EXPRESS SCRIPTS, INC.

INDEX

PART I.    FINANCIAL INFORMATION

Item 1.     Financial Statements

EXPRESS SCRIPTS, INC.
Unaudited Consolidated Balance Sheet

See accompanying Notes to Unaudited Consolidated Financial Statements

EXPRESS SCRIPTS, INC.
Unaudited Consolidated Statement of Operations

      See accompanying Notes to Unaudited Consolidated Financial Statements

EXPRESS SCRIPTS, INC.
Unaudited Consolidated Statement of Changes in Stockholders' Equity

      See accompanying Notes to Unaudited Consolidated Financial Statements

EXPRESS SCRIPTS, INC.
Unaudited Consolidated Statement of Cash Flows

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, 2002 filed with the Securities and Exchange Commission on April 1, 2003. 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, 2002.

        We believe the accompanying unaudited consolidated financial statements reflect all adjustments (consisting of only normal recurring adjustments) necessary to present fairly the Unaudited Consolidated Balance Sheet at June 30, 2003, the Unaudited Consolidated Statements of Operations for the three months and six months ended June 30, 2003 and 2002, the Unaudited Consolidated Statement of Changes in Stockholders’ Equity for the six months ended June 30, 2003, and the Unaudited Consolidated Statements of Cash Flows for the six months ended June 30, 2003 and 2002. Operating results for the three months and six months ended June 30, 2003 are not necessarily indicative of the results that may be expected for the year ended December 31, 2003.

REVENUE RECOGNITION

        Revenues from our pharmacy benefit management (“PBM”) segment are earned by dispensing prescriptions from our mail pharmacies, processing claims for prescriptions filled by retail pharmacies in our nationwide networks, and by providing services to drug manufacturers, including administration of discount programs.

        Revenues from dispensing prescriptions from our mail 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 nationwide 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 charged to clients in revenue and the corresponding ingredient cost paid to network pharmacies in cost of revenues. In retail pharmacy transactions, amounts paid to pharmacies and amounts charged to clients are always exclusive of the applicable member co-payment. Under our pharmacy agreements, the pharmacy is solely obligated to collect the co-payment from the member. Under our client contracts, we do not assume liability for the member co-payment in retail pharmacy transactions. As such, we do not include member co-payments to retail pharmacies in revenue or cost of revenue.

        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.

        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. Minor adjustments are made to these estimated revenues to reflect actual billings at the time clients are billed.

        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 cancellation, 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 are derived from specialty distribution services, sample fulfillment and sample accountability services. Revenues earned by our specialty distribution subsidiary (“SDS”) include administrative fees received from pharmaceutical manufacturers for dispensing or distributing consigned pharmaceuticals requiring special handling or packaging. We also administer sample card programs for certain manufacturers and include the ingredient costs of those drug samples dispensed from retail pharmacies in our SDS 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.

        Our Phoenix Marketing Group subsidiary (“PMG”) records an administrative fee for verifying practitioner licensure and then distributing consigned drug samples to doctors based on orders received from pharmaceutical sales representatives.

REBATE RECOGNITION

        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 mail pharmacy 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 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 because the manufacturer billing amounts and the client portion are determinable when the drug is dispensed. We pay all or a contractually agreed upon portion of such rebates to our 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.

RECEIVABLES

        Based on our revenue recognition policies previously discussed, 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 the pharmacies and historical gross margin. Estimates are adjusted to actual at the time of billing. See also the discusion above regarding rebates receivable from pharmaceutical manufacturers. Historically, adjustments to our estimates have been immaterial.

INVENTORIES

        Inventories consist of prescription drugs and medical supplies stated at the lower of first-in first-out cost or market.

PROPERTY AND EQUIPMENT

        Property and equipment is carried at cost and is depreciated using the straight-line method over estimated useful lives of seven years for furniture, five years for equipment and purchased computer software and three years for certain computer equipment exceeding minimum capitalization levels. Leasehold improvements are amortized on a straight-line basis over the term of the lease or the useful life of the asset, if shorter. Expenditures for repairs, maintenance and renewals are charged to income as incurred. Expenditures that improve an asset or extend its estimated useful life are capitalized. When properties are retired or otherwise disposed of, the related cost and accumulated depreciation are removed from the accounts and any gain or loss is included in income. Research and development expenditures relating to the development of software are charged to expense until technological feasibility is established. Thereafter, the remaining software production costs, up to the date placed into production, are capitalized and included as Property and Equipment. Amortization of the capitalized amounts commences on the date placed into production, and is computed on a product-by-product basis using the straight-line method over the remaining estimated economic life of the product but not more than five years. We regularly review the useful lives of assets and adjust the remaining lives based on the deployment of new technologies. Reductions, if any, in the carrying value of capitalized software costs to net realizable value are expensed.

OTHER INTANGIBLE ASSETS

        Other intangible assets include, but are not limited to, customer contracts, non-compete agreements, deferred financing fees, trade names and certain advance discounts paid to clients under contractual agreements. Other intangible assets, excluding trade names, which have an indefinite life, are amortized on a straight-line basis over periods from 2 to 20 years.

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 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 reflecting the inherent risk of the underlying business. No such impairment existed as of June 30, 2003 and December 31, 2002. Absent events or circumstances indicating an impairment of goodwill, we perform an annual goodwill impairment test during the fourth quarter.

EMPLOYEE STOCK-BASED COMPENSATION

        We account for employee stock options in accordance with Financial Accounting Standards Board Statement No. (“FAS”) 123, “Accounting for Stock-Based Compensation,” as amended by FAS 148, and Accounting Principles Board No. (“APB”) 25, “Accounting for Stock Issued to Employees.” 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 elected to continue applying the intrinsic value method under APB 25. Because we grant options at a price equal to market value at the time of grant, we have not recognized compensation expense for options granted. 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 months and six months ended June 30, 2003 and 2002 (see also Note 10):

⁽¹⁾     Net income, as reported, includes stock-based compensation expense for the three months ended June 30, 2003 and 2002 of $1,177 ($1,904 pre-tax) and $1,121 ($1,829 pre-tax), respectively, and for the six months ended June 30, 2003 and 2002 of $1,710 ($2,765 pre-tax) and $2,570 ($4,155 pre-tax), respectively, related to restricted shares of Common Stock awarded to certain of our officers and employees.

NEW ACCOUNTING GUIDANCE

        In January 2003, we adopted FAS 143, “Asset Retirement Obligations.” FAS 143 addresses financial accounting and reporting for obligations associated with the retirement of tangible long-lived assets and the associated asset retirement costs. FAS 143 requires the capitalization of the fair value of any legal or contractual obligations associated with the retirement of tangible, long-lived assets in the period in which the liabilities are incurred and the capitalization of a corresponding amount as part of the book value of the related long-lived asset. In subsequent periods, we are required to adjust asset retirement obligations based on changes in estimated fair value, and the corresponding increases in asset book values will be depreciated over the useful life of the related asset. As required by FAS 143, we recorded an asset retirement obligation ($3,071,000 at January 1, 2003) primarily related to equipment and leasehold improvements installed in leased mail-order facilities in which we have a contractual obligation to remove the improvements and equipment upon surrender of the property to the landlord. For certain of our leased facilities, we are required to remove equipment and convert the facilities back to office space. We also recorded a net increase in fixed assets (net of accumulated depreciation) of $1,408,000 and a $1,663,000 ($1,028,000, net of taxes) loss from the cumulative effect of change in accounting principle. The $1,408,000 asset will be depreciated, on a straight-line basis, over the remaining term of the leases, which range from seven months to ten years.

        In April 2002, FAS 145, “Rescission of FASB Statements No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical Corrections,” was issued. In rescinding FAS 4, “Reporting Gains and Losses from Extinguishment of Debt,” and FAS 64 “Extinguishments of Debt Made to Satisfy Sinking-Fund Requirements,” FAS 145 eliminates the required classification of gains and losses from extinguishment of debt as extraordinary. We adopted this provision of FAS 145 in January 2003. During the first six months of 2003, we repurchased $35,430,000 of our outstanding Senior Notes and prepaid $75,000,000 of our Term B notes. As a result, we wrote-off deferred financing fees of $1,270,000 and incurred a charge of $3,897,000 representing a premium on the purchase of the Senior Notes in the first half of 2003. The write-off of deferred financing fees and the premium on the repurchase of the Senior notes have been recorded as increases in interest expense. Implementation of FAS 145 did not have an impact on our consolidated financial position, consolidated results of operations or our consolidated cash flows.

        In July 2002, FAS 146, “Accounting for Costs Associated with Exit or Disposal Activities,” which deals with issues on the accounting for costs associated with a disposal activity, was issued. FAS 146 nullifies the guidance in EITF 94-3, “Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring)” by prohibiting liability recognition based on a commitment to an exit/disposal plan. Under FAS 146, exit/disposal costs will be expensed as incurred. We adopted the provisions of FAS 146 effective January 2003. Adoption has not had an impact on our consolidated financial position, consolidated results of operations or our consolidated cash flows.

        In September 2002, EITF 02-16, “Accounting by a Reseller for Cash Consideration Received from a Vendor” was issued. Under this pronouncement, any consideration received from a vendor is presumed to be a reduction of the prices of the vendor’s products and should, therefore, be characterized as a reduction of cost of sales. EITF 02-16 applies to rebates and to administrative fees received from pharmaceutical manufacturers for collecting, processing and reporting drug utilization data, for monitoring formulary compliance and for calculating and distributing rebates to those of our clients for whom our PBM services includes the claim processing function. Prior to our adoption of EITF 02-16, we recorded rebates, net of the amount paid to our clients, and manufacturer administrative fees as components of revenue. The transition provisions of EITF 02-16 require implementation of this pronouncement for new arrangements, including modifications of existing arrangements, entered into after December 31, 2002. Early application is permitted as of the beginning of periods for which financial statements have not been issued and prior period reclassification is allowed to the extent there is no impact on net income. The application of the provisions of EITF 02-16 does not change our consolidated net income, consolidated gross profit, consolidated financial position or our consolidated cash flows. Therefore, we adopted the provisions of EITF 02-16 during fiscal 2002, earlier than required. As a result of the adoption, our revenues for the three months and six months ended June 30, 2002 have been reduced by $235,113,000, and $433,161,000, respectively, to conform to the presentation for the three months and six months ended June 30, 2003. This amount represents the gross rebates and administrative fees received from manufacturers. Cost of revenues, for the three months and six months ended June 30, 2002, has been reduced by the same amount. Our clients’ portion of such rebates and administrative fees, a majority of this amount, has been and will continue to be recorded as a reduction of revenue. Consolidated net income and consolidated gross profit for the three months and six months ended June 30, 2002 was not impacted as a result of the adoption of EITF 02-16.

Note 2 – Changes in business

        On December 19, 2002, we entered into an agreement with Managed Pharmacy Benefits, Inc. (“MPB”) under which we acquired certain assets from MPB for approximately $11,063,000 in cash, plus the assumption of certain liabilities, and entered into an outsourcing arrangement with respect to MPB’s operations. MPB is a St. Louis-based PBM and subsidiary of Medicine Shoppe International, Inc., a franchisor of apothecary-style retail pharmacies, owned by Cardinal Health, Inc. The transaction was accounted for under the provisions of FAS 141, “Business Combinations.” The purchase price has been preliminarily allocated based upon the estimated fair value of net assets acquired at the date of the acquisition. A portion of the excess of the purchase price over tangible net assets acquired has been preliminarily allocated to customer contracts in the amount of $2,526,000. This asset is included in other intangible assets on the balance sheet and is being amortized using the straight-line method over the estimated useful life of 20 years. In addition, the excess of the purchase price over tangible net assets and identified intangible assets acquired has been preliminarily allocated to goodwill in the amount of $15,105,000, which is not being amortized. The transaction was structured as a purchase of assets, making amortization expense of intangible assets, including goodwill, tax deductible.

        On April 12, 2002, we completed the acquisition of National Prescription Administrators and certain affiliated entities (collectively “NPA”), a privately held full-service PBM, for a purchase price of approximately $466 million, which includes the issuance of 552,000 shares of our common stock (fair value of $26.4 million upon the transaction announcement date), transaction costs and a working capital purchase price adjustment of $46.8 million received during the third and fourth quarters of 2002. The transaction was accounted for under the provisions of FAS 141. 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 the purchase price over tangible net assets acquired has been allocated to intangible assets consisting of customer contracts in the amount of $76,290,000 and non-competition agreements in the amount of $2,860,000, which are being amortized using the straight-line method over the estimated useful lives of 20 years and five years, respectively. These assets are classified as other intangible assets. In addition, the excess of the purchase price over tangible net assets and identified intangible assets acquired has been allocated to goodwill in the amount of $438,525,000 which is not being amortized. During the second quarter of 2003 we finalized the allocation of the purchase price to tangible and intangible net assets resulting in a $39.7 million increase in goodwill. The increase in goodwill reflects adjustments to true-up opening balance sheet receivables, liabilities, and to adjust fixed assets to fair market value. The acquisition of NPA was funded with the proceeds of a new $325 million Term B loan facility, $78 million of cash on hand, the issuance of 552,000 shares of our common stock (fair value of $26.4 million upon the transaction announcement date), and $25 million in borrowings under our revolving credit facility. We have filed an Internal Revenue Code Section 338(h)(10) election, making amortization expense of intangible assets, including goodwill, tax deductible. We estimate this election will provide a tax benefit to us of approximately $85 million on a present value basis.

        On February 25, 2002, we purchased substantially all of the assets utilized in the operation of Phoenix Marketing Group (Holdings), Inc.(“Phoenix”), a wholly-owned subsidiary of Access Worldwide Communications, Inc., for $34.1 million in cash, including acquisition-related costs, plus the assumption of certain liabilities. The acquisition has been accounted for under the provisions of FAS 141. The purchase price has been allocated based upon the estimated fair value of net assets acquired at the date of the acquisition. The excess of purchase price over tangible net assets acquired has been allocated to intangible assets, consisting of customer contracts in the amount of $4,000,000 and non-competition agreements in the amount of $180,000, which are being amortized using the straight-line method over the estimated lives of eight years and four years, respectively, and a trade name in the amount of $1,700,000, which is 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 was allocated to goodwill in the amount of $22,136,000, which is not being amortized. The transaction was structured as a purchase of assets, making amortization expense of intangible assets, including goodwill, tax deductible.

        The following unaudited pro forma information presents a summary of our combined results of operations and those of NPA and PMG as if the acquisitions had occurred at the beginning of the period presented, along with certain pro forma adjustments to give effect to amortization of other intangible assets, interest expense on acquisition debt and other adjustments. The following pro forma financial information is not necessarily indicative of the results of operations as they would have been had the transaction been effected on the assumed date, nor is it an indication of trends in future results (in thousands, except per share data):

Note 3 – Receivables

        Included in receivables, net, as of June 30, 2003 and December 31, 2002, is an allowance for doubtful accounts of $37,778,000 and $35,822,000, respectively.

        As of June 30, 2003 and December 31, 2002, unbilled receivables were $524,438,000 and $547,686,000, 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.

Note 4 – Property and Equipment

        During 2002, the estimated useful lives of certain computer equipment and software associated with our legacy computer systems were shortened due to the continued progress of our integration to one point-of-sale claim adjudication platform. This change in the estimated useful lives increased depreciation and amortization expense by $23,310,000 during the first six months of 2002, of which, $18,360,000 was included in selling, general and administrative expenses.

Note 5 – Goodwill and other intangibles

        We adopted FAS 142, “Goodwill and Other Intangible Assets” effective January 1, 2002. FAS 142 requires that goodwill no longer be amortized. Instead, all goodwill (including goodwill associated with acquisitions consummated prior to the adoption of FAS 142) is to be evaluated for impairment annually or when events or circumstances occur indicating goodwill might be impaired. In accordance with the implementation provisions of FAS 142, we completed our transitional impairment test during the second quarter of 2002, and our first annual impairment test during the fourth quarter of 2002, neither of which indicated any impairment.

        The following is a summary of our goodwill and other intangible assets (amounts in thousands).

⁽¹⁾     During the second quarter of 2003, we finalized the allocation of the NPA purchase price to tangible and intangible net assets resulting in a $39.7 million increase in goodwill (See Note 2). Changes in goodwill and accumulated amortization from December 31, 2002 to June 30, 2003 are also a result of changes in foreign currency exchange rates.
⁽²⁾     Gross carrying amount and accumulated amortization at June 30, 2003 and December 31, 2002 excludes cumulative deferred financing fee, pre-tax write-offs of $16,959,000 and $15,689,000, respectively. Deferred financing fees are amortized over the term of the related debt and are written off in conjunction with debt prepayments.

        The aggregate amount of amortization expense of other intangible assets was $6,939,000 and $5,348,000 for the three months ended June 30, 2003 and 2002, respectively, and $13,172,000 and $9,043,000 for the six months ended June 30, 2003 and 2002, respectively. The future aggregate amount of amortization expense of other intangible assets is $11,979,000 for 2003, $23,883,000 for 2004, $22,903,000 for 2005, $17,388,000 for 2006, and $14,723,000 for 2007. 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 6 – Earnings per share

        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):

The above shares are all calculated under the “treasury stock” method in accordance with FAS 128, “Earnings Per Share.”

Note 7 – Financing

        During the second quarter of 2003 we repurchased $35,430,000 of our Senior Notes on the open market for $40,691,000, which includes $1,364,000 of accrued interest and a premium of $3,897,000 which was recorded in interest expense. During the first half of 2003, we prepaid $75,000,000 of our Term B loan facility. At June 30, 2003, the Term B loans have a remaining maturity of five years with $19,250,000 maturing in 2007 and $230,750,000 maturing in 2008. As a result of the repurchase of Senior Notes and the prepayment on the Term B loans in 2003, we recorded in interest expense, pre-tax charges of $1,270,000 in the first half of 2003 from the write-off of deferred financing fees.

Note 8 – Derivative financial instruments

        We use interest rate swap agreements to manage our interest rate risk on future variable interest payments. At June 30, 2003, we have two swap agreements to fix the variable interest rate payments on approximately $110 million of our debt under our credit facility. Under one of our swap agreements, we agree to receive a variable rate of interest on the notional principal amount of approximately $60 million based upon a three month LIBOR rate in exchange for payment of a fixed rate of 6.25% per annum. The notional principal amount will decrease to $20 million in April 2004 and matures in April 2005. Under our second swap agreement, which matures in September 2003, we agree to receive a variable rate of interest on the notional principal amount of $50 million based upon a three month LIBOR rate in exchange for payment of a fixed rate of 1.66% per annum.

        Our present interest rate swap agreements are cash flow hedges which require us to pay fixed rates of interest, and which hedge against changes in the amount of future cash flows associated with variable interest obligations. Accordingly, the fair value of our swap agreements, $4,130,000, pre-tax, at June 30, 2003, is reported on the balance sheet in other liabilities. The related deferred loss on our swap agreements, $2,571,000, net of taxes, at June 30, 2003, is deferred in shareholders’ equity as a component of other comprehensive income. This deferred loss is then recognized as an adjustment to interest expense over the same period in which the related interest payments being hedged are recorded in income. The loss associated with the ineffective portion of this agreement is immediately recognized in income. For the three months and six months ended June 30, 2003 and 2002, the gains and losses on the ineffective portion of our swap agreement were not material to the consolidated financial statements.

Note 9 – 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 June 30, 2003 and 2002 would have been $56,783,000, or $0.71 per diluted share and $46,336,000 or $0.58 per diluted shares, respectively and our net income and earnings per share for the six months ended June 30, 2003 and 2002 would have been $112,301,000 or $1.41 per diluted share and $87,375,000 or $1.09 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:

         A summary of the status of our fixed stock option plans as of June 30, 2003 and 2002, and changes during the periods ending on those dates are presented below.

        The following table summarizes information about fixed stock options outstanding at June 30, 2003:

Note 10 – Condensed consolidating financial statements

        Our Senior Notes are unconditionally and jointly and severally guaranteed by our wholly-owned domestic subsidiaries other than Great Plains Reinsurance Co., ValueRx of Michigan, Inc., Diversified NY IPA, Inc., and Diversified Pharmaceutical Services (Puerto Rico), Inc. The following condensed consolidating financial information has been prepared in accordance with the requirements for presentation of such information. We believe this information, presented in lieu of complete financial statements for each of the guarantor subsidiaries, provides sufficient detail to allow investors to determine the nature of the assets held by, and the operations of, each of the consolidating groups. During 2002, PMG was established to acquire the assets of Phoenix. Subsequent to the acquisition on February 25, 2002, the assets, liabilities and operations of PMG have been included in those of the guarantors. In addition, subsequent to the acquisition of NPA on April 12, 2002, the assets, liabilities and operations of NPA have been included in those of the guarantors.