrections”, which superceded APB No. 20, “Accounting Changes.” APB No. 20 previously required that most voluntary changes in accounting principle be recognized by including in the current period’s net income the cumulative effect of changing to the new accounting principle. In contrast, FAS 154 requires entities that voluntarily make a change in accounting principle to apply that change retrospectively to prior periods’ financial statements, unless this would be impracticable. In addition, FAS 154 makes a distinction between retrospective application of an accounting principle and the restatement of financial statements to reflect the correction of an error. FAS 154 is effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005. We do not expect the implementation of FAS 154 to have an impact on our consolidated results of operations.
In December 2004, the FASB revised FAS 123. FAS 123R will require compensation cost related to share-based payment transactions to be recognized in the financial statements. As permitted by FAS 123, we currently follow the guidance of APB 25, which allows the use of the intrinsic value method of accounting to value share-based payment transactions with employees. FAS 123R requires measurement of the cost of share-based payment transactions to employees at the fair value of the award on the grant date and recognition of expense over the requisite service or vesting period. FAS 123R allows implementation using a modified version of prospective application, under which compensation expense for the unvested portion of previously granted awards and all new awards will be recognized on or after the date of adoption. FAS 123R also allows companies to implement by restating previously issued financial statements, basing the amounts on the expense previously calculated and reported in their pro forma footnote disclosures required under FAS 123. We will adopt FAS 123R using the modified prospective method beginning January 1, 2006. The impact of adopting FAS 123R on our consolidated results of operations is not expected to differ materially from the pro forma disclosures currently required by FAS 123 (see “Employee stock-based compensation”).
Note 2 - Changes in business
On January 30, 2004, we acquired the outstanding capital stock of CuraScript, for approximately $333.4 million, which includes a purchase price adjustment for working capital and transaction costs. CuraScript is one of the nation’s largest specialty pharmacy services companies and has enhanced our ability to provide comprehensive pharmaceutical management services to our clients and their members. CuraScript operates seven specialty pharmacies throughout the United States and serves over 175 managed care organizations, 30 Medicaid programs and the Medicare program. The transaction was accounted for under the provisions of FAS 141, “Business Combinations.” The purchase price has been allocated based upon the estimated fair value of net assets acquired at the date of the acquisition. A portion of the excess of purchase price over tangible net assets acquired has been allocated to intangible assets, consisting of customer contracts in the amount of $28.7 million and non-competition agreements in the amount of $2.7 million, which are being amortized using the straight-line method over estimated useful lives of ten years and three years, respectively, and trade names in the amount of $1.3 million, which are not being amortized. These assets are included in other intangible assets. In addition, the excess of purchase price over tangible net assets and identified intangible assets acquired has been allocated to goodwill in the amount of $284.9 million, which is not being amortized.
Note 3 - Goodwill and other intangibles
The following is a summary of our goodwill and other intangible assets (amounts in thousands).
September 30, 2005 | December 31, 2004 | |||||||||||
Gross Carrying Amount | Accumulated Amortization | Gross Carrying Amount | Accumulated Amortization | |||||||||
Goodwill | ||||||||||||
PBM (1) | $ | 1,793,275 | $ | 107,079 | $ | 1,793,830 | $ | 107,031 | ||||
Non-PBM | 22,136 | - | 22,136 | - | ||||||||
$ | 1,815,411 | $ | 107,079 | $ | 1,815,966 | $ | 107,031 | |||||
Other intangible assets | ||||||||||||
PBM (1) | ||||||||||||
Customer contracts (1) | $ | 294,224 | $ | 96,401 | $ | 294,063 | $ | 85,067 | ||||
Other (1) | 72,904 | 51,701 | 72,346 | 40,408 | ||||||||
367,128 | 148,102 | 366,409 | 125,475 | |||||||||
Non-PBM | ||||||||||||
Customer contracts | 4,000 | 1,792 | 4,000 | 1,416 | ||||||||
Other | 1,880 | 161 | 1,880 | 128 | ||||||||
5,880 | 1,953 | 5,880 | 1,544 | |||||||||
Total other intangible assets | $ | 373,008 | $ | 150,055 | $ | 372,289 | $ | 127,019 |
(1)In the first quarter of 2005 we finalized the allocation of the CuraScript purchase price to tangible and intangible net assets resulting in a $1.1 million decrease in goodwill (See Note 2). Changes in goodwill and accumulated amortization from December 31, 2004 to September 30, 2005 are also a result of changes in foreign currency exchange rates.
The aggregate amount of amortization expense of other intangible assets was $7.4 million and $6.9 million for the three months ended September 30, 2005 and 2004, respectively, and $22.3 million and $27.0 million for the nine months ended September 30, 2005 and 2004, respectively. The future aggregate amount of amortization expense of other intangible assets is approximately $7.6 million for fourth quarter of 2005, $24.2 million for 2006, $20.9 million for 2007, $17.5 million for 2008, and $15.9 million for 2009, and $15.0 million for 2010. These amounts exclude the future amortization of intangible assets which will be recorded in connection with the October 14, 2005 acquisition of Priority Healthcare Corporation ("Priority") described in Note 10. The weighted average amortization period of intangible assets subject to amortization is 17 years in total, and by major intangible class is 20 years for customer contracts and six years for other intangible assets.
Note 4 - Income Taxes
Our effective tax rate decreased to 36.0% and 34.2% for the three and nine months ended September 30, 2005, as compared to 38.2% and 38.3%, respectively, for the same periods of 2004. The decrease in effective tax rate for the three months ended September 30, 2005 reflects a non-recurring net tax benefit of $1.5 million resulting primarily from the recognition of expected tax benefits associated with certain subsidiary losses generated in prior years. The decrease in the effective tax rate for the nine months ended September 30, 2005 reflects the following non-recurring items:
· | In the second quarter of 2005 we recorded a $10.2 million net tax benefit relating to a change in the apportionment of our income for state income tax purposes |
· | As a result of the recognition of expected state tax benefits associated with prior-year subsidiary losses, we recorded net tax benefits of $2.3 million and approximately $1.5 million (as mentioned above) in the first and third quarters of 2005. |
Excluding the $14.0 million non-recurring net tax benefits, the effective tax rate for the nine months ended September 30, 2005 would have been 37.4%.
Note 5 - Common Stock
On May 24, 2005, we announced a two-for-one stock split for stockholders of record on June 10, 2005, effective June 24, 2005. The split was effected in the form of a dividend by issuance of one additional share of common stock for each share of common stock outstanding. The earnings per share and the weighted average number of shares outstanding for basic and diluted earnings per share for each period have been adjusted for the stock split.
Note 6 - Earnings per share (reflecting the two-for-one stock split effective June 24, 2005)
Basic earnings per share is computed using the weighted average number of common shares outstanding during the period. Diluted earnings per share is computed in the same manner as basic earnings per share but adds the number of additional common shares that would have been outstanding for the period if the dilutive potential common shares had been issued. The following is the reconciliation between the number of weighted average shares used in the basic and diluted earnings per share calculation for all periods (amounts in thousands):
Three Months Ended September 30, | Nine Months Ended September 30, |
2005 | 2004 | 2005 | 2004 | ||||
Weighted average number of common shares | |||||||
outstanding during the period - Basic EPS | 146,312 | 152,252 | 147,285 | 153,804 | |||
Outstanding stock options | 2,285 | 1,724 | 2,122 | 1,928 | |||
Executive deferred compensation plan | 41 | 90 | 39 | 92 | |||
Restricted stock awards | 220 | 288 | 205 | 318 | |||
Weighted average number of common shares | |||||||
outstanding during the period - Diluted EPS | 148,858 | 154,354 | 149,651 | 156,142 |
The above shares are all calculated under the “treasury stock” method in accordance with FAS 128, “Earnings per Share.”
Note 7 - Stock-based compensation plans
We apply APB 25 and related interpretations in accounting for our stock-based compensation plans. Accordingly, compensation cost has been recorded based upon the intrinsic value method of accounting for restricted stock and no compensation cost has been recognized for stock options granted as the exercise price of the options was not less than the fair market value of the shares at the time of grant. If compensation cost for stock option grants had been determined based on the fair value at the grant dates consistent with the method prescribed by FAS 123, our net income and earnings per share for the three months ended September 30, 2005 and 2004 would have been $99.4 million, or $0.66 per diluted share and $60.9 million, or $0.39 per diluted share, respectively, and our net income and earnings per share for the nine months ended September 30, 2005 and 2004 would have been $280.8 million or $1.87 per diluted share and $194.9 million or $1.25 per diluted share, respectively (see also Note 1).
The fair value of options granted (which is amortized over the option-vesting period in determining the pro forma impact) is estimated on the date of grant using the Black-Scholes multiple option-pricing model with the following weighted average assumptions:
Three Months Ended September 30, | Nine Months Ended September 30, | |||
2005 | 2004 | 2005 | 2004 | |
Expected life of option | 2.5-4.5 years | 3-7 years | 2.5-5 years | 3-7 years |
Risk-free interest rate | 3.93%-4.09% | 3.27%-3.93% | 3.48%-4.09% | 1.97%-4.18% |
Expected volatility of stock | 36% | 44% | 36%-40% | 44%-47% |
Expected dividend yield | None | None | None | None |
A summary of the status of our fixed stock option plans as of September 30, 2005 and 2003, and changes during the periods ending on those dates are presented below.
Nine Months Ended | Nine Months Ended | |||||||||||
September 30, 2005 | September 30, 2004 | |||||||||||
(share data in thousands) | Shares | Weighted-Average Exercise Price | Shares | Weighted-Average Exercise Price | ||||||||
Outstanding at beginning of year | 7,170 | $ | 21.86 | 8,032 | $ | 17.98 | ||||||
Granted | 1,675 | $ | 41.48 | 1,440 | $ | 36.54 | ||||||
Exercised | (1,943 | ) | $ | 17.00 | (1,394 | ) | $ | 15.86 | ||||
Forfeited/Cancelled | (290 | ) | $ | 28.44 | (428 | ) | $ | 25.14 | ||||
Outstanding at end of period | 6,612 | $ | 27.97 | 7,650 | $ | 21.46 | ||||||
Options exercisable at period end | 3,638 | 4,520 | ||||||||||
Weighted-average fair value of options granted during the year | $ | 14.70 | $ | 16.47 |
The following table summarizes information about fixed stock options outstanding at September 30, 2005:
Options Outstanding | Options Exercisable | ||||
Range of Exercise Prices (share data in thousands) | Number Outstanding at 9/30/05 | Weighted-Average Remaining Contractual Life | Weighted-Average Exercise Price | Number Exercisable at 9/30/05 | Weighted-Average Exercise Price |
$ | 3.72 - 16.42 | 1,403 | 3.5 | $ | 12.64 | 1,402 | $ | 12.64 | ||||||||
16.85 - 23.98 | 1,844 | 5.0 | 21.23 | 1,557 | 20.73 | |||||||||||
24.07 - 37.58 | 1,560 | 5.7 | 34.26 | 645 | 33.13 | |||||||||||
37.62 - 47.14 | 1,588 | 6.4 | 40.38 | 34 | 39.19 | |||||||||||
47.37 - 59.11 | 217 | 6.7 | 48.31 | - | - | |||||||||||
6,612 | 5.2 | $ | 27.97 | 3,638 | $ | 19.98 |
Note 8 - Contingencies
We accrue self-insurance reserves based upon estimates of the aggregate liability of claim costs in excess of our insurance coverage. Reserves are estimated using certain actuarial assumptions followed in the insurance industry and our historical experience (see Note 1, “Self-insurance reserves”). The majority of these claims are legal claims and our liability estimate is primarily related to the cost to defend these claims. We do not accrue for settlements, judgments, monetary fines or penalties until such amounts are probable and estimable, in compliance with FAS 5, “Accounting for Contingencies.” Under FAS 5, if the range of possible loss is broad, the liability accrual should be based on the lower end of the range.
While we believe that our services and business practices are in compliance with applicable laws, rules and regulations in all material respects, we cannot predict the outcome of these matters at this time. An unfavorable outcome in one or more of these matters could result in the imposition of judgments, monetary fines or penalties, or injunctive or administrative remedies. We can give no assurance that such judgments, fines and remedies, and future costs associated with legal matters, would not have a material adverse effect on our financial condition, our consolidated results of operations or our consolidated cash flows.
Note 9 - Segment reporting
We report segments on the basis of services offered and have determined that we have two reportable segments: PBM services and non-PBM services. Our PBM operating results include those of CuraScript from January 30, 2004, the date of acquisition. Our domestic and Canadian PBM operating segments have similar characteristics and as such have been aggregated into a single PBM reporting segment. Our Non-PBM operating segment includes our Specialty Distribution Services and Phoenix Marketing Group service lines.
Operating income is the measure used by our chief operating decision maker to assess the performance of each of our operating segments. The following table presents information about our reportable segments, including a reconciliation of operating income to income before income taxes, for the three and nine months ended September 30, 2005 and 2004:
(in thousands) | PBM | Non-PBM | Total | ||||||
Three months ended September 30, 2005 | |||||||||
Product revenues | |||||||||
Network revenues | $ | 2,206,553 | $ | - | $ | 2,206,553 | |||
Home delivery revenues | 1,520,231 | - | 1,520,231 | ||||||
Other revenues | - | 46,005 | 46,005 | ||||||
Service revenues | 38,516 | 36,337 | 74,853 | ||||||
Total revenues | 3,765,300 | 82,342 | 3,847,642 | ||||||
Depreciation and amortization expense | 18,712 | 1,610 | 20,322 | ||||||
Operating income | 148,557 | 12,576 | 161,133 | ||||||
Undistributed loss from joint venture | (633 | ) | |||||||
Interest income | 3,506 | ||||||||
Interest expense | (5,102 | ) | |||||||
Income before income taxes | 158,904 | ||||||||
Capital expenditures | 12,700 | 3,579 | 16,279 | ||||||
Three months ended September 30, 2004 | |||||||||
Product revenues | |||||||||
Network revenues | $ | 2,283,010 | $ | - | $ | 2,283,010 | |||
Home delivery revenues | 1,395,336 | - | 1,395,336 | ||||||
Other revenues | - | 32,199 | 32,199 | ||||||
Service revenues | 28,661 | 28,484 | 57,145 | ||||||
Total revenues | 3,707,007 | 60,683 | 3,767,690 | ||||||
Depreciation and amortization expense | 16,411 | 1,241 | 17,652 | ||||||
Operating income | 95,071 | 9,533 | 104,604 | ||||||
Undistributed loss from joint venture | (954 | ) | |||||||
Interest income | 867 | ||||||||
Interest expense | (4,248 | ) | |||||||
Income before income taxes | 100,269 | ||||||||
Capital expenditures | 14,328 | 1,704 | 16,032 | ||||||
Nine Months Ended September 30, 2005 | |||||||||
Product revenues | |||||||||
Network revenues | $ | 6,830,902 | $ | - | $ | 6,830,902 | |||
Home delivery revenues | 4,473,390 | - | 4,473,390 | ||||||
Other revenues | - | 123,168 | 123,168 | ||||||
Service revenues | 110,695 | 92,863 | 203,558 | ||||||
Total revenues | 11,414,987 | 216,031 | 11,631,018 | ||||||
Depreciation and amortization expense | 55,210 | 4,415 | 59,625 | ||||||
Operating income | 419,176 | 28,684 | 447,860 | ||||||
Undistributed loss from joint venture | (1,928 | ) | |||||||
Interest income | 7,558 | ||||||||
Interest expense | (14,532 | ) | |||||||
Income before income taxes | 438,958 | ||||||||
Capital expenditures | 27,935 | 6,276 | 34,211 | ||||||
Nine Months Ended September 30, 2004 | |||||||||
Product revenues | |||||||||
Network revenues | $ | 6,985,738 | $ | - | $ | 6,985,738 | |||
Home delivery revenues | 3,945,653 | - | 3,945,653 | ||||||
Other revenues | - | 94,374 | 94,374 | ||||||
Service revenues | 69,648 | 79,597 | 149,245 | ||||||
Total revenues | 11,001,039 | 173,971 | 11,175,010 | ||||||
Depreciation and amortization expense | 47,195 | 3,282 | 50,477 | ||||||
Operating income | 331,171 | 26,775 | 357,946 | ||||||
Undistributed loss from joint venture | (3,754 | ) | |||||||
Interest income | 2,492 | ||||||||
Interest expense | (37,118 | ) | |||||||
Income before income taxes | 319,566 | ||||||||
Capital expenditures | 26,906 | 6,481 | 33,387 | ||||||
As of September 30, 2005 | |||||||||
Total assets | $ | 3,574,439 | $ | 168,752 | $ | 3,743,191 | |||
Investment in equity method investees | 710 | - | 710 | ||||||
As of December 31, 2004 | |||||||||
Total assets | $ | 3,460,426 | $ | 139,660 | $ | 3,600,086 | |||
Investment in equity method investees | 808 | - | 808 |
PBM product revenue consists of revenues from the dispensing of prescription drugs from our home delivery pharmacies and revenues from the sale of prescription drugs by retail pharmacies in our retail pharmacy networks. Non-PBM product revenues consist of revenues from certain specialty distribution activities. PBM service revenue includes administrative fees associated with the administration of retail pharmacy networks contracted by certain clients, market research programs and informed decision counseling services. Non-PBM service revenue includes revenues from certain specialty distribution services, and sample distribution and accountability services.
Revenues earned by our Canadian PBM totaled $7.7 million and $6.2 million for the three months ended September 30, 2005 and 2004, respectively, and $22.8 million and $19.2 million for the nine months ended September 30, 2005 and 2004, respectively. All other revenues are earned in the United States. Long-lived assets of our Canadian PBM (consisting primarily of fixed assets and goodwill) totaled $37.5 million and $36.1 million as of September 30, 2005 and December 31, 2004, respectively. All other long-lived assets are domiciled in the United States.
Note 10 - Subsequent Events
On October 14, 2005, we purchased the capital stock of Priority in a cash transaction for $28 per share, or approximately $1.3 billion. Priority, headquartered near Orlando, Fla., is among the nation’s largest specialty pharmacy and distribution companies, with approximately $1.7 billion in annual revenue during 2004 and approximately $1.1 billion in revenue for the six months ended July 2, 2005. This acquisition is expected to enhance our specialty pharmacy business. The $1.3 billion purchase price was financed with approximately $167.0 million of cash on hand and the remainder by adding $1.6 billion in Term A loans through a new credit facility which replaced our prior credit facility. As a result of this refinancing, we will write off approximately $3.5 million of deferred financing fees relating to our existing credit facility in the fourth quarter of 2005.
Subsequent to the closing of our acquisition of Priority, Aetna, Inc. provided notice of its election to exercise its purchase option for Priority Healthcare's 60% ownership share of Aetna Specialty Pharmacy. The transaction is subject to the satisfaction of certain contractual requirements and to the expiration of the waiting period under the Hart-Scott-Rodino Antitrust Improvements Act.
In October 2005, we refinanced our entire credit facility with a new $2.2 billion credit facility which includes $1.6 billion of Term A loans and a $600.0 million revolving credit facility. The proceeds from the $2.2 billion credit facility were used to finance the Priority acquisition and to prepay borrowings on the Term A Loan outstanding under our existing credit facility. The newly established $600.0 million revolving credit facility is also available for general corporate purposes.
Our new credit facility requires us to pay interest periodically on the London Interbank Offered Rates (“LIBOR”) or base rate options, plus a margin. The margin over LIBOR will range from 0.50% to 1.125%, depending on our consolidated leverage ratio or our credit rating. The margin over the base rate will range from 0% to 0.125% depending upon our consolidated leverage ratio. Initially, the margin over LIBOR will be 0.75% per annum. Under our new credit facility we are required to pay commitment fees on the unused portion of the $600 million revolving credit facility. The commitment fee will range from 0.10% to 0.25% depending on our consolidated leverage ratio or our credit rating. Initially, the commitment fee will be 0.15% per annum. At October 19, 2005, the weighted average interest rate on the new facility was 4.9%. Our new credit facility contains covenants that limit the indebtedness we may incur, the common shares we may repurchase, and dividends we may pay. The repurchase and dividend covenant applies if certain leverage thresholds are exceeded. The covenants also include a minimum interest coverage ratio and a maximum leverage ratio.
The following represents the schedule of current maturities for our long-term debt, reflecting the increase in debt related to the Priority acquisition in October 2005 and the refinancing of our bank credit facility in October 2005 (amounts in thousands):
Year Ended December 31, | |||
2005 | $ | 40,000 | |
2006 | 160,000 | ||
2007 | 180,000 | ||
2008 | 260,000 | ||
2009 | 420,000 | ||
Thereafter | 540,000 | ||
$ | 1,600,000 |
Item 2. Management’s Discussion And Analysis Of Financial Condition And Results Of Operations
Information that we have included or incorporated by reference in this Quarterly Report on Form 10-Q, and information that may be contained in our other filings with the Securities and Exchange Commission (the “SEC”) and our press releases or other public statements, contain or may contain forward-looking statements. These forward-looking statements include, among others, statements of our plans, objectives, expectations or intentions.
Our forward-looking statements involve risks and uncertainties. Our actual results may differ significantly from those projected or suggested in any forward-looking statements. We do not undertake any obligation to release publicly any revisions to such forward-looking statements to reflect events or circumstances occurring after the date hereof or to reflect the occurrence of unanticipated events. Factors that might cause such a difference to occur include, but are not limited to:
• | risks of integration of Priority Healthcare and CuraScript after closing |
• | costs of and adverse results in litigation, including a number of pending class action cases that challenge certain of our business practices |
• | risks arising from investigations of certain PBM practices and pharmaceutical pricing, marketing and distribution practices currently being conducted by the U.S. Attorney offices in Philadelphia and Boston, and by other regulatory agencies including the Department of Labor, and various state attorneys general |
• | risks and uncertainties regarding the implementation and the ultimate terms of the Medicare Part D prescription drug benefit, including financial risks to us if we participate in the program on a risk-bearing basis and risks of client or member losses to other providers under Medicare Part D |
• | risks associated with our acquisitions (including our acquisition of Priority Healthcare), which include integration risks and costs, risks of client retention and repricing of client contracts, and risks associated with the operations of acquired businesses |
• | risks associated with our ability to maintain growth rates, or to control operating or capital costs |
• | continued pressure on margins resulting from client demands for lower prices, enhanced service offerings and/or higher service levels, and the possible termination of, or unfavorable modification to, contracts with key clients or providers |
• | competition in the PBM industry, and our ability to consummate contract negotiations with prospective clients, as well as competition from new competitors offering services that may in whole or in part replace services that we now provide to our customers |
• | adverse results in regulatory matters, the adoption of new legislation or regulations (including increased costs associated with compliance with new laws and regulations), more aggressive enforcement of existing legislation or regulations, or a change in the interpretation of existing legislation or regulations |
• | increased compliance risks relating to our contracts with the DoD TRICARE Plan and various state governments and agencies |
• | the possible loss, or adverse modification of the terms, of relationships with pharmaceutical manufacturers, or changes in pricing, discount or other practices of pharmaceutical manufacturers |
• | risks associated with the possible loss, or adverse modification of the terms of, contracts with pharmacies in our retail pharmacy network |
• | risks associated with the use and protection of the intellectual property we use in our business |
• | risks associated with our leverage and debt service obligations, including the effect of certain covenants in our borrowing agreements |
• | risks associated with our ability to continue to develop new products, services and delivery channels |
• | general developments in the health care industry, including the impact of increases in health care costs, changes in drug utilization and cost patterns and introductions of new drugs |
• | increase in credit risk relative to our clients due to adverse economic trends |
• | risks associated with changes in average wholesale prices, which could reduce prices and margins |
• | risks associated with our inability to attract and retain qualified personnel |
• other risks described from time to time in our filings with the SEC
See the more comprehensive description of risk factors under the captions “Forward Looking Statements and Associated Risks” contained in Item 1 - “Business” of our Annual Report on Form 10-K for the year ended December 31, 2004.
OVERVIEW
As one of the largest full-service pharmacy benefit management (“PBM”) companies, we provide health care management and administration services on behalf of our clients, which include health maintenance organizations, health insurers, third-party administrators, employers, union-sponsored benefit plans and government health programs. Our integrated PBM services include network claims processing, home delivery services, specialty home delivery claim fulfillment, benefit design consultation, drug utilization review, formulary management, disease management, and drug data analysis services. We also provide non-PBM services, through our Pharma Business Solutions unit, which include distribution of specialty pharmaceuticals requiring special handling or packaging where we have been selected by the pharmaceutical manufacturer as part of a limited distribution network; distribution of pharmaceuticals to low-income patients through manufacturer-sponsored and company-sponsored generic patient assistance programs, and distribution of sample units to physicians and verification of practitioner licensure.
We report two segments, PBM and non-PBM. We derive revenues primarily from the sale of PBM services in the United States and Canada. Revenue generated by our segments can be classified as either tangible product revenue or service revenue. We earn tangible product revenue from the sale of prescription drugs by retail pharmacies in our retail pharmacy networks and from dispensing prescription drugs from our home delivery pharmacies. Service revenue includes administrative fees associated with the administration of retail pharmacy networks contracted by certain clients, market research programs, informed decision counseling services, certain specialty distribution services, and sample fulfillment and sample accountability services. Tangible product revenue generated through both our PBM and non-PBM segments represented 98.1% of revenues for the three months ended September 30, 2005 as compared to 98.4% for the same period of 2004 and 98.3% for the nine months ended September 30, 2005 as compared to 98.7% for the same period of 2004.
On January 30, 2004, we acquired the outstanding capital stock of CuraScript Pharmacy, Inc. and CuraScript PBM Services, Inc. (collectively, “CuraScript”), for approximately $333.4 million which includes a purchase price adjustment for working capital and transaction costs. Consequently, our PBM operating results include those of CuraScript from January 30, 2004.
CRITICAL ACCOUNTING POLICIES
The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Our estimates and assumptions are based upon a combination of historical information and various other assumptions believed to be reasonable under the particular circumstances. Actual results may differ from our estimates. Certain of the accounting policies that most impact our consolidated financial statements and that require our management to make difficult, subjective or complex judgments are described below. This should be read in conjunction with Note 1, “Summary of Significant Accounting Policies” and with the notes to the consolidated financial statements included in our Annual Report on Form 10-K for the year ended December 31, 2004, filed with the SEC on March 3, 2005.
REBATE ACCOUNTING
ACCOUNTING POLICY
We administer a rebate program based on actual market share performance in which rebates and the associated receivable from pharmaceutical manufacturers are estimated quarterly based on our estimate of the number of rebatable prescriptions and the rebate per prescription. The portion of rebates payable to clients is estimated quarterly based on historical allocation percentages and our estimate of rebates receivable from pharmaceutical manufacturers. With respect to our market share rebate program, estimates are adjusted to actual when amounts are received from manufacturers and the portion payable to clients is paid. With respect to rebates that are not based on market share performance, the portion of rebates payable to clients is estimated based on historical and/or anticipated sharing percentages. These estimates are adjusted to actual when amounts are paid to clients.
FACTORS AFFECTING ESTIMATE
The factors that could impact our estimates of rebates, rebates receivable and rebates payable are as follows:
· | Differences between the actual and the estimated number of rebatable prescriptions; |
· | Differences between estimated aggregate allocation percentages and actual rebate allocation percentages calculated on a client-by-client basis; |
· | Differences between actual and estimated market share of a manufacturer’s brand drug for our clients as compared to the national market share; |
· | Drug patent expirations; and |
· | Changes in drug utilization patterns. |
Historically, adjustments to our original estimates have been relatively immaterial.
UNBILLED REVENUE AND RECEIVABLES
ACCOUNTING POLICY
We bill our clients based upon the billing schedules established in client contracts. At the end of a period, any unbilled revenues related to the sale of prescription drugs that have been adjudicated with retail pharmacies are estimated based on the amount we will pay to the pharmacies and historical gross margin.
FACTORS AFFECTING ESTIMATE
Unbilled amounts are estimated based on historical margin. Historically, adjustments to our original estimates have been immaterial. Significant differences between actual and estimated margin could impact subsequent adjustments.
ALLOWANCE FOR DOUBTFUL ACCOUNTS
ACCOUNTING POLICY
We provide an allowance for doubtful accounts equal to estimated uncollectible receivables. This estimate is based on the current status of each customer’s receivable balance.
FACTORS AFFECTING ESTIMATE
We record allowances for doubtful accounts based on a variety of factors including the length of time the receivables are past due, the financial health of the customer and historical experience. Our estimate could be impacted by changes in economic and market conditions as well as changes to our customers’ financial condition.
SELF-INSURANCE RESERVES
ACCOUNTING POLICY
We accrue self-insurance reserves based upon estimates of the aggregate liability of claim costs in excess of our insurance coverage. Reserves are estimated using certain actuarial assumptions followed in the insurance industry and our historical experience. The majority of these claims are legal claims and our liability estimate is primarily related to the cost to defend these claims. We do not accrue for settlements, judgments, monetary fines or penalties until such amounts are probable and estimable, in compliance with Financial Accounting Standard (“FAS”) No. 5, “Accounting for Contingencies.” Under FAS 5, if the range of possible loss is broad, the liability accrual should be based on the lower end of the range.
FACTORS AFFECTING ESTIMATE
Self-insurance reserves are based on management’s estimates of the costs to defend legal claims. We do not have significant experience with certain of these types of cases. As such, differences between actual costs and management’s estimates could be significant. In addition, actuaries do not have a significant history with the PBM industry. Changes to assumptions used in the development of these reserves can affect net income in a given period. In addition, changes in the legal environment and number and nature of claims could impact our estimate.
OTHER ACCOUNTING POLICIES
We consider the following information about revenue recognition policies important for an understanding of our results of operations:
· | Revenues from dispensing prescriptions from our home delivery pharmacies are recorded when prescriptions are shipped. These revenues include the co-payment received from members of the health plans we serve. |
· | Revenues from the sale of prescription drugs by retail pharmacies are recognized when the claim is processed. We do not include member co-payments to retail pharmacies in revenue or cost of revenue. |
· | When we independently have a contractual obligation to pay our network pharmacy providers for benefits provided to our clients’ member, we act as a principal in the arrangement and we include the total payments we have contracted to receive from these clients as revenue and the total payments we make to the network pharmacy providers as cost of revenue. |
· | When we merely administer a client’s network pharmacy contracts to which we are not a party and under which we do not assume credit risk, we earn an administrative fee for collecting payments from the client and remitting the corresponding amount to the pharmacies in the client’s network. In these transactions, drug ingredient cost is not included in our revenues nor in our cost of revenues. |
· | We administer two rebate programs through which we receive rebates and administrative fees from pharmaceutical manufacturers. |
· | Gross rebates and administrative fees earned for the administration of our rebate programs, performed in conjunction with claim processing services provided to clients, are recorded as a reduction of cost of revenue and the portion of the rebate payable to customers is treated as a reduction of revenue. |
· | When we earn rebates and administrative fees in conjunction with formulary management services, but do not process the underlying claims, we record rebates received from manufacturers, net of the portion payable to customers, in revenue. |
· | We distribute pharmaceuticals in connection with our management of patient assistance programs and earn a fee from the manufacturer for administrative and pharmacy services for the delivery of certain drugs free of charge to doctors for their indigent patients. |
· | We earn a fee for the distribution of consigned pharmaceuticals requiring special handling or packaging where we have been selected by the pharmaceutical manufacturer as part of a limited distribution network. |
· | Non-PBM product revenues include revenues earned through administering sample card programs for certain manufacturers. We include ingredient cost of those drug samples dispensed from retail pharmacies in our Non-PBM revenues and the associated costs for these sample card programs in cost of revenues. |
· | Non-PBM service revenues include administrative fees for the verification of practitioner licensure and the distribution of consigned drug samples to doctors based on orders received from pharmaceutical sales representatives. |
RESULTS OF OPERATIONS
PBM OPERATING INCOME
Three Months Ended September 30, | Nine Months Ended September 30, | |||||||||||||||||
(in thousands) | 2005 | Increase/ (Decrease) | 2004 | 2005 | Increase/ (Decrease) | 2004 | ||||||||||||
Product revenues | ||||||||||||||||||
Network revenues | $ | 2,206,553 | (3.3 | )% | $ | 2,283,010 | $ | 6,830,902 | (2.2 | )% | $ | 6,985,738 | ||||||
Home delivery revenues | 1,520,231 | 9.0 | % | 1,395,336 | 4,473,390 | 13.4 | % | 3,945,653 | ||||||||||
Service revenues | 38,516 | 34.4 | % | 28,661 | 110,695 | 58.9 | % | 69,648 | ||||||||||
Total PBM revenues | 3,765,300 | 1.6 | % | 3,707,007 | 11,414,987 | 3.8 | % | 11,001,039 | ||||||||||
Cost of PBM revenues | 3,489,104 | 0.1 | % | 3,484,928 | 10,622,053 | 2.5 | % | 10,357,941 | ||||||||||
PBM Gross Profit | 276,196 | 24.4 | % | 222,079 | 792,934 | 23.3 | % | 643,098 | ||||||||||
PBM SG&A expenses | 127,639 | 0.5 | % | 127,008 | 373,758 | 19.8 | % | 311,927 | ||||||||||
PBM operating income | $ | 148,557 | 56.3 | % | $ | 95,071 | $ | 419,176 | 26.6 | % | $ | 331,171 |
Network claims increased by 14.9 million and 46.3 million claims, respectively, in the three and nine months ended September 30, 2005 over the three and nine months ended September 30, 2004. The increase in network claims for the three and nine months ended September 30, 2005 as compared to 2004 is primarily due to increased volume resulting from the implementation of our contract with the DoD TRICARE Retail Pharmacy (“TRICARE”) program in June 2004. Note that revenues for the TRICARE program are included in service revenue (see discussion below).
The $76.5 million, or 3.3%, decrease in network pharmacy revenues in the three months ended September 30, 2005 as compared to the same period of 2004 is attributable to the following factors:
· | Network pharmacy revenues decreased $96.7 million in the three months ended September 30, 2005, as compared to the same period of 2004 as a result of a higher mix of generic claims and a 2.7% increase in the average co-payment per retail pharmacy claim. Generic claims made up 55.6% of total network claims in the three months ended September 30, 2005 as compared to 52.6% of total network claims for the same period of 2004. As mentioned in our Critical Accounting Policies above, we do not include member co-payments to retail pharmacies in revenue or cost of revenue. |
· | These factors were partially offset by an increase in pharmacy claims, resulting in a $20.2 million increase in overall network pharmacy revenues. |
The $154.8 million, or 2.2%, decrease in network pharmacy revenues in the nine months ended September 30, 2005 as compared to the same period of 2004 is attributable to the following factors:
· | Network pharmacy revenues decreased $269.2 million in the nine months ended September 30, 2005, as compared to the same period of 2004 as a result of a higher mix of generic claims and a 2.1% increase in the average co-payment per retail pharmacy claim. Generic claims made up 55.0% of total network claims in the nine months ended September 30, 2005 as compared to 51.2% of total network claims for the same period of 2004. As mentioned in our Critical Accounting Policies above, we do not include member co-payments to retail pharmacies in revenue or cost of revenue. |
· | These factors were partially offset by an increase in pharmacy claims, resulting in a $114.4 million increase in overall network pharmacy revenues. |
The $124.9 million, or 9.0%, increase in home delivery revenues in the three months ended September 30, 2005 as compared to the same period of 2004 is attributable to the following factors:
· | Growth of our specialty pharmacy business contributed to an $87.3 million increase in home delivery revenues for the three months ended September 30, 2005 over the same period of 2004. |
· | Excluding our specialty pharmacy business, we processed an additional 0.3 million claims in the three months ended September 30, 2005 as compared to the same period of 2004. The increase in home delivery claim volume is primarily due to greater usage of our home delivery pharmacies by members of existing clients. This increase in volume resulted in a $38.3 million increase in home delivery revenues. |
· | Excluding our specialty pharmacy business, a decrease in the average home delivery revenue per claim reduced revenues by $0.7 million in the third quarter of 2005 over the same period in 2004. The decrease in average home delivery revenue per claim is primarily due to a higher mix of generic claims. Our generic fill rate increased to 43.4% in the third quarter of 2005 as compared to 40.8% for the third quarter of 2004. Our home delivery generic fill rate is lower than the retail generic fill rate as fewer generic substitutes are available among maintenance medications (e.g. therapies for diabetes, high cholesterol, etc.) commonly dispensed from home delivery pharmacies compared to acute medications that are dispensed primarily by pharmacies in our retail networks. |
The $527.7 million, or 13.4%, increase in home delivery revenues in the first nine months of 2005 as compared to the same period of 2004, is attributable to the following factors:
· | Growth of our specialty pharmacy business contributed to a $339.1 million increase in home delivery revenue for the nine months ended September 30, 2005 over the same period of 2004. This increase is partially due to an additional month of claims and revenues in 2005, as well as the growth of CuraScript as it increases its penetration into the existing ESI book of business. |
· | Excluding our specialty pharmacy business, we processed an additional 1.5 million claims in the nine months ended September 30, 2005 as compared to the same period in 2004, resulting in a $192.7 million increase in home delivery revenues. The increase in home delivery volume is primarily due to the increased usage of our home delivery pharmacies by members of existing clients. |
· | Excluding our specialty pharmacy business, a decrease in the average home delivery revenue per claim reduced revenues by $4.1 million for the nine months ended September 30, 2005 over the same period in 2004. The decrease in average home delivery revenue per claim is primarily due to a higher mix of generic claims. Our generic fill rate increased to 43.4% for the nine months ended September 30, 2005 from 39.6% for the same period of 2004. Our home delivery generic fill rate is lower than the retail generic fill rate as fewer generic substitutes are available among maintenance medications (e.g. therapies for diabetes, high cholesterol, etc.) commonly dispensed from home delivery pharmacies compared to acute medications that are dispensed primarily by pharmacies in our retail networks. |
PBM service revenues include amounts received from clients for therapy management services such as prior authorization and step therapy protocols and administrative fees earned for processing claims for clients utilizing their own retail pharmacy networks. The $9.9 million, or 34.4%, increase in PBM service revenues for the three months ended September 30, 2005, as compared to the same period in 2004, is primarily due to increased revenues resulting from the implementation of the TRICARE contract in June 2004.
The $41.0 million, or 58.9%, increase in PBM service revenues in the nine months ended September 30, 2005 as compared to the nine months ended September 30, 2004 is primarily due to the implementation of the TRICARE contract in June 2004. This increase was partially offset by a payment of $5.5 million received in the first quarter of 2004 in connection with the early termination by a client in 2001.
PBM cost of revenues increased $4.1 million, or 0.1%, and $264.1 million, or 2.5%, in the three and nine months ended September 30, 2005 as compared to the same periods in 2004 primarily as a result of the following:
· | The addition of our specialty pharmacy business in January 2004 resulted in increases of $82.3 million and $321.8 million for the three and nine months ended September 30, 2005, respectively, as compared to the same periods of 2004, primarily due to the growth of CuraScript. In addition, an additional month of Curascript claims and revenues was included in the nine months ended September 30, 2005, as compared to the same period of 2004. |
· | Excluding our specialty pharmacy business, increases in network and home delivery claims volume resulted in higher PBM cost of revenues of $36.6 million and $198.3 million for the three and nine months ended September 30, 2005, respectively, as compared to the same periods of 2004. |
· | These increases were partially offset by the net decreases in the average cost per claim and a higher mix of generic claims, which decreased cost of revenues by approximately $114.7 million and $256.0 million in the three and nine months ended September 30, 2005, respectively, as compared to the same periods of 2004. The decrease in average cost per claim is due principally to reductions in our acquisition cost for retail pharmacy services and home delivery inventory. These cost reductions are expected to benefit future periods as well. |
Our PBM gross profit increased $54.1 million, or 24.4%, and $149.8 million, or 23.3%, respectively, for the three and nine months ended September 30, 2005. Increases in gross profit result from our ability to successfully reduce our acquisition costs of drugs, from the streamlining of operations, and from higher rebate revenues, which were partially offset by increases in the portion of rebates that we share with our clients. In addition, the increase in gross profit for the nine months ended September 30, 2005 was partially offset by a $5.5 million termination payment received in the first quarter of 2004.
Selling, general and administrative expenses (“SG&A”) increased $0.6 million, or 0.5%, and $61.8 million, or 19.8%, respectively, in the three and nine months ended September 30, 2005 over the same periods of 2004. This is primarily attributable to the following factors:
· | Increased spending of $11.1 million and $44.3 million in the three and nine months ended September 30, 2005 as compared to the same periods of 2004, on costs to improve the operation and the administrative functions supporting the management of the pharmacy benefit, primarily through increased management incentive compensation. |
· | For the three and nine months ended September 30, 2005, professional fees increased $10.1 million and $25.5 million, respectively, as compared to the same periods of 2004 primarily due to increased legal fees. |
· | Increased bad debt expense of $1.5 million and $6.7 million in the three and nine months ended September 30, 2005 as compared to the same periods of 2004, related to an increase in the allowance for receivables from our clients’ members. |
· | Partially offsetting the increases noted above, prior year SG&A included a $25.0 million charge recorded in the third quarter to increase legal reserves. |
In addition to the increases in SG&A above, we also incurred expenses related our Medicare Part D Program in the third quarter of 2005, and we expect spending to continue to increase in the fourth quarter of 2005.
PBM operating income increased $53.5 million, or 56.3%, and $88.0 million, or 26.6%, respectively, in the three and nine months ended September 30, 2005 over the same period of 2004.
NON-PBM OPERATING INCOME
Three Months Ended September 30, | Nine Months Ended September 30, | |||||||||||||||||
(in thousands) | 2005 | Increase/ (Decrease) | 2004 | 2005 | Increase/ (Decrease) | 2004 | ||||||||||||
Product revenues | $ | 46,005 | 42.9 | % | $ | 32,199 | $ | 123,168 | 30.5 | % | $ | 94,374 | ||||||
Service revenues | 36,337 | 27.6 | % | 28,484 | 92,863 | 16.7 | % | 79,597 | ||||||||||
Total Non-PBM revenues | 82,342 | 35.7 | % | 60,683 | 216,031 | 24.2 | % | 173,971 | ||||||||||
Non-PBM cost of revenues | 65,338 | 38.0 | % | 47,352 | 174,054 | 27.7 | % | 136,350 | ||||||||||
Non-PBM Gross Profit | 17,004 | 27.6 | % | 13,331 | 41,977 | 11.6 | % | 37,621 | ||||||||||
Non-PBM SG&A expense | 4,428 | 16.6 | % | 3,798 | 13,293 | 22.6 | % | 10,846 | ||||||||||
Non-PBM operating income | $ | 12,576 | 31.9 | % | $ | 9,533 | $ | 28,684 | 7.1 | % | $ | 26,775 |
Non-PBM product revenues increased $13.8 million, or 42.9%, and $28.8 million, or 30.5%, respectively, for the three and nine months ended September 30, 2005 over the same periods of 2004. This is mainly due to a higher mix of specialty distribution volumes in which we include ingredient cost of pharmaceuticals dispensed in our revenues, including two new specialty distribution contracts in 2005. Non-PBM service revenues increased $7.9 million, or 27.6%, and $13.3 million, or 16.7%, respectively, for the three and nine months ended September 30, 2005. The increase is due in large part to an increase in existing client volumes as well as higher volumes under our RxOutreach program.
Non-PBM cost of revenues increased $18.0 million, or 38.0%, and $37.7 million, or 27.7%, respectively, in the three and nine months ended September 30, 2005 as compared to the same periods of 2004, mainly due to the additional volume in sample card programs where we include the ingredient costs of pharmaceuticals dispensed from retail pharmacies in our Non-PBM revenues and cost of revenues (as discussed above). Gross profit increased $3.7 million, or 27.6%, and $4.4 million, or 11.6%, for the three and nine months ended September 30, 2005 as compared to the same periods of 2004.
Non-PBM SG&A increased $0.6 million, or 16.6%, and $2.4 million, or 22.6%, respectively, for the three and nine months ended September 30, 2005 as compared to the same time periods of 2004. This is primarily due to an increase in marketing expenditures related to the RxOutreach program and increased sales expenses.
Non-PBM operating income increased $3.0 million, or 31.9%, and $1.9 million, or 7.1%, respectively, during the three and nine months ended September 30, 2005 as compared to the same periods of 2004.
OTHER (EXPENSE) INCOME
In February 2001, we entered into an agreement with AdvancePCS (now owned by Caremark RX, Inc.) and Medco Health Solutions, Inc. (formerly, “Merck-Medco, L.L.C.”) to form RxHub, an electronic exchange enabling physicians who use electronic prescribing technology to link to pharmacies, PBMs and health plans. We own one-third of the equity of RxHub (as do each of the other two founders) and have committed to invest up to $20 million over five years, with approximately $19.2 million invested through September 30, 2005. We have recorded our investment in RxHub under the equity method of accounting, which requires our percentage interest in RxHub’s results to be recorded in our Unaudited Consolidated Statement of Operations. Our percentage of RxHub’s loss for the three and nine months ended September 30, 2005 was $0.6 million ($0.4 million, net of tax) and $1.9 million ($1.3 million, net of tax), respectively, compared to $1.0 million ($0.6 million, net of tax) and $3.8 million ($2.3 million, net of tax) for the same periods of 2004.
For the three and nine months ended September 30, 2005, net interest expense decreased $1.8 million, or 52.8%, and $27.7 million, or 79.9%, respectively, as compared to the same periods in 2004, resulting from the refinancing of our entire credit facility during the first quarter of 2004 (see “—Bank Credit Facility”).
PROVISION FOR INCOME TAXES
Our effective tax rate decreased to 36.0% and 34.2% for the three and nine months ended September 30, 2005, as compared to 38.2% and 38.3%, respectively, for the same periods of 2004. The decrease in effective tax rate for the three months ended September 30, 2005 reflects a non-recurring net tax benefit of $1.5 million resulting primarily from the recognition of expected tax benefits associated with certain subsidiary losses generated in prior years. The decrease in the effective tax rate for the nine months ended September 30, 2005 reflects the following non-recurring items:
· | In the second quarter of 2005 we recorded a $10.2 million net tax benefit relating to a change in the apportionment of our income for state income tax purposes |
· | As a result of the recognition of expected state tax benefits associated with prior-year subsidiary losses, we recorded net tax benefits of $2.3 million and approximately $1.5 million (as mentioned above) in the first and third quarters of 2005. |
Excluding the $14.0 million non-recurring net tax benefits, the effective tax rate for the nine months ended September 30, 2005 would have been 37.4%.
NET INCOME AND EARNINGS PER SHARE
Net income for the three months ended September 30, 2005 increased $39.8 million, or 64.2%, over the same period of 2004. Net income increased $91.7 million, or 46.5%, for the nine months ended September 30, 2005 over the same period of 2004.
Basic and diluted earnings per share increased 70.7% and 70.0%, respectively, for the three months ended September 30, 2005 over the same period of 2004. Basic and diluted earnings per share increased 53.1% and 53.2%, respectively, for the nine months ended September 30, 2005, over the nine months ended September 30, 2004.
On May 24, 2005, we announced a two-for-one stock split for stockholders of record on June 10, 2005, effective June 24, 2005. The split was effected in the form of a dividend by issuance of one additional share of common stock for each share of common stock outstanding. The earnings per share and the weighted average number of shares outstanding for basic and diluted earnings per share for each period have been adjusted for the stock split.
LIQUIDITY AND CAPITAL RESOURCES
OPERATING CASH FLOW AND CAPITAL EXPENDITURES
For the nine months ended September 30, 2005, net cash provided by operations increased $227.8 million to $531.1 million from $303.3 million during the nine months ended September 30, 2004. This increase reflects a $128.1 million increase from net changes in our working capital components, increased earnings of $91.7 million, and a $9.1 million increase in depreciation and amortization, partially due to the acquisition of CuraScript in January 2004. The increase from changes in our working capital components primarily consists of a $64.6 million increase due to a lower accounts receivable balance, a $39.9 million increase due to improved inventory management, and a $16.6 million increase resulting from the timing of payments to vendors. Partially offsetting these increases was a $1.1 million reduction from changes in non-cash adjustments to net income.
Our capital expenditures for the nine months ended September 30, 2005 decreased $0.8 million, or 2.5%, as compared to the same period of 2004. We intend to continue to invest in technology that we believe will provide efficiencies in operations and facilitate growth and enhance the service we provide to our clients. We expect future anticipated capital expenditures will be funded primarily from operating cash flow or, to the extent necessary, with borrowings under our revolving credit facility, discussed below.
We are developing a new Patient Care Contact Center in Pueblo, Colorado which will be completed during the fourth quarter of 2005. To date, we have expensed approximately $3.0 million and capitalized approximately $5.0 million for this project (net of reimbursements from the city of Pueblo and state of Colorado). Total 2005 expenditures for the project are expected to range from $11.0 million to $13.0 million, of which approximately $4.0 million to $6.0 million will be expensed and approximately $7.0 million will be capitalized. We expect that a portion of these expenditures will be reimbursed by the city of Pueblo and the state of Colorado, and that such reimbursements will reduce the amount capitalized for this project.
CHANGES IN BUSINESS
On October 14, 2005, we purchased the capital stock of Priority in a cash transaction for $28 per share, or approximately $1.3 billion. Priority, headquartered near Orlando, Fla., is among the nation’s largest specialty pharmacy and distribution companies, with approximately $1.7 billion in annual revenue during 2004 and approximately $1.1 billion in revenue for the six months ended July 2, 2005. This acquisition is expected to enhance our specialty pharmacy business. The $1.3 billion purchase price was financed with approximately $167.0 million of cash on hand and the remainder by adding $1.6 billion in Term A loans through a new credit facility which replaced our prior credit facility. As a result of this refinancing, we will write off approximately $3.5 million of deferred financing fees relating to our existing credit facility in the fourth quarter of 2005.
On January 30, 2004, we acquired the outstanding capital stock of CuraScript, for approximately $333.4 million, which includes a purchase price adjustment for working capital and transaction costs. CuraScript is one of the nation’s largest specialty pharmacy services companies and has enhanced our ability to provide comprehensive pharmaceutical management services to our clients and their members. CuraScript operates seven specialty pharmacies throughout the United States and serves over 175 managed care organizations, 30 Medicaid programs and the Medicare program. The transaction was accounted for under the provisions of FAS 141, “Business Combinations.” The purchase price has been allocated based upon the estimated fair value of net assets acquired at the date of the acquisition. A portion of the excess of purchase price over tangible net assets acquired has been allocated to intangible assets, consisting of customer contracts in the amount of $28.7 million and non-competition agreements in the amount of $2.7 million, which are being amortized using the straight-line method over estimated useful lives of ten years and three years, respectively, and trade names in the amount of $1.3 million, which are not being amortized. These assets are included in other intangible assets. In addition, the excess of purchase price over tangible net assets and identified intangible assets acquired has been allocated to goodwill in the amount of $284.9 million, which is not being amortized.
Goodwill is evaluated for impairment annually or when events or circumstances occur indicating that goodwill might be impaired. In addition, we evaluate whether events or circumstances have occurred that indicate the remaining estimated useful lives of other intangible assets may warrant revision or that the remaining balance of an asset may not be recoverable. The measurement of possible impairment is based on the ability to recover the balance of assets from expected future operating cash flows on an undiscounted basis. Impairment losses, if any, would be determined based on the present value of the cash flows using discount rates that reflect the inherent risk of the underlying business. No such impairment existed at September 30, 2005 or December 31, 2004.
We regularly review potential acquisitions and affiliation opportunities. We believe available cash resources, bank financing or the issuance of additional common stock or other securities could be used to finance future acquisitions or affiliations. There can be no assurance we will make new acquisitions or establish new affiliations in 2005 or thereafter.
In January 2004, we entered into an agreement to provide PBM services for the Medicare discount program of Pharmacy Care Alliance, Inc. (“PCA”), a nonstock, not-for-profit entity jointly controlled by the National Association of Chain Drugstores (“NACDS”) and us. Our PBM services include the negotiation of discounts from individual retailers and pharmaceutical manufacturers, the enrollment of cardholders and the processing of prescription claims.
During 2004, we entered into a lending agreement with PCA, whereby we committed to lend up to $17.0 million to PCA in the form of a revolving line of credit available through December 31, 2005. Requests for borrowings on the revolving line of credit require the unanimous consent of PCA’s board of directors, which consists of representatives from NACDS and from our management team, or its designated representatives. PCA will utilize the revolving line of credit to fund its operating expenditures. NACDS has agreed to guarantee $2.0 million on the revolving line of credit. As of September 30, 2005, we have loaned PCA $14.6 million, and have received $2.9 million in interest and principal payments.
In regard to the revolving line of credit extended to PCA, the collectibility of any unsecured borrowings will be a function of PCA’s success in enrolling new members for its Medicare discount program. Enrollment as of September 30, 2005 is approximately 254,000 members. Because 2004 enrollment and utilization was lower than expected, the outstanding balance of our receivable from PCA was fully reserved at the end of 2004.
BANK CREDIT FACILITY
On February 13, 2004, we refinanced our entire credit facility, negotiating an $800.0 million credit facility with a bank syndicate which includes $200.0 million of Term A loans, $200.0 million of Term B loans and a $400.0 million revolving credit facility. At September 30, 2005, our credit facility consisted of $170.0 million of Term A loans, $197.0 million of Term B loans and a $400.0 million revolving credit facility (of which no debt was outstanding at September 30, 2005). During the third quarter of 2005, we made scheduled payments on our Term A and Term B loans totaling $5.0 million and $0.5 million, respectively.
Our credit facility requires us to pay interest periodically on the London Interbank Offered Rates (“LIBOR”) or base rate options, plus a margin. The margin on the Term A loans and on amounts outstanding under the revolving credit facility is dependent on our credit rating and our ratio of debt to earnings before interest, taxes, depreciation and amortization (“EBITDA”). The Term B loan interest is based on the LIBOR or alternative base rate options plus a margin of 1.5% or 0.25% per annum, respectively. Under our credit facility we are required to pay commitment fees on the unused portion of the $400.0 million revolving credit facility ($400.0 million at September 30, 2005). The commitment fee will range from 0.2% to 0.5% depending on our credit rating and our consolidated leverage ratio. The commitment fee is currently 0.25% per annum.
At September 30, 2005, the weighted average interest rate on the facility was 5.03%. Our credit facility contains covenants that limit the indebtedness we may incur, the common shares we may repurchase and dividends we may pay. The covenants also include a minimum interest coverage ratio and a maximum leverage ratio. At September 30, 2005, we were in compliance with all covenants associated with our credit facility.
In October 2005, we refinanced our entire credit facility with a new $2.2 billion credit facility which includes $1.6 billion of Term A loans and a $600.0 million revolving credit facility. The proceeds from the $2.2 billion credit facility were used to finance the Priority acquisition and to prepay borrowings on the Term A Loan outstanding under our existing credit facility. The newly established $600.0 million revolving credit facility is also available for general corporate purposes.
Our new credit facility requires us to pay interest periodically on the London Interbank Offered Rates (“LIBOR”) or base rate options, plus a margin. The margin over LIBOR will range from 0.50% to 1.125%, depending on our consolidated leverage ratio or our credit rating. The margin over the base rate will range from 0% to 0.125% depending upon our consolidated leverage ratio. Initially, the margin over LIBOR will be 0.75% per annum. Under our new credit facility we are required to pay commitment fees on the unused portion of the $600 million revolving credit facility. The commitment fee will range from 0.10% to 0.25% depending on our consolidated leverage ratio or our credit rating. Initially, the commitment fee will be 0.15% per annum. At October 19, 2005, the weighted average interest rate on the new facility was 4.9%. Our new credit facility contains covenants that limit the indebtedness we may incur, the common shares we may repurchase, and dividends we may pay. The repurchase and dividend covenant applies if certain leverage thresholds are exceeded. The covenants also include a minimum interest coverage ratio and a maximum leverage ratio.
The following represents the schedule of current maturities for our long-term debt, reflecting the increase in debt related to the Priority acquisition in October 2005 and the refinancing of our bank credit facility in October 2005 (amounts in thousands):
Year Ended December 31, | |||
2005 | $ | 40,000 | |
2006 | 160,000 | ||
2007 | 180,000 | ||
2008 | 260,000 | ||
2009 | 420,000 | ||
Thereafter | 540,000 | ||
$ | 1,600,000 |
CONTRACTUAL OBLIGATIONS
The following table sets forth our schedule of maturities of our long-term debt and future minimum lease payments due under noncancellable operating leases as of September 30, 2005 (in thousands):
Payments Due by Period as of September 30, | ||||||||||||||||
Contractual obligations | Total | 2005 | 2006 - 2007 | 2008 - 2009 | After 2009 | |||||||||||
Long-term debt (1) | $ | 367,507 | $ | 5,500 | $ | 69,112 | $ | 245,112 | $ | 47,783 | ||||||
Future minimum lease payments (2) | 106,009 | 6,070 | 44,328 | 22,961 | 32,650 | |||||||||||
Total contractual obligations | $ | 473,516 | $ | 11,570 | $ | 113,440 | $ | 268,073 | $ | 80,433 | ||||||
(1) As a result of our financing activities subsequent to September 30, 2005, including the addition of a Term A loan to partially finance the Priority acquisition, borrowing on our revolving credit facility and the refinancing of our bank credit facility (see “—Bank Credit Facility”), maturities on our long-term debt have changed. As of October 14, 2005, the effective date of our bank credit facility refinancing, we are required to make long-term debt principal payments totaling $40.0 million in 2005, $160.0 million in 2006, $180.0 million in 2007, $260.0 million in 2008, $420.0 million in 2009, and $540.0 million after 2009.
(2) In July 2004, we entered into a capital lease with the Camden County Joint Development Authority in association with the development of our new Patient Care Contact Center in St. Marys, Georgia. At September 30, 2005, our lease obligation is $13.5 million. In accordance with Financial Accounting Standards Board (“FASB”) Interpretation Number 39, “Offsetting of Amounts Related to Certain Contracts,” our lease obligation has been offset against $13.5 million of industrial revenue bonds issued to us by the Camden County Joint Development Authority.
OTHER MATTERS
In June 2005, the FASB issued Financial Accounting Standard (“FAS”) No. 154, “Accounting Changes and Error Corrections”, which superceded Accounting Principles Board No. (“APB”) 20, “Accounting Changes”. APB No. 20 previously required that most voluntary changes in accounting principle be recognized by including in the current period’s net income the cumulative effect of changing to the new accounting principle. In contrast, FAS 154 requires entities that voluntarily make a change in accounting principle to apply that change retrospectively to prior periods’ financial statements, unless this would be impracticable. In addition, FAS 154 makes a distinction between retrospective application of an accounting principle and the restatement of financial statements to reflect the correction of an error. FAS 154 is effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005. We do not expect the implementation of FAS 154 to have an impact on our consolidated results of operations.
In December 2004, the FASB revised FAS 123, “Share-Based Payment” (“FAS 123R”), which replaced FAS 123, “Accounting for Stock-Based Compensation”, and superseded APB No. 25, “Accounting for Stock Issued to Employees.” FAS 123R will require compensation cost related to share-based payment transactions to be recognized in the financial statements. As permitted by FAS 123, we currently follow the guidance of APB 25, which allows the use of the intrinsic value method of accounting to value share-based payment transactions with employees. FAS 123R requires measurement of the cost of share-based payment transactions to employees at the fair value of the award on the grant date and recognition of expense over the requisite service or vesting period. FAS 123R allows implementation using a modified version of prospective application, under which compensation expense for the unvested portion of previously granted awards and all new awards will be recognized on or after the date of adoption. FAS 123R also allows companies to implement by restating previously issued financial statements, basing the amounts on the expense previously calculated and reported in their pro forma footnote disclosures required under FAS 123. We will adopt FAS 123R using the modified prospective method beginning January 1, 2006. The impact of adopting FAS 123R on our consolidated results of operations is not expected to differ materially from the pro forma disclosures currently required by FAS 123 (see note 7 to our unaudited consolidated financial statements).
We make available through our website (www.express-scripts.com), access to our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, all amendments to those reports (when applicable), and other filings with the SEC. Such access is free of charge and is available as soon as reasonably practicable after such information is filed with the SEC. In addition, the SEC maintains an internet site (www.sec.gov) containing reports, proxy and information statements, and other information regarding issuers filing electronically with the SEC (which includes us). Information included on our website is not part of this quarterly report.
IMPACT OF INFLATION
Changes in prices charged by manufacturers and wholesalers for pharmaceuticals affect our revenues and cost of revenues. Most of our contracts provide that we bill clients based on a generally recognized price index for pharmaceuticals, and accordingly we have been able to recover price increases from our clients under the terms of our agreements.
Item 3. Quantitative and Qualitative Disclosures About Market Risk
We are exposed to market risk from changes in interest rates related to debt outstanding under our credit facility. Our earnings are subject to change as a result of movements in market interest rates. At September 30, 2005, we had $367.5 million of obligations which were subject to variable rates of interest under our credit facility. A hypothetical increase in interest rates of 1% would result in an increase in annual interest expense of approximately $3.7 million (pre-tax), presuming that obligations subject to variable interest rates remained constant.
Item 4. Controls and Procedures
We maintain a comprehensive set of disclosure controls and procedures (as defined in Rules 13a-15(e) and under the Securities Exchange Act of 1934 (“Exchange Act”)) designed to provide reasonable assurance that information required to be disclosed in our filings under the Exchange Act is recorded, processed, summarized and reported accurately and within the time periods specified in the SEC’s rules and forms. Under the supervision and with the participation of our management, including our President and Chief Executive Officer and our Senior Vice President and Chief Financial Officer, we have evaluated the effectiveness of the design and operation of our disclosure controls and procedures as of the end of the period covered by this report. Based upon this evaluation, the President and Chief Executive Officer and the Senior Vice President and Chief Financial Officer concluded that the design and operation of these disclosure controls and procedures are effective in providing reasonable assurance of the achievement of the objectives described above.
During the third quarter ended September 30, 2005, there was no change in our internal control over financial reporting that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.
PART II. OTHER INFORMATION
Item 1. Legal Proceedings
We and/or the Company’s subsidiary, NPA, are defendants in several lawsuits that purport to be class actions, which were described in our Annual Report on Form 10-K for the year ended December 31, 2004. Each case seeks damages in an unspecified amount, and the allegations are such that the Company cannot at this time estimate with any certainty the damages that the plaintiffs seek to recover. Because none of the cases has yet been certified by the court as a class action, we are unable to evaluate the effect that unfavorable outcomes might have on our financial condition or consolidated results of operations. The following developments have occurred since the Annual Report:
· | International Association of Firefighters, Local No. 22, et al. v. National Prescription Administrators and Express Scripts, Inc. (Cause No. L03216-02, Superior Court of New Jersey, Law Division, Camden County). Plaintiff has voluntarily dismissed all remaining class action claims. We no longer deem the case to have the potential to be material to us. |
· | City of Paterson, et al. v. Benecard Prescription Services, et. al. (Cause No. L-005908-02, Superior Court of New Jersey, Law Division, Camden County). Following the filing of the dismissal of the claims by the Township of Hamilton, the settlement between the Township of Hamilton and co-defendant Benecard was not finalized. The dismissal was withdrawn and we have renewed our motion for summary judgment. |
· | Irwin v. AdvancePCS, et al. (Cause No. RG030886393, Superior Court of the State of California for Alameda County). Plaintiffs filed the second amended complaint and we filed a motion to dismiss the complaint. |
· | North Jackson Pharmacy, Inc., et al. v. Express Scripts (Civil Action No. CV-03-B-2696-NE, United States District Court for the Northern District of Alabama). Plaintiffs have filed a motion for class certification. We have filed a response opposing the motion. |
· | People of the State of New York, et al v. Express Scripts, Inc. (Cause No. 4669-04, Supreme Court of the State of New York, County of Albany) The State of New York filed a motion with the appellate division for permission to appeal the stay issued by the trial court. This motion was denied. |
· | In re Express Scripts Securities Litigation (Cause No. 4:04-CV-1009, United States District Court for the Eastern District of Missouri ) The shareholder lawsuit, Sylvia Childress, et al v. Express Scripts, Inc., et al (Cause No. 04-CV-01191, United States District Court for the Eastern District of Missouri) Lidia Garcia, et al v. Express Scripts, Inc., et al (Cause No. 04-CV-1009, United States District Court for the Eastern District of Missouri); Robert Espriel, et al v. Express Scripts, Inc., et al (Cause No. 04-CV-01084, United States District Court for the Eastern District of Missouri); Raymond Hoffman, et al v. Express Scripts, Inc., et al (Cause No. 04-CV-01054, United States District Court for the Eastern District of Missouri); John R. Nicholas, et al v. Express Scripts, Inc., et al (Cause No. 04-CV-1295, United States District Court for the Eastern District of Missouri); John Keith Tully, et al v. Express Scripts, Inc., et al (Cause No. 04-CV-01338, United States District Court for the Eastern District of Missouri), were consolidated. Plaintiffs have filed an amended complaint. |
The investigation by the U.S. Attorney’s Office in Boston, Massachusetts into certain of our business practices, including our formulary development process and our business relationships with certain group buying entities and pharmaceutical manufacturers continues. From time to time we have received subpoenas requesting additional information. We continue to cooperate with the investigation.
The investigation by the Kansas City, Missouri office of the DOL continues. The Company has received an additional letter from the DOL requesting additional documents relating to various aspects of the Company’s business. The Company continues to cooperate with the investigation.
We believe that our services and business practices are in compliance with all applicable laws, rules and regulations in all material respects, and we will cooperate fully with the government in these investigations. We cannot predict the outcome of these matters at this time. An unfavorable outcome in one or more of these matters could result in the imposition of monetary fines or penalties, or injunctive or administrative remedies, and we can give no assurance that such fines and remedies would not have a material adverse effect on our financial condition, our consolidated results of operation or our consolidated cash flows.
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
(e) The following is a summary of our stock repurchasing activity during the three months ended September 30, 2005 (share data in thousands):
Period | Shares purchased | Average price paid per share | Shares purchased as part of a publicly announced program | Maximum shares that may yet be purchased under the program | ||||||||
7/1/2005 - 7/31/2005 | - | $ | - | - | 12,104 | |||||||
8/1/2005 - 8/31/2005 | 3,954 | 55.63 | 3,954 | 8,150 | ||||||||
9/1/2005 - 9/30/2005 | - | - | - | 8,150 | ||||||||
Third quarter 2005 total | 3,954 | $ | 55.63 | 3,954 |
We have a stock repurchase program, originally announced on October 25, 1996, under which our Board of Directors has approved the repurchase of a total of 38.0 million shares. There is no limit on the duration of the program. Approximately 29.9 million of the 38.0 million total shares have been repurchased through September 30, 2005. Additional share purchases, if any, will be made in such amounts and at such times as we deem appropriate based upon prevailing market and business conditions, subject to restrictions on the amount of stock repurchases contained in our bank credit facility.
Item 6. Exhibits
(a) See Index to Exhibits below.
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
EXPRESS SCRIPTS, INC.
(Registrant)
Date: October 26, 2005 By: /s/ George Paz
George Paz, Chief Executive Officer and
President
Date: October 26, 2005 By: /s/ Edward Stiften
Edward Stiften, Sr. Vice President and
Chief Financial Officer
INDEX TO EXHIBITS—TO BE UPDATED
(Express Scripts, Inc. - Commission File Number 0-20199)
Exhibit Number | Exhibit |
2.11 | Stock Purchase Agreement, dated December 19, 2003, by and among the Company, CPS Holdings, LLC, CuraScript Pharmacy, Inc. and CuraScript PBM Services, Inc, incorporated by reference to Exhibit No. 2.1 to the Company’s Current Report on Form 8-K filed December 24, 2003. |
2.21 | Agreement and Plan of Merger, dated July 21, 2005, by and among the Company, Pony Acquisition Corporation, and Priority Healthcare Corporation, incorporated by reference to Exhibit No. 2.1 to the Company’s Current Report on Form 8-K filed July 22, 2005. |
3.1 | Amended and Restated Certificate of Incorporation of the Company, incorporated by reference to the Company’s Annual Report on Form 10-K for the year ending December 31, 2001, incorporated by reference to Exhibit No. 3.2 to the Company’s Quarterly Report on Form 10-Q for the quarter ending June 30, 2004. |
3.2 | Certificate of Amendment to the Certificate of Incorporation of the Company dated June 2, 2004, incorporated by reference to Exhibit No. 3.3 to the Company’s Quarterly Report on Form 10-Q for the quarter ending June 30, 2004. |
3.3 | Third Amended and Restated Bylaws, incorporated by reference to Exhibit No. 3.2 to the Company’s Annual Report on Form 10-K for the year ending December 31, 2000. |
4.1 | Form of Certificate for Common Stock, incorporated by reference to Exhibit No. 4.1 to the Company’s Registration Statement on Form S-1 filed June 9, 1992 (No. 33-46974) (the “Registration Statement”). |
4.2 | Stockholder and Registration Rights Agreement dated as of October 6, 2000 between the Company and New York Life Insurance Company, incorporated by reference to Exhibit No. 4.2 to the Company's Amendment No. 1 to Registration Statement on Form S-3 filed October 17, 2000 (Registration Number 333-47572). |
4.3 | Asset Acquisition Agreement dated October 17, 2000, between NYLIFE Healthcare Management, Inc., the Company, NYLIFE LLC and New York Life Insurance Company, incorporated by reference to Exhibit No. 4.3 to the Company's amendment No. 1 to the Registration Statement on Form S-3 filed October 17, 2000 (Registration Number 333-47572). |
4.4 | Rights Agreement, dated as of July 25, 2001, between the Corporation and American Stock Transfer & Trust Company, as Rights Agent, which includes the Certificate of Designations for the Series A Junior Participating Preferred Stock as Exhibit A, the Form of Right Certificate as Exhibit B and the Summary of Rights to Purchase Preferred Shares as Exhibit C, incorporated by reference to Exhibit No. 4.1 to the Company's Current Report on Form 8-K filed July 31, 2001. |
4.5 | Amendment dated April 25, 2003 to the Stockholder and Registration Rights Agreement dated as of October 6, 2000 between the Company and New York Life Insurance Company, incorporated by reference to Exhibit No. 4.8 to the Company’s Quarterly Report on Form 10-Q for the period ending March 31, 2003. |
4.6 | Amendment No. 1 to the Rights Agreement between the Corporation and American Stock Transfer & Trust Company, as Rights Agent, dated May 25, 2005, incorporated by reference to Exhibit No. 10.1 to the Company’s Current Report on Form 8-K filed May 31, 2005. |
10.1 | Credit Agreement, dated as of October 14, 2005, among Express Scripts, Inc., Credit Suisse, as administrative agent, Citigroup Global Markets Inc., as syndication agent, Bank of Nova Scotia, Calyon New York Branch, Deutsche Bank Securities Inc., JPMorgan Chase Bank, N.A., The Royal Bank of Scotland plc, Sun Trust and Union Bank of California, as co−documentation agents and the lenders named therein, incorporated by reference to Exhibit No. 10.1 to the Company’s Current Report on Form 8-K filed October 14, 2005. |
31.12 | Certification by George Paz, as President and Chief Executive Officer of Express Scripts, Inc., pursuant to Exchange Act Rule 13a-14(a). |
31.22 | Certification by Edward Stiften, as Senior Vice President and Chief Financial Officer of Express Scripts, Inc., pursuant to Exchange Act Rule 13a-14(a). |
32.12 | Certification by George Paz, as President and Chief Executive Officer of Express Scripts, Inc., pursuant to 18 U.S.C. § 1350 and Exchange Act Rule 13a-14(b). |
32.22 | Certification by Edward Stiften, as Senior Vice President and Chief Financial Officer of Express Scripts, Inc., pursuant to 18 U.S.C. § 1350 and Exchange Act Rule 13a-14(b). |
1 | The Company agrees to furnish supplementally a copy of any omitted schedule to this agreement to the Commission upon request. |
2 | Filed herein. |