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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-K

[X]		Annual Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 for the fiscal year ended March 31, 2002

or

Commission File Number: 0-21447

AdvancePCS
(Exact name of registrant as specified in its charter)

750 West John Carpenter Freeway, Suite 1200, Irving, TX 75039
(formerly 5215 North O’Connor, Suite 1600, Irving, TX 75039)
(Address of principal executive offices)

Securities registered pursuant to Section 12(b) of the Act:

Securities registered pursuant to Section 12(g) of the Act:

Class A common stock, $0.01 par value
(Title of Class)

     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  No 

     Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.

     The aggregate market value of the voting stock held by non-affiliates of the registrant, based upon the closing sale price of the Class A common stock on May 31, 2002 as reported on the Nasdaq National Market, was approximately $1,839,810,924.

     As of May 31, 2002, registrant had (1) 80,404,488 shares of Class A common stock, $.01 par value, outstanding, (2) 12,913,334 shares of Class B-1 common stock, $.01 par value, outstanding and (3) 200 shares of Class B-2 common stock, $.01 par value, outstanding.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the Proxy Statement for registrant’s 2002 annual meeting of stockholders are incorporated by reference in Part III.

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AdvancePCS

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SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS

     This Form 10-K includes forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. We have based these forward-looking statements on our current expectations and projections about future events. Statements that are predictive in nature, that depend upon or refer to future events or conditions or that include words such as “expects,” “anticipates,” “intends,” “plans,” “believes,” “estimates,” “thinks,” and similar expressions are forward-looking statements. These statements involve known and unknown risks, uncertainties and other factors that may cause our actual results and performance to be materially different from any future results or performance expressed or implied by these forward-looking statements. These factors include, among other things, those matters discussed under the caption “Risk Factors,” as well as the following:

•		general economic and business conditions;
•		new governmental regulations and changes in, or the failure to comply with existing governmental regulations;
•		legislative proposals that impact our industry or the way we do business;
•		changes in our industry;
•		competition;
•		demographic changes;
•		changes in Medicare and Medicaid payment levels;
•		liability and other claims asserted against us;
•		changes in our relations with our clients; and
•		our ability to attract and retain qualified personnel.

     Although we believe that these statements are based upon reasonable assumptions, we can give no assurance that our goals will be achieved. Given these uncertainties, prospective investors are cautioned not to place undue reliance on these forward-looking statements. These forward-looking statements speak only as of the date made. Except as required by law, we are under no duty to update any of the forward-looking statements after the date of this report to conform such statements to actual results.

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PART I

Item 1. BUSINESS

     The following description of our business should be read in conjunction with the information included elsewhere in this Form 10-K for the year ended March 31, 2002. This description contains forward-looking statements that involve risks and uncertainties. Our actual results could differ significantly from the results discussed in the forward-looking statements due to the factors set forth in “Risk Factors” and elsewhere in this Form 10-K. References in this Form 10-K to “we,” “our,” or “us” refer to AdvancePCS.

Overview

     We are a leading provider of health improvement services in the United States. As the largest pharmacy benefit management company, or PBM, based on number of lives covered, we currently serve more than 75 million health plan members and manage approximately $28 billion in prescription drug spending on an annualized basis on behalf of our health plan sponsors. In addition, we offer a wide range of other health improvement products and services, such as prescription discount cards for the uninsured and under-insured, web-based programs, disease management, clinical trials and outcomes studies. Our mission is to improve the quality of care delivered to health plan members while helping health plan sponsors reduce overall costs.

     We generate revenues by providing our health improvement services to two primary customer groups: health plan sponsors and pharmaceutical manufacturers. We serve a broad range of health plan sponsors, including BlueCross BlueShield plans and other managed care organizations, employer groups, third-party administrators of health plans, insurance companies, government agencies and labor union-based trusts. We work closely with pharmaceutical manufacturers to negotiate lower drug costs for our health plan sponsors. We also provide pharmaceutical manufacturers with clinical trial, research and information management services.

Industry Background

     Prescription drug costs in the United States is the fastest growing component of health care costs. The U.S. Centers for Medicare & Medicaid (CMS) estimates that prescription drugs accounted for approximately 9.5% of U.S. health care expenditures in 2001, representing approximately a 16.1% increase in expenditures over those in 2000. CMS projects that the cost of prescription drugs will rise between 10% and 15% per year through 2010. We believe factors contributing to this trend include:

	•		higher drug utilization due to the growing use of pharmaceuticals as a first line of attack in disease treatment;
	•		increasing availability of pharmacy benefits to health plan members;
	•		an aging population;
	•		increasing direct-to-consumer advertising by pharmaceutical manufacturers;
	•		an expected increase in new drug introductions, primarily due to increases in research and development spending by pharmaceutical companies, as well as more rapid drug approval by the U.S. Food and Drug Administration or FDA; and
	•		high costs for newly-developed, more effective drug therapies and an increasing pipeline of biotechnology pharmaceuticals.

     PBMs were first formed during the 1970s to provide health plan sponsors with a more efficient and less costly means of managing their members’ prescription drug benefit, particularly the processing of pharmaceutical claims. In recent years, managed care has evolved from a short-term, cost-driven model to a long-term, medical outcomes-based model, where the overall cost and quality of patient care are both key considerations of the health plan sponsor. While PBMs continue to process hundreds of millions of pharmaceutical claims per year, PBMs have also developed additional services, including mail order pharmacy fulfillment in the 1980s and point-of-sale claims processing, formulary development and other clinical services in the 1990s. By designing and implementing effective pharmacy benefit plans and formularies, PBMs gained the ability to influence the choice of pharmaceuticals used by a health plan’s members. PBMs use their formulary influence and increased purchasing power to negotiate both rebates from pharmaceutical manufacturers and discounts from retail pharmacies in order to generate savings for health plan sponsors.

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     Over the past few years, the PBM industry has undergone significant consolidation. We believe such consolidation has principally been driven by the significant benefits of size and scale, including:

	•		cost-saving opportunities to leverage a fixed-cost infrastructure over greater prescription claim volume, resulting in greater pricing flexibility; and
	•		increased negotiating leverage with pharmaceutical manufacturers and retail pharmacies, resulting in greater ability to obtain lower drug costs for health plan sponsors.

     We believe PBMs that effectively capture these benefits will be better positioned to strengthen their relationships with plan members, physicians and health plan sponsors and improve their competitive position.

     Medicare, the primary health insurer for more than 37 million Americans over the age of 65, does not currently offer an outpatient prescription drug benefit. Several legislative proposals are under consideration in Congress to provide Medicare recipients with outpatient drug benefits. The terms of the current proposals vary and there can be no assurance of actual implementation of such a benefit. Depending on the approval and final design of a Medicare drug benefit, PBMs could play a significant role in its administration.

Our Competitive Advantages

We are the largest PBM in the industry

     As the largest PBM based on number of lives covered, we currently serve more than 75 million members enrolled with our health plan sponsors. We operate through a network of approximately 60,000 retail pharmacies and, on an annualized basis, we estimate that we manage more than 550 million pharmacy claims representing approximately $28 billion in prescription drug spending. Our large member base gives us significant leverage when negotiating rebates and discounts from pharmaceutical companies and retail pharmacies. In addition, we believe that our mail service pharmacies are of sufficient scale and capacity to effectively compete on large contracts. As the industry leader based on number of lives covered, we intend to position ourselves as the first choice of health plan sponsors who need a PBM with scale and scope to help effectively manage their growing prescription drug costs.

We maintain an independent status

     We benefit from our independent status, as we are not controlled by a pharmaceutical manufacturer, retail pharmacy or health plan sponsor. We believe this independence is valued by health plan sponsors for the inherent choice and impartiality we are able to provide.

We offer a wide range of health improvement products and services

     We believe we have one of the widest ranges of health improvement products and services in the industry. We provide a broad range of PBM products and services complemented by consumer and information products and technology solutions. Our PBM products and services include data, clinical and mail order services. Our data service operations process prescription claims through our retail pharmacy network. Our clinical services perform formulary design and compliance services as well as provide proprietary decision support tools. Our mail pharmacy services provide our members with the convenience of having prescriptions delivered through the mail.

     We also offer consumer cards for uninsured and under-insured consumers, as well as web-based products and services such as online pharmacy services and web site development services for health plan sponsors. In addition, we offer a wide range of other health improvement products and services that utilize our data management and predictive modeling capabilities, such as disease management, clinical trials and outcome studies.

We have a diverse client base with substantial penetration across all key client segments

     Historically, we have had strong client relationships with BlueCross BlueShield companies and other managed care organizations which together represent approximately half of our prescription claims volume. We have also focused on and developed expertise in serving self-insured employers, insurance carriers and government plans. We currently have a diverse client base and substantial market penetration among each of these major target client groups.

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We have a focused and experienced management team with an established track record in growing our business and integrating acquisitions

     Our management team, including our founder and chief executive officer, David D. Halbert, has consistently delivered strong operating and financial results through internal growth and the acquisition and successful integration of several companies. During the last eight fiscal years, we have grown significantly, with total revenues increasing from approximately $64.4 million in fiscal year 1995 to approximately $13.1 billion in fiscal year 2002 and EBITDA increasing from approximately $1.8 million in fiscal year 1995 to approximately $300.4 million in fiscal year 2002.

     We now have approximately 6,000 employees and contractors and an experienced senior management team. On October 2, 2000, we acquired PCS Holding Corporation (PCS), a pharmacy benefit management company that was wholly-owned by Rite Aid Corporation. We have successfully completed most of the steps in integrating PCS that are necessary for us to operate as a single, combined company. In addition, we have successfully integrated the following seven acquisitions in the past four years:

	•		Innovative Medical Research, Inc., which conducts clinical trials and survey research for the pharmaceutical and managed care industries, in 1998;
	•		Baumel-Eisner Neuromedical Institute, Inc., which conducts neurological and psychiatric clinical trials of investigational new drugs on behalf of the pharmaceutical industry, in 1998;
	•		Foundation Health Pharmaceutical Services, the pharmacy benefit operations of Foundation Health Systems, Inc., now known as Health Net, in 1999;
	•		First Florida International (FFI), which provides PBM services as well as unique direct-to-consumer capabilities, in 2000;
	•		Dresing-Lierman, Inc. and its wholly owned subsidiary, TheraCom Inc. (TheraCom), which provides specialty pharmacy services in the biotechnology arena, in 2001;
	•		Consumer Health Interactive, Inc. (CHI), an internet health portal development company, in 2001; and
	•		iScribe software code and other assets relating to physician connectivity, in 2001.

Strategy

     Our mission is to improve the quality of care delivered to health plan members while helping health plan sponsors reduce overall costs. In order to accomplish this mission, we plan to:

Increase sales penetration to existing customers

     One of our primary growth strategies is to increase sales penetration of our health improvement services within our existing customer base. We offer a broad array of disease management, clinical and research products, developed internally for specific client segment needs and through acquisitions. We are cross-selling into our different customer bases the full suite of programs. For example, the customers in the employer group segment, are increasingly interested in our disease management programs that we originally developed for health plans. Similarly, certain clinical programs and services that we have acquired are being introduced across our customer base.

Increase specialty pharmacy services

     We also plan to increase sales of specialty pharmacy services, our newest product offering, to our existing customers. In June 2001, we launched AdvancePCS SpecialtyRx to improve the management of patients using injectable and other high technology drugs, through a joint venture with Priority Healthcare; and in August 2001, we acquired TheraCom to provide customized services around complex emerging biotechnology therapies and the significant patient management needs associated with those therapies. We are able to offer our clients a fully integrated pharmaceutical care management program designed to encourage appropriate drug utilization, competitive pricing and comprehensive integrated reporting for better cost management, and PBM based electronic claims processing for greater administrative ease. As of May 31, 2002, we have successfully sold specialty pharmacy services to clients representing approximately 10 million lives and already have begun providing services for clients representing 8 million of those lives. In addition, we intend to continue to market TheraCom service offerings as part of the AdvancePCS specialty pharmacy services.

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Increase our mail service penetration

     We believe that our mail services reduce costs to health plan sponsors through volume purchasing, generic dispensing and higher rebates through greater formulary compliance. Historically, we have not promoted our mail pharmacies aggressively, as we did not have the scale to operate mail pharmacy services efficiently. However, with our scale and recent growth in mail service, we see a significant opportunity to profitably expand penetration of our mail order business, which provides lower costs for our health plan sponsors and convenience of home delivery to their members.

     We plan to increase the percentage of the prescriptions filled by our mail pharmacies by aggressively promoting our mail services to the members of our health plan sponsors. We estimate that we manage more than 550 million pharmacy claims on an annualized basis and of these less than 10% of the prescriptions for these claims are filled by our mail pharmacies. We believe that our primary competitors are filling a significantly greater proportion of their members’ prescriptions through mail service.

Increase our core health plan sponsor customer base

     The number of members served by our programs has increased from an estimated 5.2 million at March 31, 1995 to more than 75 million at March 31, 2002. We plan to continue to grow our customer base by marketing our scale and comprehensive service offerings to a broader range of health plan sponsors. We believe that our increased size and ability to negotiate higher rebates and discounts make us more attractive to our clients. Since the announcement of the PCS transaction, we have entered into multi-year contracts with new clients representing over 10 million lives. In addition, we have successfully renewed all major customer contracts that have been bid since the PCS transaction.

Further develop web-based capabilities and pursue new technology initiatives

     Our health plan sponsors are increasingly interested in the convenience of technology-enabled, pharmacy-related products and services for their members. We provide our clients with comprehensive web-based solutions, which include web-enabled PBM functions, such as online refills and online prescription drug history, web-based content and web site development services for health plan sponsors. We plan to expand our current web-based product offerings, which would include developing new initiatives to offer broader medical content to health plan sponsors and to empower consumers by involving them more directly in their medical care. We are also currently working with health plan sponsors to develop web-enabled pharmacy services on their respective web sites for members. For example, we offer health plan sponsors online access to plan performance and other management reports and industry trend information as well as the capability to exchange eligibility data online.

     In response to client demand for their own e-health solutions, we provide web development services for health plan sponsors and an e-health portal. We develop e-health web portals for our clients by either co-branding our own e-health portal or creating a completely customized private-label web site on their behalf. We developed our own e-health portal, BuildingBetterHealth.com, which provides consumers a comprehensive source of health, wellness and medical information, including access to medical and drug encyclopedias, an extensive medical library, medication guides, diet and nutritional resources, information about diseases, pregnancy, child and elder care, current news articles about health care developments and related content.

     In addition, we intend to continue to explore and implement new technologies to enable us to more effectively deliver our products and services. For example, we are currently participating in pilot programs that support the development of emerging technology solutions using handheld devices that provide enhanced point-of-care prescribing capabilities to physicians. These devices provide timely information, such as patient histories, formulary checks and drug utilization reviews to physicians at the point-of-care to allow for electronic transmittal of prescriptions. During fiscal year 2002, we acquired the assets of iScribe to enhance our physician connectivity capabilities. Further, we are a founding partner in a venture, RxHub, that will develop an electronic exchange to enable physicians who use electronic prescribing technology to link to pharmacies, PBMs and health plan sponsors that their patients use. As a result, we expect improved formulary compliance, better outcomes and lower costs for us and our health plan sponsors in the future.

Continue to gain efficiencies from our acquisition of PCS

     Through the acquisition of PCS, we have created significant cost saving opportunities and increased negotiating leverage with pharmaceutical manufacturers and retail pharmacies. We expect to continue to realize synergies from the integration of PCS. The integration has already involved the renegotiations of existing contracts with pharmaceutical manufacturers and retail pharmacy chains and the consolidation of some operations to maximize the efficiency of our combined infrastructure. Future synergy opportunities exist in streamlining operations and developing additional efficiencies through our scale.

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Pursue strategic acquisitions and alliances

     We plan to continue our strategy of selectively pursuing acquisitions and alliances that are consistent with our corporate mission. In particular, we seek opportunities to:

	•		increase the size of our core PBM business;
	•		expand our product offerings for health plan sponsors and pharmaceutical manufacturers; and
	•		enhance our current health improvement programs.

Recent Acquisitions and Joint Ventures

     In December 2001, we purchased software code and other assets of iScribe to expand our capabilities and expertise in the area of physician connectivity. We believe that this acquisition supplements our efforts to develop mobile electronic applications that deliver pharmacy benefit and prescribing information to physicians and other healthcare team members at the point of care. iScribe’s technology will enhance our communications with physicians through wireless and online technology. As we develop this technology, we plan to provide physicians hand-held and online access to formulary guidelines, patient drug histories, drug interaction information and alternate therapy choices. By providing physicians this information before a prescription is written, patient care and service can be improved and we can reduce the costs for health plans and lower copays for patients. Ultimately, we believe this technology will allow physicians to transmit prescriptions to the patient’s pharmacy through RxHub, our electronic exchange joint venture.

     In August 2001, we acquired TheraCom, a specialty pharmacy provider based in Bethesda, Maryland. TheraCom is a focused specialty pharmacy company that provides customized services relating to complex and emerging biotechnology therapies and the significant patient management needs associated with those therapies. TheraCom has substantial experience providing distribution and related services to the biotechnology industry, including product coverage advocacy, insurance verification, reimbursement processing, pharmacist counseling and intervention, clinical and dosage monitoring, adherence counseling, nurse training and in-home nursing coordination. TheraCom also provides Internet, direct marketing, advertising and product launch support services. TheraCom is a licensed pharmacy offering nationwide dispensing services, as well as a licensed wholesaler for distribution orders. We maintained TheraCom and its employees at its present location. TheraCom management, including founders Robert Dresing, chairman, and Mark Hansan, president and chief executive officer, continue to direct its operations. The TheraCom transaction was accounted for under purchase accounting rules.

     In July 2001, we established a joint venture with Priority Healthcare Corp., a national specialty pharmacy and distribution company located in Lake Mary, Florida. This joint venture, operating under the name AdvancePriority SpecialtyRx, provides our customers with comprehensive, quality specialty pharmacy services. We have a 51% ownership share in the joint venture and Priority Healthcare Corp. has a 49% interest. Priority Healthcare Corp. is a national specialty pharmacy and distributor that provides biopharmaceuticals, complex therapies and related disease treatment programs and services.

     In January 2000, we acquired a 19% interest in CHI, an internet health portal development company. Effective September 30, 2001 we acquired the remaining equity interests of CHI. CHI is a San Francisco-based provider of web-based marketing and operational solutions for managed care organizations. CHI’s flagship product, ConsumerDirect, is a private label e-health portal that enables members and non-members of various health plans to access health improvement information and services. CHI has built destination portals for leading clients such as Blue Shield of California, Blue Cross Blue Shield of Massachusetts and Blue Cross and Blue Shield of Minnesota.

Health Improvement Products and Services

PBM Services

     We offer a broad range of data, mail and clinical services to our customers through our PBM operations. We provide value by improving the level of care and lowering the costs associated with a pharmacy benefit plan.

     Data Services. Through our data services operations, we processed more than 456 million prescription claims for health plan sponsors in fiscal year 2002. We also administer a network of approximately 60,000 retail pharmacies that has agreed to provide prescription drugs to individual members of our health plan sponsors at pre-negotiated prices. The retail pharmacies in our network are linked to us through our online, real-time claims processing systems that are designed to significantly reduce the cost of processing prescriptions for those linked pharmacies. When a member of one of our health plan sponsors

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presents a prescription or health plan identification card to a retail pharmacist in our network, our online system provides the pharmacist with the following information:

	•		verification of whether the individual is eligible for benefits;
	•		the prescription benefits the individual’s health plan has selected, including whether the drug to be dispensed is included on the health plan’s formulary and the individual’s co-payment obligation;
	•		the amount the pharmacy can expect to receive as payment for its services; and
	•		an alert message to warn the pharmacist of possible interactions, including drug-drug, drug-food, drug-age and drug-pregnancy interactions.

On behalf of health plan sponsors, we aggregate all pharmacy benefit claims on a system-wide basis and facilitate payments to retail pharmacies.

     Mail Services. We believe that our mail pharmacies reduce costs to health plan sponsors through volume purchasing, generic dispensing and higher rebates through greater formulary compliance. Mail service is ideal for maintenance medications because of the convenience of home delivery and improved patient compliance through methods such as refill reminders. Our mail pharmacies currently dispense almost thirteen million prescriptions on an annualized basis, typically in the form of a three-month supply of medications for chronic conditions. Our mail service operations are highly automated, featuring bar code and scanning technology to route and track orders, computerized dispensing of many medications and computer-generated mailing labels and invoices. To enhance accurate dispensing of prescriptions, our mail service system is equipped with automated quality control features and a registered pharmacist inspects each prescription.

     Our mail pharmacy operations are located in Fort Worth, Texas and Birmingham, Alabama. We have consolidated our Richardson, Texas mail pharmacy operations into our larger facilities in Fort Worth, Texas and Birmingham, Alabama. In April 2001, we announced plans to open a new mail service pharmacy near Wilkes-Barre, Pennsylvania. This new state of the industry facility will begin operation in mid-October 2002. It will be capable of processing 500,000 prescriptions per week when developed to full capacity.

     While the majority of our mail service prescriptions are currently submitted through the mail, we will continue to promote our web-based capabilities to further reduce the costs associated with prescription refills. For additional information on our web-based capabilities, see “– Web-based Health Improvement Products and Services” below.

     Clinical and Other Services. Our clinical services professionals work closely with health plan sponsors to design and administer pharmacy benefit plans that, through the use of formularies and other techniques, promote clinically appropriate drug usage while reducing drug costs. Our formulary development process begins with a panel of independent physicians and pharmacists who perform a clinical review of available drugs for inclusion in the formulary based on safety and efficacy. After the clinical review has been performed, we negotiate rebates and discounts with pharmaceutical manufacturers to obtain the most cost effective formulary for our health plan sponsors.

     We encourage formulary compliance through programs that operate at the patient, prescribing physician and pharmacist levels. We help design tiered co-payment plans, which require a health plan member to pay higher amounts for non-preferred drugs. We attempt to influence physician prescribing patterns by analyzing physicians’ prescribing behavior relative to physician peer groups and notifying them when their practices differ from peer group norms and medical best practices. We provide face-to-face consultations between our clinical pharmacists and high-prescribing physicians in an effort to align prescribing practices in targeted categories and diseases that are in the best interests of health plan sponsors and members. We also provide our own educational materials to physicians, pharmacists and health plan sponsors. Through the retail pharmacies, we offer a voluntary therapeutic interchange program that encourages pharmacists to consult with patients and physicians regarding therapeutically equivalent, cost-effective drug alternatives. Our programs support cost effective, clinically appropriate drug management and help to ensure that members receive appropriate drug therapies.

     In addition, we have developed consulting products and services to assist health plan sponsors in designing programs that manage prescription drug costs effectively while maintaining high physician and member satisfaction. Such programs include restrictive formularies, three-tiered co-payments and prior authorization features. We have developed a proprietary decision support system that offers virtually unlimited querying capability of pharmacy, medical and laboratory data, sophisticated outcomes analyses, detailed physician and pharmacy provider profiling, utilization trending and formulary and rebate analysis. This system allows health plan sponsors to study the effectiveness of specific drugs, identify and address areas for improvement and develop new programs.

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Specialty Pharmacy

     On June 18, 2001 we announced the launch of our specialty pharmacy business, AdvancePCS SpecialtyRx, to provide our clients with a single-sourced solution to their complex and growing specialty pharmacy needs. We entered the specialty pharmacy business to further our goal of improving overall health care for patients using injectable and other expensive, high-technology drugs, while controlling the costs incurred by medical plan sponsors to provide these therapies. Specialty pharmacy services focus on pharmaceutical products that generally are biotechnological in nature and are given by injection. These services traditionally are used by small patient populations with chronic, often complex diseases requiring challenging regimens and a high level of clinical expertise. Costs for individual therapies average approximately $18,000 annually, but can range up to $200,000 annually.

     In forming this specialty pharmacy business we established a joint venture with Priority Healthcare Corp. under the name AdvancePriority SpecialtyRx, which provides our customers with comprehensive, quality specialty pharmacy services. In addition, we provide customized services around complex and emerging biotechnology therapies and the significant patient management needs associated with those therapies through our wholly-owned subsidiary, TheraCom. TheraCom has substantial experience providing distribution and related services to the biotechnology industry, including product coverage advocacy, insurance verification, reimbursement processing, pharmacist counseling and intervention, clinical and dosage monitoring, adherence counseling, nurse training and in-home nursing coordination. TheraCom also provides Internet, direct marketing, advertising and product launch support services.

Consumer Card Services

     According to the U.S. Census Bureau, in 1999 approximately 43 million Americans had no health insurance coverage. We estimate that approximately 17 million more Americans do not have outpatient prescription drug coverage included with their health insurance. Additionally, millions of Americans with outpatient drug coverage have inadequate benefits. We provide services to make prescription drugs more affordable for groups and individuals that have limited or no prescription drug insurance coverage. Through our discount cash card services, participants receive a discount on covered prescription drugs at the point of sale, thereby reducing their prescription drug costs. We are able to achieve our goal of providing prescription drugs to consumers at reduced prices by negotiating rebates on prescription drugs from pharmaceutical manufacturers and discounts from retail pharmacies based on our size and ability to influence market share. In order to maximize the cost savings to participants, we also provide messages to pharmacies participating in the programs to inform them of clinically appropriate alternative drugs that may have a lower out-of-pocket cost for the patient. In addition to cost savings, patients benefit by participating in our drug program by allowing us to capture the patients’ drug history and to identify and alert the dispensing pharmacist to any potential drug interactions.

     We currently have five discount cash card programs. Three of our programs have more than 40,000 participating retail pharmacies nationwide and include a mail service option to provide additional savings to participants. Currently, we market our programs under MatureRx®, femScript® and AvidaRx™, which we acquired through our acquisition of FFI. We also provide private label discount cash card programs for customers. MatureRx is designed to meet the needs of senior citizens that are beneficiaries of Medicare, which does not currently cover the cost of prescription drugs, by reducing their costs for prescription drugs. FemScript is designed to help women obtain prescription coverage for oral contraceptives and estrogen replacement therapies. AvidaRx and the AdvancePCS private label discount cash card programs offer savings on preferred products to participants. In addition, we launched the AdvancePCS RxSavings Plan, which is a direct to consumer offering. The AdvancePCS private label discount cash card program and the RxSavings Plan offer savings on a broad range of products to participants through approximately 47,000 participating retail pharmacies nationwide.

Web-based Health Improvement Products and Services

     We believe that our web-based offerings are the most comprehensive in the industry. Through these offerings we intend to both increase member satisfaction with our PBM services and enhance our operating efficiency. We also aim to facilitate the member retention and growth goals of our health plan sponsors by providing such plans with leading e-health web site development services and access to our e-health portals.

     PBM Services. Our online pharmacy services allow us to both reduce costs and improve service. When visiting our web sites, members of our health plan sponsors can place orders for prescriptions, check order status, locate network pharmacies and review formulary information, which saves processing and customer service costs. We believe a key differentiating characteristic of our online PBM services is the ability of patients to access online a confidential and complete history of all prescriptions dispensed to them. In addition, we continue to work with our health plan sponsors to develop interfaces that enable them to seamlessly link into our PBM services through their own web sites. For example, we offer health plan

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sponsors online access to plan performance and other management reports and industry trend information as well as the capability to exchange eligibility data online.

     Client Services. In response to client demand for their own e-health solutions, we provide web development services for health plan sponsors, an e-health portal and an online drugstore. We develop e-health web portals for our clients through our wholly-owned subsidiary CHI by either co-branding our own e-health portal or creating a completely customized private-label web site on their behalf. CHI assisted us in the development of our corporate e-health portal, BuildingBetterHealth.com, which provides consumers a comprehensive source of health, wellness and medical information, including access to medical and drug encyclopedias, an extensive medical library, medication guides, diet and nutritional resources, information about diseases, pregnancy, child and elder care, current news articles about health care developments and related content. In addition, our online drugstore AdvanceRx.com offers consumers the further convenience of shopping for other drugstore products while filling their prescriptions online or visiting BuildingBetterHealth.com or one of the other web sites that we developed for health plan sponsors. AdvanceRx.com offers over-the-counter products, health and beauty products, vitamins and nutritional supplements, medical supplies and similar products, covering over 7,000 different SKUs.

Disease Management and Other Health Improvement Programs

     Disease Management. We help health plan sponsors manage the cost and treatment of specific chronic diseases by improving medical outcomes and lowering the cost of health care delivery. Our programs are designed to support the quality initiatives and fulfill the third party accreditation requirements, such as those of the National Committee on Quality Assurance, of our health plan sponsors. These programs monitor the contracted population and intervene when individuals demonstrate symptoms of a specific disease or high risk indications.

     Our disease management programs are executed by a dedicated team of clinicians and managed care professionals and typically have five principal elements:

	•		Data integration. We compile and analyze medical, laboratory, pharmacy and other relevant data for a particular group of health plan members.
	•		Case finding. We identify patients from the group who have the specific disease and stratify them for targeted interventions.
	•		Treatment assessment. We compare treatment received by identified patients with nationally accepted treatment guidelines. We also assess physician knowledge of clinical guidelines for targeted interventions.
	•		Targeted interventions. We intervene with identified patients by educating them about their disease and providing self-management tools. We also provide physicians with treatment guidelines, patient profiles and patient management tools. Finally nurse outreach and case management intervention programs are applied to the more challenging care coordination and monitoring cases.
	•		Outcomes analysis. We measure the results of the intervention by tracking the identified patients’ medical outcomes and monitoring ongoing compliance with their treatment programs.

     We have designed disease management programs for cardiovascular secondary risk reduction, asthma, diabetes, heart failure, depression and hypertension. We have approximately 16 million eligible members who are enrolled in health plans currently under contract for one or more of our programs. We believe our disease management programs are supported by our ability to assess quality of life, quality of care and overall satisfaction with the disease management programs. We also assess the economic benefit of the programs to our health plan sponsors.

     The Company has established the Centers for Health Improvement. Beginning in fiscal year 2001, we packaged our disease management programs into population-based initiatives. These six Centers target a specific population and focus on data analysis, survey research, and behavior change models, to create a 4 step process whereby our clients may learn more about the particular challenges and barriers to change these populations may exhibit in being helped and empowered to make the correct healthcare and drug therapy choices, both from a quality and cost standpoint. Patient education, therapy compliance, and empowered interaction with their caregivers are key components of these intervention strategies. From these research activities, the AdvancePCS Clinical Division has taken a leadership position in developing new and measurable health improvement capabilities and products. Examples of our Centers:

     The Center for Work and Health. Our Center for Work and Health focuses specifically on employer group clients and the impact that illnesses have on losses in productive hours of work. In this regard, the Center for Work and Health views health care dollars as an investment in human capital that needs to be effectively managed to improve the quality of life of

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employees and to reduce lost productive hours and absenteeism due to illness. The Center for Work and Health focuses on health problems that both have a substantial impact on productivity and can be improved, such as arthritis pain, back pain, musculoskeletal pain, depression, diabetes, gastrointestinal disorders, allergic rhinitis, migraines and numerous other conditions. Many of these conditions are common in working populations and are under-diagnosed, not adequately managed and under-treated. Strategies that facilitate effective care are likely to improve outcomes and, as a result, reduce lost hours of productivity. We believe these results are particularly valuable to our employer group clients, who are responsible for the cost of medical care and benefit economically from a reduction in lost productivity.

     The Center for Healthier Aging and Patient Safety. Our Center for Healthier Aging and Patient Safety encourages better health for elderly and the chronically ill through preventative and interventional programs designed to promote the appropriate use of pharmacy therapy and reduce overall health care costs for these patients. Through focused data analysis, we work to assure that medications provide their intended advantages with minimal unintended adverse effects. We also work with pharmaceutical manufacturers to evaluate appropriate medications and medication information for elderly patients and their physicians. As a result, we believe that our emphasis on effective care for the elderly will increase our visibility in the marketplace and position us to take advantage of any future Medicare drug benefit opportunities.

     The other population focused Centers are Center for School and Health (school aged patients), Center for Women’s Health (women), Center for Priority Populations (Medicaid) and Center for Specialty Care (persons with rare or very complicated disease states).

Outcomes studies

     We provide pharmaceutical manufacturers an established vehicle for conducting studies that can document a drug’s economic and clinical benefits in a real world environment. In addition, our surveying capabilities permit us to evaluate the effectiveness of disease management strategies. We perform outcome studies on a broad range of conditions including chronic pain, dementia, asthma and diabetes.

     Our outcomes studies services include conducting studies to further the understanding of the characteristics of diseases and to develop simple to use tools, such as questionnaires and decision trees, for diagnosing diseases. In addition, we develop measurements for monitoring patient medical outcomes and determine how to best influence the health status of individuals. We also evaluate the direct and indirect costs of health care, as well as conduct surveys to evaluate physician knowledge and behavior in order to develop individualized educational materials for each physician.

Clinical trials

     Through our clinical research operations, we assist pharmaceutical manufacturers in conducting clinical trials for both new drugs and new uses for existing drugs. Our current clinical trial initiatives are focused on Alzheimer’s disease and other neurological disorders, psychological conditions and pain relief. We provide key functions in the clinical trials process, including:

	•		recruiting patients and physicians to participate in trials;
	•		administering the trials as designed by the pharmaceutical manufacturers; and
	•		measuring the patients’ results.

     The large size and breadth of our PBM population enhances our clinical trial recruitment and execution capabilities. Our patient enrollment methods are designed to reduce drug development time, which permits sponsors of clinical trials to introduce their products into the market faster and to maximize the economic return for such products. We use a call center and medically appropriate surveys to identify patients eligible to participate in our clinical trials. We believe that the combination of our clinical trials expertise with the largest PBM membership base allows us to more thoroughly and accurately evaluate the clinical benefits and predict the impact of new pharmaceutical products and services on health care expenditures and patient care management.

Clients

     We generate a significant portion of our revenues from contracts with health plan sponsors. Blue Cross and Blue Shield Association Federal Employee Program (FEP) accounted for 11% and 13% of the Company’s revenues for the years ended March 31, 2001 and 2002, respectively. Health Net, formerly Foundation Health Systems (FHS), accounted for 41% and 14% of the Company’s revenues for the years ended March 31, 2000 and 2001, respectively. Health Net accounted for less than 10% of the Company’s revenues in fiscal year 2002. Government contracts, including state and federal, represented

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approximately 19% of our client base in fiscal year 2002. No other customer accounted for over 10% of the Company’s revenues in fiscal years 2000, 2001, or 2002.

     Historically, we have had strong client relationships with BlueCross BlueShield companies and other managed care organizations. We have also focused on and developed expertise in serving self-insured employers, insurance carriers and government plans. We now have a diverse client base and substantial market penetration among all major target client groups.

Sales, Marketing and Service

     As of March 31, 2002, we had a staff of more than 700 sales and support people. Our sales force is supplemented by client service representatives in more than 30 offices throughout the United States. As part of our strategy to expand our client base, we have reorganized our sales force into teams focused on each client segment. Through this reorganization, our sales force is able to focus on the specific characteristics and needs of our current and prospective clients in each segment.

     The sales process for health plan sponsors usually lasts a minimum of six to nine months and sometimes can extend for a year or longer. Often, we initiate the sales process with potential clients at our most senior levels. A staff of sales representatives uses a team approach to work with a number of senior level individuals within a health plan sponsor. In this manner, we are able to work with health plan sponsors at multiple levels within their organizations and our health plan sponsors have multiple contacts within our organization.

     Once we have contracted with a health plan sponsor for our services, we commit to provide it with the highest level of support. For example, our benefits design group works with our health plan sponsors to design the pharmacy benefits that they will provide to the individuals in their plans. Each client is supported by a multi-functional team led by a senior-level account manager who coordinates with designated resources across our company. The account management teams are organized by market segment to enhance their understanding of the needs and complexities of our clients.

     In addition, we commit to our health plan sponsors that the individuals enrolled in their plans will receive high quality member service. To fulfill this promise, we manage three advanced call centers staffed with over 1,200 member service representatives who are available to answer incoming calls 24 hours a day, seven days a week. In order to service our growing customer base, we are expanding into a fourth call center which will give us coverage in all four time zones in the continental United States. For the year ended March 31, 2002, our call centers received approximately 316,000 calls per week, on average.

Suppliers

     On April 1, 2001, we entered into a three-year agreement with a wholesale distributor, Amerisource Bergen, to be our primary supplier of pharmaceuticals to our mail pharmacies. We believe our supplier arrangements are more than adequate and we maintain strong relationships with back-up wholesalers and suppliers. In addition, we believe alternative suppliers can be utilized without any disruptions. If a drug is not in our inventory, we can generally obtain it from either a primary or secondary supplier within one or two business days. We believe it would be relatively easy to switch from one supplier to another. Other than with respect to our mail pharmacies, we do not purchase products for retail pharmacies or otherwise supply products to them. Retail pharmacies typically have their own arrangements with wholesale distributors or pharmaceutical manufacturers.

Information Systems

     Information technology systems are a critical part of our business. We maintain a number of separate, proprietary systems that are designed to efficiently support our specific departments, yet are compatible for electronic data interchange. Our information technology systems are highly scalable and run on a variety of platforms. We have an experienced systems staff of more than 900 employees. We maintain extensive preventative measures to protect against disaster, including redundancy in all aspects of processing, telecommunications and power sources.

     As part of our integration efforts with PCS, we moved our Richardson, Texas data center into our Scottsdale, Arizona data center. Although we combined physical locations, we are continuing to maintain our separate data processing platforms in order to avoid client disruptions associated with conversion. The Scottsdale, Arizona data center has received ISO 9002 certification from the International Organization for Standardization, the world’s foremost quality standards organization, and has also received an exceptional audit grade from registrars with the professional services firm, Deloitte & Touche LLP.

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Competition

     We compete with a number of national companies, including Merck-Medco Managed Care, LLC, or Medco, a subsidiary of Merck & Co., Inc., or Merck, a pharmaceutical manufacturer, Express Scripts, Inc. and Caremark Rx, Inc. On January 29, 2002, Merck announced plans to establish Medco as a separate, publicly traded company; and on April 17, 2002, Merck filed on Form S-1 to register shares of Medco’s common stock in a proposed underwritten public offering. In addition, we compete with a number of local and regional PBMs and mail order pharmacies, some of which may be owned by health plans or retail pharmacy chains. These competitors may possess purchasing and other advantages over us that could allow them to price competing services more aggressively than we can because of their market position, affiliations and other aspects of their businesses.

     We believe that the primary competitive factors in the PBM industry include:

	•		the size and financial strength of the company;
	•		independence from pharmaceutical manufacturers, retail pharmacies and health plan sponsors;
	•		the ability to reduce health plan sponsor costs by negotiating favorable rebates and volume discounts from pharmaceutical manufacturers;
	•		the quality, scope and costs of programs offered; and
	•		the ability to use clinical strategies to improve patient outcomes and reduce costs.

Government Regulation

     Various aspects of our business are governed by federal and state laws and regulations and compliance is a significant operational requirement for us. We believe that we are in substantial compliance with all existing legal requirements material to the operation of our business. However, the application of complex standards to the detailed operation of our business always creates areas of uncertainty. Numerous health care laws and regulations have been proposed at the state and federal level, many of which could affect our business. We cannot predict what additional federal or state legislation or regulatory initiatives may be enacted in the future regarding health care or the business of PBMs, or how existing laws may be interpreted. It is possible that federal or state governments might impose additional restrictions or adopt interpretations of existing laws that could have a material adverse affect on our business, profitability or growth prospects.

     Among the federal and state laws and regulations that affect aspects of the PBM business are the following:

     Regulation of Confidentiality of Patient Identifiable Information. Government regulation of the use of patient identifiable information has grown substantially over the past several years and is likely to increase further in the future. Many states have recently enacted laws dealing with the use and disclosure of health information, and this is expected to be an area of significant activity in many states this year again. The proposals vary widely, some relating to only certain types of information, others to only certain uses and yet others to only certain types of entities. Texas, California and New York are some of the larger states that focused on health information privacy this year. Numerous proposals have been circulated at the state and federal level and there is no assurance that these proposals, if adopted, will not have a material adverse effect on our business, profitability and growth prospects. The programs that we offer our health plan customers are information-based, utilizing aggregated and anonymous data, as well as patient-specific information, depending upon the needs of the customer. Further government restrictions on the use of patient identifiable information could adversely affect our ability to promote formulary compliance and to conduct health improvement programs and outcomes studies, as well as our business growth strategy based on these programs.

     In the absence of comprehensive federal privacy legislation, in December 2000, the Department of Health and Human Services, or HHS, issued final regulations regarding the privacy of individually identifiable health information pursuant to the Health Insurance Portability and Accountability Act of 1996, or HIPAA. This final privacy rule applies to both electronic and paper records and imposes extensive requirements on the way in which cover entities, health care providers, health plans, and health care information clearinghouses and their business associates use and disclose protected information. This final rule gives patients significant rights to understand and control how their protected health information is used and disclosed. Direct providers, such as pharmacies, are required to obtain patient consents for treatment, payment and health care operations. For all uses or disclosures of protected information that do not involve treatment, payment or health care operations, the rule requires all covered entities to obtain a valid patient authorization, which is more demanding than consent. In most cases, use or disclosure of protected health information must be limited to the minimum amount necessary to achieve the purpose of the use or disclosure. In March 2002, HHS published a Notice of Proposed Rule Making that, if adopted, would change certain

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requirements and affect current implementation strategies already underway. The compliance date for the final privacy rule is April 14, 2003. Sanctions for failing to comply with standards issued pursuant to HIPAA include criminal penalties and civil sanctions. Additional guidelines on the application of the final privacy rule are expected to be released in the near future and these could impact the manner in which we use or disclose protected health information.

     HHS also published in 2000 a final rule on transaction standards and code sets, which establishes requirements for the use of particular standard formats for reporting health care claims to payors. Ultimately, public and private payors will refuse to accept claims that do not utilize these formats. The health care industry will need to adapt to these new standards. Compliance will add to our regulatory burden.

     In addition, in August 1998, HHS issued proposed regulations pursuant to HIPAA that govern the security of individually-identifiable health information. A final security rule has not yet been published but, once issued, it is likely to impose additional administrative burdens on health care providers, health plans and their business associates, relating to the storage, utilization and transmission of health information.

     Due to the complex and controversial nature of the HIPAA regulations, they may be subject to court challenge, as well as further legislative and regulatory actions that could alter their effect. However, as currently written, they will likely increase our burden of regulatory compliance with respect to our health improvement programs and other information-based products and may reduce the amount of information we may use if patients do not consent to its use. There can be no assurance that the restrictions and duties imposed will not have a material adverse effect on our business, profitability or growth prospects.

     Even without new legislation and beyond the final federal HIPAA regulations, individual health plan sponsors could prohibit us from including their patients’ medical information in our various databases of medical data. They could also prohibit us from offering services that involve the compilation of such information.

     Anti-Kickback Laws. Subject to certain exceptions, federal law prohibits the payment, offer, receipt or solicitation of any remuneration that is knowingly and willfully intended to induce the referral of Medicare, Medicaid or other federal health care program beneficiaries for the purchase, lease, ordering or recommendation of the purchase, lease or ordering of items or services reimbursable under federal health care programs. Several states also have similar laws, known as “all payor” statutes, which apply anti-kickback prohibitions beyond services for which federal health care program payments may be made. Sanctions for violating these federal and state anti-kickback laws may include criminal and civil sanctions and exclusion from participation in federal health care programs. State anti-kickback laws vary and have rarely been interpreted by courts. However, in several cases, courts have ruled that contracts that violate anti-kickback laws are void as a matter of public policy.

     The federal anti-kickback statute has been interpreted broadly by courts, by the Office of Inspector General, or OIG and within administrative tribunals. Courts have ruled that a violation of the statute may occur even if only one of the purposes of a payment arrangement is to induce patient referrals or purchases. Among the practices that have been identified by the OIG as potentially improper under the statute are “product conversion programs” in which benefits are given by pharmaceutical manufacturers to pharmacists or physicians for changing a prescription, or recommending or requesting such a change, from one drug to another. These laws have been cited as a partial basis, along with the state consumer protection laws discussed below, for investigations and multi-state settlements relating to financial incentives provided by pharmaceutical manufacturers to physicians or pharmacists in connection with such programs.

     Because of the federal statute’s broad scope, federal regulations establish some “safe harbors” from liability. Safe harbors exist for, among other things, certain properly reported discounts received from vendors, certain investment interests, certain properly disclosed payments made by vendors to group purchasing organizations and certain managed care risk-sharing arrangements. A practice that does not fall within a safe harbor is not necessarily unlawful, but may be subject to scrutiny and challenge.

     We believe that we are in compliance with the legal requirements imposed by these laws and regulations and we believe that there are material differences between the drug-switching programs about which the OIG has raised concerns and the programs we offer to our customers. To date, the government has not, to our knowledge, commenced enforcement actions under the anti-kickback statutes against PBMs with regard to their negotiation of discounts, rebates and administrative fees from drug manufacturers in connection with drug purchasing and formulary management programs, or their contractual agreements with pharmacies that participate in their networks, or their relationships with their health plan customers. However, in June of 2000, MIM Corporation, a PBM, settled a lawsuit with the federal government and the State of Tennessee asserting that it had defrauded the Tennessee Medicaid program in managing its prescription drug benefit by making false claims and diverting payments.

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     In June 1998, the United States Attorney’s Office for the Eastern District of Pennsylvania began a civil investigation into whether rebates and other payments made by pharmaceutical manufacturers to PBMs, or payments made by PBMs to retail pharmacies or others, may violate the anti-kickback laws or other federal laws. To date, no specific prosecutions or settlements have been made public. As part of this investigation, in November of 1999, prior to our acquisition of PCS, PCS received a subpoena from the OIG requesting records and data about PCS’s programs. In May 2001, AdvancePCS turned over documents responsive to the subpoena. There is litigation pending in the Eastern District of Pennsylvania regarding further enforcement of the subpoena and other matters relating to the propriety of the United States Government’s investigation. It is impossible to predict the outcome.

     The United States Attorney’s Office has also contacted some of the pharmaceutical manufacturers with which we have agreements and has asked these manufacturers to provide copies of documents relating to their agreements with us. We believe subpoenas have been issued to other PBMs and pharmaceutical manufacturers as well. At this time, we are unable to predict whether the government will commence any action challenging any of our programs and practices. We believe that our programs and those programs of PCS prior to the acquisition are in compliance with the requirements imposed by the anti-kickback laws and other applicable laws and regulations. Nevertheless, we could be subject to scrutiny, investigation or challenge under these laws and regulations as a result of the OIG investigation or otherwise, which could have a material adverse effect on our business, profitability and growth prospects. For more information regarding the OIG investigation, see “– Legal Proceedings and Government Investigations” below.

     OIG Study. The OIG Office of Evaluation and Inspections, which seeks to improve the effectiveness and efficiency of the HHS’s programs, issued a report on PBM arrangements on April 15, 1997. The report was based primarily on a nationwide survey of HMOs that use PBMs and examined the benefits of and concerns raised by, the HMOs’ relationships with PBMs.

     The report identified concerns about the potential for bias resulting from alliances of PBMs and pharmaceutical manufacturers and the lack of oversight by HMOs regarding the performance of PBMs in delivering quality services to health plan members. The report recommended that CMS and state Medicaid programs should include stronger oversight provisions in their risk contracts with HMOs by requiring HMOs to review the performance of the PBMs with which they contract. The report also recommended that CMS the FDA and the Health Resources and Services Administration, working with outside organizations, should develop quality measures for pharmacy practices that can be used in managed care settings. We intend to closely monitor these agency actions and whether these actions would have any impact on our business.

     ERISA Regulation. We have agreements to provide PBM services to a number of self-funded corporate health plans. These plans are subject to the Employee Retirement Income Security Act of 1974, or ERISA, which regulates employee pension and health and welfare benefit plans. We believe that our activities are sufficiently limited that we do not assume any of the plan fiduciary responsibilities that would subject us to regulation under ERISA. Our agreements with our self-funded corporate plan customers state that we are not the fiduciary of the plan. However, the U.S. Department of Labor, which is the agency that enforces ERISA, could assert that the fiduciary obligations imposed by the statute apply to certain aspects of our operations. In past decisions, the United States Supreme Court and other federal courts have generally declined to extend fiduciary status to managed care organizations that contract with ERISA plans. However, future cases involving PBMs could be decided differently and if we were deemed to be a fiduciary, we could potentially be subject to claims over benefit denials. In addition, we could also be subject to claims for breaching fiduciary duties in connection with the services we provide to the plan.

     AdvancePCS was served with a purported private class action lawsuit filed in the United States District Court in Arizona on or about December 17, 2001. The lawsuit alleges that AdvancePCS acts as a fiduciary, as that term is defined in ERISA and that AdvancePCS has breached certain fiduciary obligations under ERISA. AdvancePCS believes that it does not act as an ERISA fiduciary or assume the ERISA fiduciary responsibilities as alleged in the complaint. AdvancePCS believes that its business practices are in compliance with ERISA. AdvancePCS believes that it does not assume any of the plan fiduciary responsibilities that would subject it to regulations under ERISA. AdvancePCS has denied all allegations of wrongdoing and is vigorously defending this suit. For more information regarding this action, see “Legal Proceedings and Government Investigations” below.

     In March 1998, Mulder v. PCS Health Systems, Inc. was filed as an alleged class action lawsuit, contending that we are an ERISA fiduciary and that we have breached our fiduciary obligations under ERISA in connection with our development and implementation of formularies, preferred drug listings and intervention programs. We have denied all allegations of wrongdoing and are vigorously defending this lawsuit. For information regarding this action, see “– Legal Proceedings and Government Investigations” below.

     ERISA prohibits a “party in interest” to a plan from engaging in certain types of transactions with the plan, including purchases, sales and loans, in the absence of an available exemption. Violations are subject to civil and possibly criminal liability. By providing services to these plans, we are subject to the restrictions on a party in interest. We believe that we are in compliance with these provisions of ERISA. However, we can provide no assurance that the government would not challenge our practices.

     FDA Regulation. The U.S. Food and Drug Administration, or FDA, generally has authority under the Federal Food, Drug and Cosmetic Act, or FDCA, to regulate drug promotional materials that are disseminated “by or on behalf” of a pharmaceutical manufacturer. In January 1998, the FDA issued a Draft Guidance for Industry regarding the regulation of

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activities of pharmacy benefit managers that are directly or indirectly controlled by pharmaceutical manufacturers. In that draft guidance, the FDA purported to have the authority to hold pharmaceutical manufacturers responsible for the promotional activities of PBMs, depending upon the nature and extent of the relationship between the pharmaceutical manufacturer and the PBM. We and many other companies and associations commented to the FDA in writing regarding its authority to regulate the communications of PBMs that are not owned by pharmaceutical manufacturers. In the fall of 1998, the FDA withdrew the guidance and stated that it would reconsider the basis for its issuance. To date, the FDA has not taken any further action on the issue. Although it appears that the FDA has changed its position regarding regulation of communications by PBMs, there is no assurance that it will not re-examine the issue and seek to assert the authority to regulate the communications of such PBMs.

     The FDA also regulates the conduct of clinical trials for drugs. In general, the sponsor of the drug product that is being studied, or the manufacturer that will have the right to market the drug product if it is approved by the FDA, has the responsibility to comply with the laws and regulations that apply to the conduct of the clinical trials. However, in providing services related to the conduct of clinical trials, we may assume some or all of the sponsor’s or clinical investigator’s obligations related to the study of the drug. In October 1998, the FDA announced that the agency would give Institutional Review Boards, or IRBs, the independent bodies that oversee the conduct of clinical investigations, increased access to information pointing to violative or potentially violative conduct on the part of the physicians conducting the clinical trials, or clinical investigators. Recently, public concern over the conduct of clinical trials for drugs has grown and scrutiny of the authority and the role of IRBs, as well as the oversight of clinical trials for drugs has increased. New regulations or standards may be enacted that would increase the regulatory compliance burden on those involved in clinical investigations.

     We believe that we meet our regulatory responsibilities with regard to our involvement in clinical trials. However, the interpretation of the laws and regulations relating to the conduct of clinical trials is complex and sometimes subjective. We cannot assure you that the FDA will not at some point consider our compliance efforts to be inadequate and initiate administrative enforcement actions against us. If we fail to successfully defend against an administrative enforcement action, it could result in an administrative order suspending, restricting or eliminating our ability to participate in the clinical trial process, which would materially limit our business operations. Moreover, some violations of the FDCA are punishable by civil and criminal penalties against both the violating company and responsible individuals. If warranted by the facts, we and our employees involved in the trials could face civil and criminal penalties, which include fines and imprisonment.

     Managed Care Reform. Legislation is being debated on both the federal and state level and has been enacted in several states, aimed primarily at improving the quality of care provided to individuals enrolled in managed care plans. Some of these initiatives would, among other things, require that health plan members have greater access to drugs not included on a plan’s formulary, give health plan members the right to sue their health plans for malpractice when they have been denied care and mandate the content of the appeals or grievance process when a health plan member is denied coverage. The scope of the managed care reform proposals under consideration by Congress and state legislatures, and enacted by states, to date vary greatly, and the extent to which future legislation may be enacted is uncertain. However, these initiatives could greatly impact the managed care and pharmaceutical industries and, therefore, could have a material impact on our business.

     Direct Regulation of PBMs. Several states, including Georgia, New Jersey and New York, have introduced legislation that would directly regulate PBMs, but to our knowledge, no state has passed such legislation. Several regulatory and quasi-regulatory bodies, such as the National Association of Insurance Commissioners, the National Association of Boards of Pharmacy and the National Committee on Quality Assurance, have considered or are considering proposals to regulate PBMs and proposals to increase the regulation of certain PBM activities, such as formulary and utilization management and downstream risk assumption. As discussed below under “- Licensure Laws,” state licensure of certain activities, such as utilization review and third party administration, also may adversely impact our business and operations. While the outcome of these initiatives is uncertain, any resulting legislation could significantly impact our business, both directly as a PBM and indirectly through the impact on the pharmacy benefit services we are able to deliver on behalf of our health plan sponsors.

     Consumer Protection Laws. Most states have consumer protection laws, which have been the basis for investigations and multi-state settlements relating to financial incentives provided by pharmaceutical manufacturers to retail pharmacies in connection with drug switching programs. In addition, under a settlement agreement entered into with 17 states on October 25, 1995, Medco agreed to require pharmacists affiliated with Medco mail service pharmacies to disclose to physicians and patients the financial relationships between Merck, Medco and the mail service pharmacy when such pharmacists contact physicians seeking to change a prescription from one drug to another. We believe that our contractual relationships with pharmaceutical manufacturers and retail pharmacies do not include the features that were viewed by enforcement authorities as problematic in these settlement agreements and that our business practices are otherwise compliant with consumer protection laws. However, we could be subject to scrutiny or challenge under one or more of these laws. Additionally, most states have enacted consumer protection laws relating to a wide range of managed health care activities, including provider contracting, member appeals and access to services and supplies.

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     Network Access Legislation. A significant number of states have adopted some form of legislation affecting our ability to manage our retail pharmacy provider networks or from to remove pharmacies from a network. These laws may require us, directly or through our health plan customers, to admit any retail pharmacy willing to meet the plan’s price and other terms for network participation; these laws are sometimes referred to as “any willing provider” or “freedom of choice” laws. To date, we have not been materially affected by these statutes because we administer a large network of approximately 60,000 retail pharmacies and will admit any licensed pharmacy that meets our credentialing criteria, involving such matters as adequate insurance coverage, minimum hours of operation and the absence of disciplinary actions by the relevant state agencies.

     Formulary Restrictions. A number of states have begun to actively regulate the management of prescription drug benefits. Texas, California, New York and New Jersey have taken the lead proposing legislation on a wide range of issues affecting the delivery of pharmacy benefits. Many other states have followed, although they often focus on particular aspects, such as the development and use of formularies or pharmacy network issues. For example, some states have passed laws mandating coverage for off-label uses of drug products, such as the off-label uses of chemotherapeutic agents where those uses are recognized in peer-reviewed medical journals or reference compendia. Other states have begun to enact laws that regulate the development and use of formularies by insurers, HMOs and other third party payors. These laws have included requirements on the development, review and updating of formularies, the role and composition of pharmacy and therapeutics committees, the disclosure of formulary information to health plan members and a process for allowing members to obtain non-preferred drugs without additional cost-sharing where they are medically necessary and the formulary drugs are determined to be inappropriate. Additionally, the National Association of Insurance Commissioners is developing a model law on drug formularies, currently known as the Health Carrier Prescription Benefit Management Model Act, that, if ultimately enacted throughout the country, may provide more uniformity for health plans and PBMs. Among other things, the model law would address the disclosure of formulary information to health plan members, members’ access to non-preferred drugs and availability of an appeals process for members to use when coverage of a non-preferred drug is denied by the health plan or its designee. Increasing regulation of formularies by states could significantly affect our ability to develop and administer formularies on behalf of our insurer, HMO and other health plan customers.

     Legislation Imposing Plan Design Restrictions. Some states have legislation that prohibits a health plan sponsor from implementing certain restrictive design features. For example, some states prohibit insurers, HMOs and other health plans from requiring members to use mail pharmacies. Other restrictions affect the ability to make formulary changes and restrictions. Other states mandate coverage of certain benefits or conditions. This legislation does not generally apply to us, but it may apply to some of our customers such as HMOs and insurers. If similar legislation were to become widespread and broad in scope, it could have the effect of limiting the ability of PBMs to achieve economic benefits through health benefit management services.

     Licensure Laws. Many states have licensure or registration laws governing certain types of ancillary health care organizations, including preferred provider organizations, third party administrators and companies that provide utilization review and related services. The scope of these laws differs significantly from state to state and the application of these laws to the activities of pharmacy benefit managers is often unclear. We have registered under these laws in those states in which we have concluded, after discussion with the appropriate state agency, that such registration is required. Moreover, we have structured our operations and procedures to comply with the regulatory standards for these regulated entities, where appropriate. As noted above under “–Direct Regulation of PBMs,” some states have introduced legislation that, if enacted, would subject PBMs to comprehensive regulation. Such enactments could adversely affect our business and operations.

     Legislation and Regulation Affecting Drug Prices. The federal Medicaid rebate statute provides that manufacturers must provide rebates to the program on all drugs purchased equivalent to the difference between the average price of the drugs and the best price at which the manufacturer sells the drugs to wholesalers. In addition, under the Federal Supply Schedule, the government seeks and obtains favorable pricing based on manufacturers’ commercial prices and sales practices. Some manufacturers may see these policies as a disincentive to offering discounts to private purchasers, including the plans represented by AdvancePCS. Some states have adopted legislation or regulations providing that a pharmacy participating in the state’s Medicaid program must give program patients the best price that the pharmacy makes available to any third party plan. These requirements are sometimes referred to as “most favored nation” payment systems. Other states have enacted “unitary pricing” legislation, which mandates that all wholesale purchasers of drugs within the state be given access to the same discounts and incentives. Any such legislation, if enacted in any state, may adversely affect our ability to negotiate discounts from network pharmacies or manufacturers. Some manufacturers may view these Medicaid rebate provisions as a disincentive to provide discounts, which could adversely affect our ability to control costs.

     A number of states also have bills pending for broad drug price controls that would extend price controls beyond the Medicaid program. Many of these bills impose maximum drug prices based on the Federal Supply Schedule and require that manufacturers and/or pharmacies extend this pricing to one or more segments of the state’s population, such as to all Medicare beneficiaries. If enacted, these bills could adversely affect our mail order pharmacy’s reimbursement rates, or

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otherwise discourage the use of the full range of our services by current or future clients. A number of states have begun to seek supplemental rebates from drug manufacturers, beyond those required by the federal Medicaid statute. Some of those states may utilize the services of PBMs to negotiate and administer these supplemental rebate programs.

     In 2000, Congress passed the Medicine Equity and Drug Safety Act of 2000, directing the FDA to promulgate regulations allowing pharmacists and drug wholesalers to reimport approved drugs, originally manufactured in the United States, back into the United States from other countries where the drugs were sold at a lower price. The purpose of the law was to enable United States citizens to purchase drugs at prices comparable to lower prices charged for such medicines in other countries. In December 2000, the Secretary of HHS notified President Clinton that HHS would not seek the necessary funding to implement the law, since she believed it was too flawed as written to be effective. The Secretary of HHS in the Bush Administration has put his review of this policy on hold. New legislative proposals to permit reimportation have been introduced in Congress this year. Whether and how such a policy will ultimately be implemented through law or regulations is unclear. It may offer PBMs opportunities to reduce costs, but faces substantial opposition from the prescription drug industry. The ultimate effect of the legislation on our business is not known at this point.

     Recently, the federal and state governments have increased their attention to how drug manufacturers develop pricing information, which in turn is used in setting payments under the Medicare and Medicaid programs. One element common to many payment formulas, Average Wholesale Price, or AWP, has come under criticism as not accurately reflecting prices actually charged and paid at the wholesale or retail level. The Department of Justice is currently conducting and the House Commerce Committee has conducted, an investigation into the use of AWP for federal program reimbursement and whether it has inflated drug expenditures by the Medicare and Medicaid programs. In addition, the Clinton administration, along with many states, proposed changing the basis for calculating reimbursement of certain drugs by the Medicare and Medicaid programs. Instead of using AWP as historically reported by First DataBank, a company that specializes in the compilation of drug pricing information, the federal and state governments proposed to use a different set of pricing data, also compiled by First DataBank, which generally yielded lower prices for certain drugs. As part of the 2000 Consolidated Appropriations Act, P.L. 106-554, however, Congress enjoined reductions in Medicare drugs reimbursed based on the revised data pending a study by the General Accounting Office and the CMS has suspended the implementation of this data with respect to Medicare pending this study.

     The GAO released its AWP report in September 2001, which found that physicians and suppliers can obtain Medicare-covered drugs at prices significantly below current Medicare payments. Likewise, wholesaler and group purchasing organization prices generally available to physicians were considerably less than the AWPs used to establish Medicare payment levels. The GAO recommended that CMS take steps to begin reimbursing providers for Part B-covered drugs and related services at levels reflecting providers’ acquisition costs, using information about actual market transaction prices. Moreover, the GAO recommended that CMS evaluate expanding competitive bidding for drugs covered under Part B.

     In March 2002, the Senate Finance Committee held a hearing on Medicare outpatient drug pricing, at which the HHS OIG noted that its studies have consistently found that Medicare pays too much for prescription drugs. The CMS Administrator announced his intention to take action to reform Medicare drug pricing. Some members of Congress have also expressed an interest in reforming the Medicare reimbursement formula as part of a future Medicare prescription drug benefit legislation.

     These changes and other legislative or regulatory adjustments that may be made to the program for reimbursement of drugs by Medicare and Medicaid, if implemented, could significantly affect our ability to negotiate discounts with pharmaceutical manufacturers. In addition, it may affect our relations with pharmacies and health plans. In some circumstances, they might also impact the reimbursement that our mail order pharmacy receives from managed care organizations that contract with government health programs to provide prescription drug benefits or otherwise elect to rely on the revised First DataBank pricing information. Furthermore, private payors may choose to follow the federal and state governments’ example and adopt different drug pricing bases. This could affect our ability to negotiate with plans, manufacturers and pharmacies regarding discounts.

     In January of 2001, Bayer Corporation entered into a $14 million settlement with the Department of Justice regarding a qui tam suit that alleged that Bayer had artificially inflated the average wholesale price that it reported to government health care programs. In addition, Bayer agreed to report new pricing information, the “average sale price”, to government health care programs, which is calculated differently from the average wholesale price. In October of 2001, TAP Pharmaceuticals agreed to pay the government $875 million for a range of alleged misconduct, including inflation of AWP, and encouraging physicians to maximize their profits by exploiting the “spread” between acquisition costs and the AWP-based Medicare reimbursement. In light of the increased focus on calculation of AWP, AdvancePCS’s private plan customers may opt to rely on different data and demand similar calculations from manufacturers. To the extent that they do, our ability to negotiate rebates with manufacturers could be negatively impacted.

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     Medicare Prescription Drug Benefit. Medicare reimbursement and coverage of prescription drugs continues to be an issue in Congress. Medicare currently offers a very limited outpatient prescription drug benefit. Proposals have been made to expand Medicare outpatient drug coverage while reducing Medicare drug reimbursement amounts, although the prospects for legislation remain uncertain. Several legislative proposals are under consideration in Congress to provide Medicare recipients with broader outpatient drug benefits administered through the use of PBMs. Moreover, many states have established or are considering establishing or expanding state drug assistance programs that would increase access to drugs by those currently without coverage. We cannot assess at this stage how such proposals, if enacted, will impact drug costs or our business.

     Medicare Drug Discount Card. In June 2001 President Bush proposed Medicare sponsored drug discount card programs administered through PBMs and other vendors. The proposal was temporarily enjoined in court after pharmacists and drug store trade associations challenged CMS’s statutory authority to implement such a program. In March 2002, the Administration published a proposed rule to establish a new discount card program, seeking to cure some of the earlier procedural defects. While it is uncertain whether or not a Medicare drug discount card program will ever be enacted, such a program could have a significant impact on our business through our discount card programs.

     Regulation of Financial Risk Plans. The administration of fee-for-service prescription drug plans by PBMs generally is not subject to insurance regulation by the states. However, if a pharmacy benefit manager offers to provide prescription drug coverage on a capitated basis or otherwise accepts financial or insurance type risk in providing the benefit, laws in various states may regulate the plan. These laws may require that the party at risk establish reserves or otherwise demonstrate financial responsibility. Laws that may apply in such cases include laws governing the business of insurance, HMOs, limited prepaid health service plans, preferred provider organizations and organized delivery systems. Many of these state laws may be preempted in whole or in part by ERISA, which provides for comprehensive federal regulation of employee benefit plans. However, the scope of ERISA preemption is uncertain and is subject to conflicting court rulings. Other state laws may be invalid in whole or in part as an unconstitutional attempt by a state to regulate interstate commerce, but the outcome of challenges to these laws on this basis is uncertain. This issue has received a great deal of attention recently. For example, the National Community Pharmacists Association has asked the National Association of Insurance Commissioners to examine whether PBMs should be subject to state insurance laws. Compliance with state laws and regulations is a significant operational requirement for us and increased state regulation could limit our flexibility to adopt alternative and novel fee arrangements with our customers.

     Mail Pharmacy Regulation. Our mail pharmacy operation, including our online pharmacy, distributes drugs throughout the United States. Our fulfillment centers are presently located in Fort Worth, Texas and Birmingham, Alabama. We are licensed by United States, Texas and Alabama authorities to do business as a pharmacy and to deliver controlled substances. In April 2001, we announced plans to open a new mail service pharmacy near Wilkes-Barre, Pennsylvania. This new state of the industry facility will begin operation in mid-October 2002. Many of the states into which we deliver pharmaceuticals and controlled substances have laws and regulations that require out-of-state mail service pharmacies to register with that state’s board of pharmacy, or similar regulatory body, in order to mail drugs into the state. We have registered in every state that, to our knowledge, requires such registration. In addition, some states require out-of-state mail service pharmacies to have a pharmacist at the mail order location that is licensed in the state to which the drugs are shipped, as well as meeting other standards. To the extent that such laws or regulations are applicable to us, we believe that we are in compliance.

     Other Statutes and Regulations Affecting our Mail Pharmacy Operations. CMS requires mail order pharmacies to provide toll-free numbers for patient counseling of Medicaid recipients residing out of state. Other than reimbursement for specialty pharmacy products, we do not currently receive reimbursement from any state Medicaid programs. Congressional directives to provide useful information on prescription drugs to consumers may involve participation by mail order pharmacies in disseminating such information. Federal statutes and regulations govern the labeling, packaging, advertising and adulteration of prescription drugs and the dispensing of controlled substances. The Federal Trade Commission requires mail order sellers of goods generally to engage in truthful advertising, to stock a reasonable supply of the product to be sold, to fill mail orders within thirty days and to provide customers with refunds when appropriate. The United States Postal Service has statutory authority to restrict the transmission of drugs and medicines through the mail to a degree that could have an adverse effect on our mail service operations. The United States Postal Service historically has exercised this statutory authority only with respect to controlled substances. Alternative means of delivery are available to us.

Employees

     On March 31, 2002, we had 5,655 employees, including 375 pharmacists. None of our employees is represented by a labor union. In the opinion of management, we have good relationships with our employees.

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Insurance

     Our PBM operations, including the dispensing of pharmaceutical products by our mail service pharmacies, and the services rendered in connection with our health improvement services and our non-PBM operations, such as the products and services provided in connection with our clinical trial services, may subject us to litigation and liability for damages. We believe that our insurance protection is adequate for our present business operations, but there can be no assurance that we will be able to maintain our professional and general liability insurance coverage in the future or that such insurance coverage will be available on acceptable terms or be adequate to cover any or all potential product or professional liability claims. A successful product or professional liability claim in excess of our insurance coverage, or one for which an exclusion from coverage applies, could have a material adverse effect upon our financial position or results of operations.

Risk Factors

Risks Related to Our Business

Competition in our industry is intense and could reduce or eliminate our profitability.

     The PBM industry is very competitive. If we do not compete effectively, our business, profitability and growth prospects could suffer. Our competitors include profitable and well-established companies that have significant financial, marketing and other resources. Some of our competitors in the PBM business are owned by profitable and well-established pharmaceutical manufacturers or national retail pharmacy chains, which may give them purchasing power and other advantages over us by virtue of their ownership structure and enable them to succeed in taking away some of our customers.

     Competitive pressures have historically contributed to a decrease in our gross profit margins. Our margins were 5.4% in the year ended March 31, 1999, 4.1% in the year ended March 31, 2000, 3.3% in the year ended March 31, 2001 and 3.5% in the year ended March 31, 2002. Our margins may decline as we attract and renew larger customers who typically have greater bargaining power than smaller customers and may require us to sell our services at decreased prices. We cannot be sure that we will continue to remain competitive, nor can we be sure that we will be able to successfully market our PBM services to customers at our current levels of profitability.

If we lose key health plan sponsors, our business, profitability and growth prospects could suffer.

     We depend on a limited number of large health plan sponsors for a significant portion of our consolidated revenues. Five customers generated approximately 35% of the claims we processed in fiscal year 2002. Our business, profitability and growth prospects could suffer if we were to lose one or more of our significant health plan sponsors.

     Our contracts with health plan sponsors typically provide for multi-year terms, with automatic 12-month renewals unless either party terminates the contract by giving written notice in accordance with the agreement. Many of our health plan sponsors put their contracts out for competitive bidding prior to expiration. We could lose health plan sponsors if they cancel their agreements with us, if we fail to win a competitive bid at the time of contract renewal, if the financial condition of any of our health plan sponsors deteriorates or if our health plan sponsors are acquired by, or acquire, companies with which we do not have contracts. Over the past several years, insurance companies, health maintenance organizations, or HMOs and managed care companies have experienced significant consolidation. Our health plan sponsors have been and may continue to be, subject to consolidation pressures.

If we lose relationships with one or more key pharmaceutical manufacturers or if the payments we receive from pharmaceutical manufacturers decline, our business, profitability and growth prospects could suffer.

     We have contractual relationships with numerous pharmaceutical manufacturers that pay us rebate payments on behalf of our health plan sponsors based on use of selected drugs by their health plan members, as well as fees for other programs and services. We believe our business, profitability and growth prospects could suffer if:

	•		we lose relationships with one or more key pharmaceutical manufacturers;
	•		rebates decline due to the failure of our health plan sponsors to meet market share or other thresholds;
	•		legal restrictions are imposed on the ability of pharmaceutical manufacturers to offer formulary rebates or purchase our programs or services; or
	•		pharmaceutical manufacturers choose not to offer formulary rebates or purchase our programs or services.

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     Over the next few years, as patents expire covering many brand name drugs that currently have substantial market share, generic products will be introduced that may substantially reduce the market share of the brand name drugs. Historically, manufacturers of generic drugs have not offered formulary rebates on their drugs. Our pricing could be altered if the use of newly-approved, brand name drugs added to formularies, which are on the lists of preferred prescription drugs covered by a health plan, does not offset any decline in use of brand name drugs whose patents expire.

If we lose pharmacy network affiliations, our business, profitability and growth prospects could suffer.

     Our contracts with retail pharmacies, which are non-exclusive, are generally terminable by either party on short notice. If one or more of the top pharmacy chains elects to terminate its relationship with us or if we are only able to continue our relationship on terms less favorable to us, our members’ access to retail pharmacies and our business could suffer. In addition, some large retail pharmacy chains either own or have strategic alliances with PBMs or could attempt to acquire or enter into these kinds of relationships with PBMs in the future. Ownership of, or alliances with, PBMs by retail pharmacy chains could have material adverse effects on our relationships with these retail pharmacy chains and on our business, profitability and growth prospects.

Failure to continue to develop or acquire new products, services and technologies could adversely affect our business, profitability and growth prospects.

     We and our competitors continually develop new products and services to assist our customers in managing their pharmacy benefit. If we are unsuccessful in continuing to develop innovative products and services, our ability to attract new customers and retain existing customers may suffer. If our product development strategies are not successful, our business, profitability and growth prospects could suffer. Historically, we have experienced expense increases when developing new products. We anticipate that we will need to expend significant resources to develop or acquire new products and services in the future, which may adversely impact our profitability.

We have debt obligations that could restrict our operations.

     To finance our acquisition of PCS, we entered into an $825 million senior secured credit facility and issued $200 million of senior subordinated notes to the seller, Rite Aid Corporation, or Rite Aid. We repaid the senior subordinated notes with the proceeds from our offering of $200 million in 81/2% Senior Notes Due 2008 (Senior Notes). As of March 31, 2002, our outstanding debt was approximately $501 million and our ratio of debt to total stockholders’ equity was approximately 0.6 to 1. As of June 5, 2002, we have significantly reduced our indebtedness under the credit facility with only the $175 million revolving credit facility currently in place, and have increased our indebtedness under our asset securitization facility to $300 million. For additional information about our indebtedness, see “Management’s Discussion and Analysis — Liquidity and Capital Resources” below.

     Our indebtedness could have adverse consequences, including:

	•		increasing our vulnerability to adverse economic and industry conditions;
	•		limiting our flexibility in planning for, or reacting to, changes in our business and the industry in which we operate; and
	•		limiting our ability to borrow additional funds.

     Our debt service requirements will require the use of a substantial portion of our operating cash flow to pay interest on our debt instead of other corporate purposes.

Any failure to meet our debt obligations could harm our business, financial condition and results of operations.

     If our cash flow and capital resources are insufficient to fund our debt obligations, we may be forced to sell assets, seek additional equity or debt capital or restructure our debt. In addition, any failure to make scheduled payments of interest and principal on our outstanding indebtedness would likely result in a reduction of our credit rating, which could harm our ability to incur additional indebtedness on acceptable terms. Although we have not defaulted on, or failed to meet, any of our debt obligations, we cannot assure you that our cash flow and capital resources will be sufficient for payment of interest on and principal of our debt in the future or that any such alternative measures would be successful or would permit us to meet scheduled debt service obligations. Any failure to meet our debt obligations could harm our business, profitability and growth prospects.

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Restrictive financing covenants limit the discretion of our management.

     Our credit facility and certain agreements governing our debt contain a number of covenants that limit the discretion of our management with respect to certain business matters. Our credit facility covenants, among other things, restrict our ability to:

	•		incur additional indebtedness;
	•		issue preferred stock;
	•		declare or pay dividends and other distributions;
	•		create liens;
	•		make capital expenditures;
	•		make certain investments or acquisitions;
	•		enter into mergers or consolidations;
	•		make sales of assets; and
	•		engage in certain transactions with affiliates.

     The Senior Notes’ indenture contains similar restrictive covenants. In addition, under our credit facility, we are required to satisfy a minimum fixed charge coverage ratio, a maximum total leverage ratio and a minimum interest coverage ratio. A breach of any agreements governing our debt would permit the acceleration of the related debt, which could harm our business, profitability and growth prospects. These restrictions may place us at a disadvantage compared to our competitors that have fewer restrictive covenants and are not required to operate under such restrictions.

If we are unable to manage potential problems and risks related to future acquisitions and alliances, our business, profitability and growth prospects could suffer.

     Part of our growth strategy includes acquisitions and alliances involving complementary products, services, technologies and businesses. For example, on October 2, 2000 we acquired PCS, which dramatically increased the size of our company. If we are unable to overcome the potential problems and inherent risks related to such acquisitions and alliances, our business, profitability and growth prospects could suffer. Our ability to continue to expand successfully through acquisitions and alliances depends on many factors, including our ability to identify acquisition or alliance prospects and negotiate and close transactions. Even if we complete future acquisitions or alliances:

	•		we could fail to successfully integrate the operations, services and products of any acquired company;
	•		we could fail to select the best alliance partners or fail to effectively plan and manage any alliance strategy;
	•		our management’s attention could be diverted from other business concerns; and
	•		we could lose key employees of the acquired company.

     Many companies compete for acquisition and alliance opportunities in the PBM industry. Some of our competitors are companies that have significantly greater financial and management resources than we do. This may reduce the likelihood that we will be successful in completing acquisitions and alliances necessary to the future success of our business.

If our business continues to grow rapidly and we are unable to manage this growth, our business, profitability and growth prospects could suffer.

     Our business has grown rapidly in the last eight years due to our acquisitions, with total revenues increasing from approximately $64.4 million in fiscal year 1995 to $13.1 billion in fiscal year 2002. If we continue to grow rapidly, we will need to hire additional senior and line management, increase our investment in employee recruitment, training and retention and expand our information processing and financing control systems. Our future operating results will depend in part on the ability of our officers and other key employees to continue to recruit, train, retain and effectively manage our employees as well as to improve our operations, customer support and financial control systems. Our future growth will also depend on our

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ability to access capital. If we are unable to finance continued growth, manage future expansion successfully or hire and retain the personnel needed to manage our business successfully, then our business, profitability and growth prospects could suffer.

If we lose key employees on whom we depend, in particular our chairman and chief executive officer, David D. Halbert, our business could suffer.

     We believe that our continued success will depend to a significant extent upon retaining the services of our senior management. Our business could be materially and adversely affected if we lose the services of Mr. David D. Halbert, our chairman of the board and chief executive officer, or other persons in senior management, because we would lose the strategic direction and experience that these officers contribute, as well as the benefits of their relationships with customers, pharmaceutical manufacturers and stockholders. Except as limited by their employment agreements, any of our senior management could seek other employment at any time. We do not currently have “key-person” life insurance policies on any of our employees. If we cannot recruit, train, retain and effectively manage key employees, our business, profitability and growth prospects could suffer.

If we become subject to liability claims that are not covered by our insurance policies, we may be liable for damages and other expenses that could have a material adverse effect on our business, profitability and growth prospects.

     A successful product or professional liability claim in excess of our insurance coverage where we are required to pay damages, incur defense costs or face negative publicity, could have a material adverse effect on our liquidity, our reputation in the industry and our ability to attract and retain clients. While we intend to maintain professional and general liability insurance coverage at all times, we cannot assure you that we will be able to maintain insurance in the future, that insurance will be available on acceptable terms or that insurance will be adequate to cover any or all potential product or professional liability claims.

     Various aspects of our business may subject us to litigation and liability for damages. For example, our clinical trials services involve the risk of liability for personal injury from unforeseen adverse side effects or improper administration of a new drug. Other aspects of our business that may subject us to liability include:

	•		the dispensing of pharmaceutical products;
	•		the performance of PBM services and health improvement services; and
	•		the operation of our call centers and web sites.

Some investors own a significant amount of our stock and may exert influence over corporate transactions and other matters.

     As a result of our acquisition of PCS, Joseph Littlejohn & Levy Fund III, L.P. and certain other investors, collectively referred to as JLL and Rite Aid received shares of Series A preferred stock. The Series A preferred stock was convertible into Class B common stock. The Class B common stock is convertible into our Class A common stock on a one-for-one basis. Rite Aid converted all its shares of Series A preferred stock into Class B common stock and then substantially all of those shares of Class B common stock into Class A common stock. Rite Aid sold all of its shares of Class A common stock in our secondary offering that was completed in March 2001. However, Rite Aid has retained ownership of a sufficient number of shares of Class B common stock to retain its right to designate two of our 11 directors through December 8, 2002. JLL has converted all of its shares of Series A preferred stock into our Class B common stock. As a holder of Class B common stock JLL is entitled to designate two of our 11 directors and we cannot take certain actions without their consent. Assuming conversion of all its shares of Class B common stock into Class A common stock, JLL would beneficially own approximately 13.9% of our Class A common stock. Accordingly, JLL may be able to substantially influence the outcome of stockholder votes and otherwise have influence over our business. The interests of these investors may differ from interests of other stockholders.

Risks could arise due to Arthur Andersen LLP being our past auditors

     You may have no effective remedy against Arthur Andersen LLP in connection with a material misstatement or omission in these financial statements, particularly in the event that Arthur Andersen LLP ceases to exist or becomes insolvent as a result of the indictment or other proceedings against Arthur Andersen LLP.

     Arthur Andersen LLP, which audited our financial statements included in this report for the years ended March 31, 2000 and March 31, 2001, has informed us that on March 14, 2002 an indictment was unsealed charging it with federal obstruction

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of justice arising from the government’s investigation of Enron Corp. On June 15, 2002, Arthur Andersen was convicted of obstructing justice in connection with investigations of their former client Enron Corp.

     Arthur Andersen LLP consented to the inclusion of their report in the annual reports and registration statements we filed prior to January 31, 2002. Some changes to the financial statements covered by Arthur Andersen LLP’s report for 2000 and 2001 were made after January 31, 2002, but we do not believe these changes materially affect the financial results covered by Arthur Andersen LLP’s report. A complete discussion of these changes is located in Notes 2 and 15 to the financial statements included with this report. These adjustments and changes to the financial statements audited by Arthur Andersen include those related to our two-for-one stock split, accomplished through a stock dividend on October 23, 2001. We also made adjustments to restate our accounting for our investment in CHI (in accordance with “Opinions of the Accounting Principles Board (APB) No. 18”) from the cost basis to the equity method of accounting upon our acquisition of the remaining equity of CHI in September, 2001, after Arthur Andersen LLP’s last audit of our annual financial statements for the fiscal year ended March 31, 2001. The last consent provided to us by Arthur Andersen LLP, dated January 31, 2002, was received after we began restating our quarterly financial statements to account for our acquisition of CHI on an equity rather than cost basis as required by APB 18.

     Our inability to include in future registration statements or reports financial statements for one or more years audited by Arthur Andersen LLP or to obtain Arthur Andersen LLP’s consent to the inclusion of their report on our 2000 and 2001 financial statements may impede our access to the capital markets.

     Should we seek to access the public capital markets, Securities and Exchange Commission (SEC) rules will require us to include or incorporate by reference in any prospectus three years of audited financial statements. Until our audited financial statements for the fiscal year ending March 31, 2004 become available, the SEC’s current rules would require us to present audited financial statements for one or more fiscal years audited by Arthur Andersen LLP. Prior to that time the SEC may cease accepting financial statements audited by Arthur Andersen LLP, in which case we would be unable to access the public capital markets unless PricewaterhouseCoopers LLP, our current independent accounting firm, or another independent accounting firm, is able to audit the financial statements originally audited by Arthur Andersen LLP. In addition, as a result of the departure of our former engagement team leaders, Arthur Andersen LLP is no longer in a position to consent to the inclusion or incorporation by reference in any prospectus of their report on our audited financial statements for the years ended March 31, 2000 and March 31, 2001, and investors in any subsequent offerings for which we use their audit report will not be entitled to recovery against them under Section 11 of the Securities Act of 1933 for any material misstatements or omissions in those financial statements. Consequently, our financing costs may increase or we may miss attractive market opportunities if either our annual financial statements for 2000 and 2001 audited by Arthur Andersen LLP should cease to satisfy the SEC’s requirements or those statements are used in a prospectus but investors are not entitled to recovery against our auditors for material misstatements or omissions in them.

Risks Related to Our Industry

Prior to our acquisition of PCS, PCS received a subpoena from the Department of Health and Human Services Office of Inspector General in connection with an industry-wide investigation, and although there have been no charges filed against AdvancePCS, we could be subject to scrutiny, investigation or challenge under federal or state anti-kickback and false claims, or other laws, which could cause our business, profitability and growth prospects to suffer.

     Federal anti-kickback laws generally prohibit the receipt or solicitation of payment in return for purchasing or ordering, or arranging for or recommending the purchasing or ordering of, items and services reimbursable by federal health care programs. Some states have similar laws that apply across all payors. To date, these laws have not been applied to prohibit the types of business arrangements we have with pharmaceutical manufacturers, health plan sponsors or retail pharmacies. However, courts and enforcement authorities that administer the anti-kickback laws have historically interpreted these laws broadly.

     In November 1999, PCS received a subpoena by the OIG requesting PCS to produce certain documents about its programs and how they operate in connection with an industry-wide investigation. The investigation was instigated and is being pursued by the United States Attorney’s Office for the Eastern District of Pennsylvania, which indicated an intention to review PBMs’ programs in light of anti-kickback and other laws and regulations. Specifically, the focus of this investigation appears to be PBMs’ relationships with pharmaceutical manufacturers and retail pharmacies and PBMs’ programs relating to drug formulary compliance, including rebate and other payments made by pharmaceutical manufacturers to PBMs and payments made by PBMs to retail pharmacies or others, and therapeutic intervention activity. AdvancePCS has turned over documents responsive to the subpoena. There is litigation pending in the Eastern District of Pennsylvania regarding further enforcement of the subpoena and other matters relating to the propriety of the United States Government’s investigation. It is impossible to predict the outcome.

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     The United States Attorney’s Office has also contacted some of the pharmaceutical manufacturers with which we have agreements and has asked these manufacturers to provide copies of documents relating to their agreements with us. At this time, we are unable to predict whether the government will commence any action challenging any of our programs and practices. We believe that our programs and those of PCS prior to the acquisition are in compliance with the requirements imposed by anti-kickback laws and other applicable laws and regulations. Nevertheless, we could be subject to scrutiny, investigation or challenge under these laws and regulations as a result of the OIG investigation or otherwise. Such scrutiny, investigation or challenge could alter our business practices related to formulary products and services and our relationships with pharmaceutical manufacturers, which could reduce our profitability and growth prospects.

If legislative or regulatory initiatives restrict our ability to use patient identifiable medical information, our clinical programs and our business growth strategy based on these services could suffer.

     Through our health improvement programs, we help our health plan sponsor customers identify individuals who will most benefit from the programs. Governmental restrictions on the use of patient identifiable information may adversely affect our ability to conduct health improvement programs and medical outcome studies and could adversely affect our growth strategy based on these programs. Federal and state legislation has been proposed and some state laws have been enacted, to restrict the use and disclosure of patient identifiable medical information. Additional legislation could be enacted in the future that severely restricts or prohibits our use of patient identifiable information, which could harm our business, profitability and growth prospects.

     In December 2000, the HHS issued final regulations regarding the privacy of individually identifiable health information pursuant to the Health Insurance Portability and Accountability Act of 1996, or HIPAA. This final rule on privacy applies to both electronic and paper records and imposes extensive requirements on the way in which health care providers, health plan sponsors and their business associates use and disclose protected information. The final rule gives patients significant rights to understand and control how their protected health information is used and disclosed. Direct providers, such as pharmacies, are required to obtain patient consents for treatment, payment and health care operations. For all uses or disclosures of protected information that do not involve treatment, payment or health care operations, the rule requires all covered entities to obtain a valid patient authorization, which is more demanding than consent. In most cases, use or disclosure of protected health information must be limited to the minimum amount necessary to achieve the purpose of the use or disclosure. In March 2002, HHS published a Notice of Proposed Rule Making that if adopted, would change certain requirements and affect current implementation strategies already underway. The compliance date for the final privacy rule is April 14, 2003. Sanctions for failing to comply with standards issued pursuant to HIPAA include criminal penalties and civil sanctions. Additional guidelines on the application of the final privacy rule are expected to be released in the near future and these could impact the manner in which we use or disclose protected health information.

     HHS also published in 2000 a final rule on transaction standards and code sets, which establishes requirements for the use of particular standard formats for reporting health care claims to payors. Ultimately, public and private payors will refuse to accept claims that do not utilize these formats. The health care industry will need to adapt to these new standards. Compliance will add to our regulatory burden.

     In addition, in August 1998, HHS issued proposed regulations pursuant to HIPAA that govern the security of individually-identifiable health information. A final security rule has not yet been published but, once issued, it is likely to impose additional administrative burdens on health care providers, health plans and their business associates, relating to the storage, utilization and transmission of health information.

     Due to the complex and controversial nature of the privacy regulations, they may be subject to court challenge, as well as further legislative and regulatory actions that could alter their effect. We cannot at this time predict with specificity what impact the final HIPAA rule on the privacy of individually identifiable health information, or the final security rule, may have on us. However, they will likely increase our burden of regulatory compliance with respect to our health improvement programs and other information-based products and may reduce the amount of information we may use if patients do not consent to such use. There can be no assurance that the restrictions and duties imposed by the recently adopted final rule on the privacy of individually-identifiable health information, or the eventual final rule on security of individually-identifiable health information, will not materially impact our ability to offer new and existing products and services, such as certain health improvement programs and other clinical programs to our clients, thereby reducing our profitability and growth prospects.

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     Even without new legislation and beyond the final federal regulations, individual health plan sponsor customers could prohibit us from including their patients’ medical information in our various databases of medical data. They could also prohibit us from offering services that involve the compilation of such information.

If we are ever deemed to be a fiduciary of a health benefit plan governed by ERISA, we could be subject to claims for benefit denials and liability for breach of fiduciary duty.

     We have agreements to provide PBM services to a number of self-funded corporate health plans. These plans are subject to the ERISA, which regulates employee pension and health and welfare benefit plans. We believe that our activities are sufficiently limited that we do not assume any of the plan fiduciary responsibilities that would subject us to regulation under ERISA. Our agreements with our self-funded corporate plan customers state that we are not the fiduciary of the plan. However, the U.S. Department of Labor, which is the agency that enforces ERISA, could assert that the fiduciary obligations imposed by the statute apply to certain aspects of our operations. If we were deemed to be a fiduciary, we could potentially be subject to claims relating to benefit denials. In addition, we could also be subject to claims for breaching fiduciary duties in connection with the services we provide to the plan.

     AdvancePCS was served with a purported private class action lawsuit filed in the United States District Court in Arizona on or about December 17, 2001. The lawsuit alleges that AdvancePCS acts as a fiduciary, as that term is defined in the ERISA, and that AdvancePCS has breached certain fiduciary obligations under ERISA. AdvancePCS believes that it does not act as an ERISA fiduciary or assume the ERISA fiduciary responsibilities as alleged in the complaint. AdvancePCS believes that its business practices are in compliance with ERISA. The lawsuit seeks unspecified monetary damages and injunctive relief. AdvancePCS believes that it does not assume any of the plan fiduciary responsibilities that would subject it to regulation under ERISA. Although the ultimate outcome is uncertain, an adverse determination could potentially cause us to change our business practices with respect to formularies, preferred drug listings and intervention programs, potentially reducing our profitability and growth prospects. A class of plaintiffs has not yet been certified and we intend to oppose such certification. AdvancePCS has denied all allegations of wrongdoing and is vigorously defending this suit.

     In March 1998, a class action lawsuit captioned Mulder v. PCS Health Systems, Inc. was filed in the United States District Court for the District of New Jersey. This action alleges that PCS is an ERISA fiduciary and that we have breached our fiduciary obligations under ERISA in connection with our development and implementation of formularies, preferred drug listings and intervention programs for our sponsors of ERISA health plans. The plaintiffs are seeking injunctive relief and monetary damages in an unspecified amount. A class of plaintiffs has not yet been certified and we intend to oppose such certification. AdvancePCS has denied all allegations of wrongdoing and is vigorously defending this lawsuit. Although the ultimate outcome is uncertain, an adverse determination could potentially cause us to change our business practices with respect to formularies, preferred drug listings and intervention programs, potentially reducing our profitability and growth prospects.

     ERISA also prohibits a “party in interest” to a plan from engaging in certain types of transactions with the plan, including purchases, sales and loans, absent an available exemption. Violations are subject to civil and criminal liability. By providing services to these plans, we are subject to the restrictions on a party in interest. We believe that we are in compliance with these provisions of ERISA. However, there is no guarantee that the government would not challenge our practices.

If there are changes in federal or state financing and regulation of the health care industry, our customers may delay or reduce the purchase of our services.

     During the past several years, the United States health care industry has been subject to an increase in governmental regulation and legislation, on both the federal and state level. We cannot predict what effect, if any, these proposals might have on our business, profitability and growth prospects. Congress is considering proposals to change Medicare drug coverage and reimbursement policies and many states are considering proposals to provide or expand drug assistance programs. Some states have begun to seek supplemental Medicaid rebates from drug manufacturers, beyond those required by the federal Medicaid statute. Both Congress and the states are expected to consider legislation to increase governmental regulation of managed care plans. Some of these initiatives would, among other things, require that health plan members have greater access to drugs not included on a plan’s formulary and give health plan members the right to sue their health plans for malpractice when they have been denied care. The scope of the managed care reform proposals under consideration by Congress and state legislatures and enacted by certain states to date vary greatly and the extent to which future legislation may be enacted is uncertain. However, these initiatives could greatly impact the managed care and pharmaceutical industries and, therefore, could have a material adverse impact on our business, profitability and growth prospects.

     In addition, several legislative proposals are under consideration in Congress to provide Medicare recipients with expanded outpatient drug benefits through the use of PBMs. While we believe that a Medicare prescription drug benefit

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could provide us with new business opportunities, the structure of such a program could have a material adverse impact on our business, profitability and growth prospects.

     Several states, including California, New Jersey and New York, have introduced legislation that would directly regulate PBMs, but to our knowledge, no state has passed such legislation. Several regulatory and quasi-regulatory bodies, such as the National Association of Insurance Commissioners, the National Association of Boards of Pharmacy and the National Committee on Quality Assurance, are also considering proposals to regulate PBMs and proposals to increase the regulation of certain PBM activities, such as formulary and utilization management and downstream risk assumption. While the outcome of these initiatives is uncertain, any resulting legislation could materially harm our business, both directly as a PBM and indirectly through the impact on the pharmacy benefit services we are able to deliver on behalf of our health plan sponsors.

     There is great attention being paid to the pricing of prescription drug products and how they are reimbursed by government programs. One pharmaceutical manufacturer has settled a lawsuit with the federal government asserting that it inappropriately calculated drug prices for Federal health care programs and agreed to provide a new calculation formula. In addition, a number of class action lawsuits have been filed against various pharmaceutical manufacturers. These cases generally allege that for certain drugs, the manufacturers inflated the average wholesale prices upon which some federal health care programs based reimbursement to physicians and pharmacists. Most of these cases have been consolidated for pretrial proceedings in one federal court in Massachusetts. The manufacturers deny any wrongdoing and are defending the litigation.

     Legislative and regulatory proposals have been put forward that would alter the calculation of drug prices for federal programs and likely reduce expenditures. These proposals may increase governmental involvement in health care and health benefit management services and otherwise change the way our customers do business. Health care organizations may react to these proposals and the uncertainty surrounding them by cutting back or delaying the purchase of our health benefit management services and manufacturers may react by reducing rebates or reducing supplies of certain products, which would materially harm our business, profitability and growth prospects.

If government laws or regulations relating to the financial relationships between PBMs and pharmaceutical manufacturers are interpreted and enforced in a manner adverse to our PBM and health improvement programs, we may be subject to enforcement actions and our business operations could be materially limited.

     In January 1998, the FDA issued a Draft Guidance for Industry regarding the regulation of activities of PBMs that are directly or indirectly controlled by pharmaceutical manufacturers. To date, the FDA has not taken any further action. Although it appears that the FDA has changed its position regarding regulation of communications by PBMs, there is no assurance that it will not re-examine the issue and seek to assert the authority to regulate the communications of such PBMs.

If government laws or regulations are enacted, interpreted or enforced in a manner adverse to our clinical research programs, we may be subject to administrative enforcement actions, as well as civil and criminal liability.

     We assist pharmaceutical manufacturers in conducting clinical trials for new drugs, or new uses for existing drugs. The conduct of clinical trials is regulated by the FDA under the authority of the FOCA and the related regulations. Oversight of clinical trials has received increasing scrutiny in recent years. If government laws or regulations are interpreted and enforced in a manner adverse to our clinical research programs, we may be subject to administrative enforcement actions, as well as civil and criminal liability. In general, the sponsor of the drug product that is being studied, or the manufacturer that will have the right to market the drug product if it is approved by the FDA, has the responsibility to comply with the laws and regulations that apply to the conduct of the clinical trials. However, in providing services related to the conduct of clinical trials, we may assume some or all of the sponsor’s or clinical investigator’s obligations related to the study of the drug. In October 1998, the FDA announced that the agency would give Institutional Review Boards, which are independent bodies that oversee the conduct of clinical investigations, increased access to information pointing to violative or potentially violative conduct on the part of clinical investigators, for example the physicians who conduct the clinical trials.

     Because the interpretation and enforcement of these laws and regulations relating to the conduct of clinical trials is uncertain, the FDA may consider our compliance efforts to be inadequate and initiate administrative enforcement actions against us. If we fail to successfully defend against an administrative enforcement action, it could result in an administrative order suspending, restricting or eliminating our ability to participate in the clinical trial process, which would materially limit our business operations. Moreover, some violations of the FOCA are punishable by civil and criminal penalties against both the violating company and responsible individuals. If warranted by the facts, we and our employees involved in the trials could face civil and criminal penalties, which include fines and imprisonment.

     As a consequence of the severe penalties we and our employees potentially could face, we must devote significant operational and managerial resources to comply with these laws and regulations. Although we believe that we substantially

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comply with all existing statutes and regulations material to the operation of our business, regulatory authorities may disagree and initiate enforcement or other actions against us. In addition, we cannot predict the impact of future legislation and regulatory changes on our business or assure you that we will be able to obtain or maintain the regulatory approvals required to operate our business.

ITEM 2. PROPERTIES

     Our existing facilities consist of approximately 1.3 million square feet, of which we own 150,400 square feet and lease the remainder. The monthly lease payments were approximately $1.6 million in the month of March 2002. The following table sets forth information with respect to our principal facilities.

In addition, we have several other facilities throughout the United States that we use for sales offices, clinics, data services and other corporate purposes. We believe our facilities are adequate to meet our requirements for the foreseeable future.

ITEM 3. LEGAL PROCEEDINGS AND GOVERNMENT INVESTIGATIONS

     AdvancePCS was served with a purported private class action lawsuit filed in the United States District Court in Arizona on or about December 17, 2001. The lawsuit alleges that AdvancePCS acts as a fiduciary, as that term is defined in ERISA and that AdvancePCS has breached certain fiduciary obligations under ERISA. AdvancePCS believes that it does not act as an ERISA fiduciary or assume the ERISA fiduciary responsibilities as alleged in the complaint. AdvancePCS believes that its business practices are in compliance with ERISA. The lawsuit seeks unspecified monetary damages and injunctive relief. AdvancePCS believes that it does not assume any of the plan fiduciary responsibilities that would subject it to regulation under ERISA. Although the ultimate outcome is uncertain, an adverse determination could potentially cause us to change our business practices with respect to formularies, preferred drug listings and intervention programs, potentially reducing our profitability and growth prospects. A class of plaintiffs has not yet been certified and we intend to oppose such certification. AdvancePCS has denied all allegations of wrongdoing and is vigorously defending this suit.

     In November 1999, PCS received a subpoena by the OIG requesting PCS to produce certain documents about its programs and how they operate in connection with an industry-wide investigation. The investigation was instigated and is being pursued by the United States Attorney’s Office for the Eastern District of Pennsylvania, which indicated an intention to review PBMs’ programs in light of anti-kickback and other laws and regulations. Specifically, the focus of this investigation appears to be PBMs’ relationships with pharmaceutical manufacturers and retail pharmacies and PBMs’ programs relating to drug formulary compliance, including rebate and other payments made by pharmaceutical manufacturers to PBMs and payments made by PBMs to retail pharmacies or others, and therapeutic intervention activity. AdvancePCS has turned over documents responsive to the subpoena. There is litigation pending in the Eastern District of Pennsylvania regarding further enforcement of the subpoena and other matters relating to the propriety of the United States Government’s investigation. It is impossible to predict the outcome.

     The United States Attorney’s Office has also contacted some of the pharmaceutical manufacturers with which we have agreements and has asked these manufacturers to provide copies of documents relating to their agreements with us. At this time, we are unable to predict whether the government will commence any action challenging any of our programs and practices. AdvancePCS believes that its programs and those of PCS prior to the acquisition are in compliance with the requirements imposed by anti-kickback laws and other applicable laws and regulations. Nevertheless, we could be subject to scrutiny, investigation or challenge under these laws and regulations as a result of the OIG investigation or otherwise, which could have a material adverse effect on our business, profitability and growth prospects.

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     In March 1998, a class action lawsuit captioned Mulder v. PCS Health Systems, Inc., case number 98-1003, was filed in the United States District Court of the District of New Jersey. This action alleges that PCS is an ERISA fiduciary and that we have breached our fiduciary obligations under ERISA in connection with our development and implementation of formularies, preferred drug listings and intervention programs for our sponsors of ERISA health plans. In particular, plaintiffs allege that our therapeutic interchange programs and negotiation of formulary rebates and discounts from pharmaceutical manufacturers violate fiduciary obligations. The plaintiffs are seeking injunctive relief and monetary damages in an unspecified amount. AdvancePCS believes that it does not assume any of the plan fiduciary responsibilities that would subject it to regulation under ERISA. Although the ultimate outcome is uncertain, an adverse determination could potentially cause us to change our business practices with respect to formularies, preferred drug listings and intervention programs, potentially reducing our profitability and growth prospects. A class of plaintiffs has not yet been certified and we intend to oppose such certification. AdvancePCS has denied all allegations of wrongdoing and is vigorously defending this suit.

     On December 17, 2001 AARP and United Healthcare Insurance Co. (United) filed a multi-count complaint against AdvancePCS in federal court in Minneapolis, Minnesota in a matter captioned United Healthcare Insurance Co. and AARP v. AdvancePCS, Civ. No. 01-CV-2320 (D. Minn.). AARP and United have asserted claims against AdvancePCS for violation of Minnesota’s deceptive trade practices act, tortious interference with prospective economic advantage and unjust enrichment. Specifically, AARP and United claim that AdvancePCS created confusion among certain AARP members and pharmacists through the launch of the AdvancePCS prescription drug discount program. AARP and United have requested preliminary and permanent injunctive relief and recently quantified their compensatory damage claim of $30 million, including attorneys’ fees and costs. AdvancePCS has moved to dismiss all counts of the Complaint. On March 18, 2002, without holding an evidentiary hearing, the district court granted AARP and United’s request for preliminary injunctive relief. The court’s order was modified on March 22, 2002. AdvancePCS has appealed the district court’s orders and this appeal is pending. AdvancePCS has denied AARP and United’s allegations and is vigorously defending this matter.

     In addition, we are a defendant in lawsuits from time to time arising in the ordinary course of business, the outcome of which we believe will not have a material adverse effect on our business, profitability and growth prospects.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

     No matters were submitted to a vote of security holders during the fourth quarter of fiscal 2002.

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PART II

ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS

     Our Class A common stock has been traded on the Nasdaq National Market under the symbol ADVP since our initial public offering on October 8, 1996. The following table sets forth the range of quarterly high and low sales prices per share of our Class A common stock as quoted on the Nasdaq National Market. On October 1, 2001 we announced a two-for-one stock split, effected in the form of a stock dividend of our common stock. Financial information and stock prices contained throughout the Form 10-K have been adjusted to reflect the impact of the stock split.

     On March 31, 2002 there were approximately 19,000 beneficial owners, based on our most recent mailing to shareholders, of our Class A common stock represented by 128 holders of record.

     We have never paid any cash dividends on our Class A common stock and do not expect to pay cash dividends in the foreseeable future. In the past we have paid cash dividends on our preferred stock. We intend to retain future earnings to finance the ongoing operations and growth of our business.

     There is no established public trading market for our Class B-1 common stock or our Class B-2 common stock. On March 31, 2002, there was one holder of our Class B-1 common stock, JLL, and one holder of our Class B-2 common stock, Rite Aid.

     The number of shares of common stock subject to outstanding options and remaining available for grant pursuant to our stock based compensation plans as of March 31, 2002 is reflected in the table below. All of our stock based compensation plans have been approved by our shareholders.

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Equity Compensation Plan Information

ITEM 6. SELECTED HISTORICAL FINANCIAL AND OPERATING DATA

     The following tables present selected consolidated statement of operations, balance sheet and supplemental data of AdvancePCS for the periods and dates indicated. The selected statement of operations for each of the years in the five-year period ended March 31, 2002 and the balance sheet data as of March 31, 1998, 1999, 2000, 2001 and 2002 presented below are derived from our consolidated financial statements and accompanying notes, which, for the fiscal years 1998 through 2001 have been audited by Arthur Andersen LLP, independent accountants and for fiscal year 2002 have been audited by PricewaterhouseCoopers LLP, independent accountants.

     The results of operations of PCS for the period commencing October 2, 2000, the date of our acquisition of PCS, are reflected in the financial statements of AdvancePCS after that date.

     The information contained in this section should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in the historical consolidated financial statements and related notes of each of AdvancePCS and PCS.

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AdvancePCS

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ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Overview

     We are a leading provider of health improvement services in the United States. As the largest PBM based on number of lives covered, we currently serve more than 75 million health plan members and manage approximately $28 billion in prescription drug spending on an annualized basis on behalf of our health plan sponsors. In addition, we offer a wide range of other health improvement products and services, such as prescription discount cards for the uninsured and under-insured, web-based programs, disease management, clinical trials and outcomes studies. Our mission is to improve the quality of care delivered to health plan members while helping health plan sponsors reduce overall costs.

     Over the past few years, the PBM industry has undergone significant consolidation. We believe such consolidation has principally been driven by the significant benefits of size and scale, including:

	•		cost-saving opportunities to leverage a fixed-cost infrastructure over greater prescription claim volume, resulting in greater pricing flexibility; and
	•		increased negotiating leverage with pharmaceutical manufacturers and retail pharmacies, resulting in greater ability to obtain lower drug costs for health plan sponsors.

We believe PBMs that effectively capture these benefits will be positioned to strengthen their relationships with plan members, physicians and health plan sponsors and improve their competitive position.

Critical Accounting Policies

Revenue Recognition

     We purchased PCS on October 2, 2000 and have included this business in our consolidated results of operations since that time. We made changes in our revenue recognition presentation to conform the different policies used by Advance Paradigm and PCS. These changes are reflected in all periods presented. These changes are as follows:

(1)		The historical PCS amounts have been reclassified to reflect the change in presentation of data services revenues. In cases in which we have assumed an independent obligation to pay our network pharmacy providers and act as a principal in the transaction, we include payments from our plan sponsors for these benefits as revenues and payments to our pharmacy providers as cost of revenues (i.e. gross reporting). Historically, PCS recorded only claims processing fees as revenues (i.e. net reporting). The change results in higher revenues and an equal increase in cost of revenues. This change had no effect on gross profit or operating income.
(2)		In addition, the historical financial statements of AdvancePCS have been revised to reflect a change in recognition of clinical and other service revenues. We receive funds from pharmaceutical manufacturers for formulary rebate programs that we administer on behalf of our health plan sponsors. We record revenues in the amount of the administration fees we charge for our services (i.e. net reporting) and include the cost of such services in cost of revenues. Previously, we recognized the entire amount of the rebate, including our administration fee, in revenues and the portion of the rebate paid to our client in cost of revenues (i.e. gross reporting). This revision resulted in lower revenues and an equal decrease in cost of revenues. This change had no effect on gross profit or operating income.

     Revenues from the dispensing of pharmaceuticals from our mail service pharmacy are recognized when each prescription is shipped. Revenues from sales of prescription drugs by pharmacies in our nationwide network and claims processing fees are recognized when the claims are adjudicated. At the point-of-sale, the pharmacy claims are adjudicated using our on-line claims processing system. When we independently contract to pay our network pharmacy providers, we assume credit risk and act as a principal in the transaction, therefore, we include payments from plan sponsors for these benefits as revenues and payments to its pharmacy providers as cost of revenues (i.e. gross reporting) in accordance with EITF 99-19 “Reporting Gross Revenue as a Principle vs Net as an Agent.” If we are only administering plan sponsors’ network pharmacy contracts, the Company records the claims processing fees as revenue (i.e. net reporting). If we had reported our data services revenues using net reporting, revenues and cost of revenues would have decreased by $1.5 billion, $5.9 billion and $10.8 billion, respectively, for the fiscal years ended March 31, 2000, 2001 and 2002.

     Clinical services fees received from the plan sponsors or pharmaceutical manufacturers are recognized in revenues as earned in accordance with the contractual agreements. Clinical services revenue includes service fees for negotiating rebates

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with pharmaceutical manufacturers on behalf of its health plan sponsor customers. The rebate due from the manufacturer is determined based on a complex formula including such factors as volume and quarterly drug utilization. We estimate the most recent quarter’s rebate receivables from the manufacturers and rebate payable to plan sponsors and its fees based on the terms of its contracts and claims for the quarter. Following the end of the quarter, we invoice the drug manufacturer. We revise our estimates based upon the invoiced amounts. Rebates received from pharmaceutical manufacturers on behalf of plan sponsors are excluded from revenues. Clinical services revenues from certain disease management and health benefit management products are reimbursed at predetermined contractual rates based on the delivery or completion of the services.

Cost of Revenues

     Cost of revenues includes product costs, pharmacy claims payments made to our retail network pharmacies and other direct costs associated with the provision of customer services and the sale and/or dispensing of prescriptions including our call center operations. Rebate amounts paid to plan sponsors, collected from pharmaceutical manufacturers, are excluded from cost of revenues.

Selling, General and Administrative

     Selling, general and administrative expenses reflect the costs of operations dedicated to generating new sales and maintaining existing client relationships. These expenses also include costs relating to certain corporate functions including executive oversight, accounting, treasury, tax, legal, public affairs, human resources, procurement and other services.

Use of Estimates

     Preparation of the consolidated 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 and disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the reporting periods. We have made significant estimates of the purchase price, fair market value of the assets acquired and liabilities assumed in our acquisitions, clinical service revenues and costs, reserves for uncollectable accounts and contract losses and the value of our various investments. We continually evaluate the appropriateness of the amounts recorded and revise these estimates regularly. Actual results could differ from those estimates.

Accounts Receivable

     Accounts receivable balances represent trade receivables generated from health benefit management and related services. To reduce the potential for credit risk, the Company performs ongoing evaluations of its customer’s financial condition but does not generally require significant collateral. As of March 31, 2001 and 2002, unbilled receivables were $418.6 million and $495.7 million, respectively. Unbilled receivables to plan sponsors are typically billed within 15 days and unbilled receivables to manufacturers are typically billed within 90 days, based on the respective contractual billing schedule.

Goodwill and Other Intangible Assets

     We have adopted Statement of Accounting Financial Standards (SFAS) 142 effective April 1, 2001. Under SFAS 142 goodwill is no longer amortized. In addition, certain identified intangibles with indefinite lives are also not amortized, but are subject to periodic impairment testing. Amortization expense for the fiscal year ended March 31, 2002 was $10.9 million, which represented the amortization relating to the identified intangible assets with finite lives. Over the next five years, intangible amortization expense relating to these identified intangibles will be as follows (in thousands):

     Under SFAS 142 assembled workforce is not a recognized intangible asset and accordingly has been reclassified as goodwill. In addition, the trade name is deemed to have an indefinite life as it is expected to generate cash flows indefinitely. Accordingly, the trade name is no longer amortized. The effect of the adoption of SFAS 142 is summarized in the following table:

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     As required by SFAS 142 the results for the prior year’s financials have not been restated. Net income as if SFAS 142 had been adopted is presented below:

Acquisitions

     In January 2000, AdvancePCS acquired a 19% interest in Consumer Health Interactive, Inc. (CHI), an internet health portal development company, with an option to acquire the additional interest. Effective September 30, 2001 we acquired the remaining equity interests of CHI, which we did not previously own. The acquisition of the remaining interest was accounted for using the purchase method of accounting. The acquisition of the remaining 81% equity interest was completed with cash of $9.2 million, making CHI a wholly owned subsidiary. Under the terms of the acquisition we may pay additional cash upon the achievement by CHI of certain account growth targets. Prior to the complete acquisition of CHI, we had accounted for our 19% interest in CHI on the cost basis. In accordance with APB Opinion 18 all prior period financial statements have been restated to account for CHI as though we had accounted for our investment on the equity method.

     Effective August 1, 2001 we completed the acquisition of 100% of the equity of Dresing-Lierman, Inc. and its wholly owned subsidiary, TheraCom Inc. (collectively, TheraCom), a specialty pharmacy and distribution company located in Bethesda, Maryland. The aggregate purchase price paid was 1.3 million shares of our Class A common stock. An additional 384,006 shares of Class A common stock were placed in escrow, subject to release upon achievement of future financial performance. In addition, we paid $10.6 million to eliminate TheraCom’s outstanding indebtedness. The acquisition was accounted for using the purchase method of accounting. The excess of the purchase price paid over the net identifiable assets and liabilities of TheraCom, $39.1 million, was recorded as goodwill. We also recognized $4.7 million in intangible

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customer contracts. The portion of the purchase price allocated to the net identifiable assets and goodwill is preliminary and subject to revision following the results of an appraisal and further identification of intangible assets.

     On October 2, 2000 we completed the acquisition of PCS for an aggregate purchase price of approximately $1.0 billion, of which we paid Rite Aid, the seller, $675 million in cash and issued to Rite Aid $200 million in senior subordinated notes and $125 million in our convertible preferred stock. The cash portion of the purchase price was financed with the proceeds of an $825 million senior secured credit facility and $150 million in equity financing committed by JLL. In connection with the equity financing, we issued to JLL 65,854 shares of Series A-1 preferred stock for an aggregate purchase price of $65.9 million, six shares of Series B convertible preferred stock and 8.4 million shares of our Class A common stock for an aggregate purchase price of $84.1 million. On December 8, 2000, the six shares of Series B convertible preferred stock and the 8.4 million shares of Class A common stock automatically converted into 8.4 million shares of Class B-1 common stock. In connection with the senior subordinated notes, we issued to Rite Aid warrants to purchase 1.6 million shares of Class A common stock. The senior subordinated notes were fully redeemed on March 13, 2001. The warrants terminated upon repayment of the senior subordinated notes. The acquisition of PCS was accounted for using the purchase method of accounting. The excess of the purchase price paid over the net identifiable assets and liabilities of PCS was recorded as goodwill.

     Effective July 5, 2000, we completed a merger with FFI. We issued seven million shares of our Class A common stock in exchange for all of the outstanding shares of FFI. The merger constituted a tax-free reorganization and has been accounted for as a pooling of interests. The historical financial results have been restated in accordance with APB 16 to reflect the merger as though FFI had always been a part of AdvancePCS.

Sources of Revenue

     We group the revenues from all of our health improvement service offerings into three categories: data, mail and clinical services.

Data services

     Through our data services operations we process prescription claims on behalf of our health plan sponsor customers. When a member of one of our health plan sponsors presents a prescription or health plan identification card to a retail pharmacist in our network, the pharmacist accesses our online system to receive information regarding eligibility, patient history, health plan formulary listings and negotiated price. The member generally pays a co-pay to the retail pharmacy and the pharmacist fills the prescription. On behalf of our health plan sponsors, during each billing cycle, our systems electronically aggregate pharmacy benefit claims, which include prescription costs plus our claims processing fees. Once we receive payments from health plan sponsors, we remit the amounts owed by those health plan sponsors to the retail pharmacies and retain the claims processing fees.

     We have established a nationwide network of over 60,000 retail pharmacies, each of which pay an access fee to be included in our network. Our contracts with most of our health plan sponsors provide for member access to our retail pharmacy network. Under these contracts, we have an independent obligation to pay network retail pharmacies for the drugs dispensed, meaning we have assumed this risk. We are a principal in the transaction; therefore, we record the aggregate pharmacy benefit claim payments from our health plan sponsors as revenues and include prescription costs to be paid to retail pharmacies in cost of revenues.

     Some of our other customers have established their own pharmacy networks. Under contracts with these customers, we are not at risk for retail pharmacy payment obligations. Thus, we record only our claims processing fees as revenues and do not include prescription costs in revenues or cost of revenues.

     As a result, customers that use our network will generate higher revenues than customers that use their own networks. Similarly, while a customer who uses our network may contribute the same gross profit in terms of dollars as a customer that uses its own network, gross profit as a percentage of revenue will be significantly lower for the customer using our network because of the higher level of revenue we recognize.

Mail services

     We derive mail services revenues from the sale of pharmaceuticals to members of our customers’ health plans. These revenues include the cost of the pharmaceuticals plus a dispensing fee. Our cost of revenues includes product costs and other direct costs associated with the dispensing of prescription drugs.

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Clinical and other services

     We have historically derived our clinical revenues primarily from formulary management and administration of rebate and volume discount programs of pharmaceutical manufacturers relating to our PBM and consumer card operations. We record revenues in the amount of the fees we charge for our services and include the cost of such services in cost of revenues. Some of these revenues are based on estimates of rebates generated for our clients that are subject to final settlement with the manufacturer. In addition, we generate clinical revenues on a fee-for-service basis on the sale of our comprehensive health improvement products and services, including disease management, clinical trials and outcomes studies.

Results Of Operations — AdvancePCS

     The following table sets forth certain consolidated historical financial data of AdvancePCS. Historical revenues for AdvancePCS and PCS have been revised to reflect adoption of consistent revenue recognition policies as described above.

Fiscal Year 2002 Compared to Fiscal Year 2001

     Revenues. Our revenues for fiscal year 2002 increased by $6.1 billion, or 87%, compared to revenues for fiscal year 2001. The increase in revenues was primarily the result of our acquisition of PCS on October 2, 2000. Approximately $5.0 billion, or 82% of the increase in revenues was attributable to data services and a 69% increase in the number of pharmacy claims processed during the period. Claims processed increased from 269 million in fiscal year 2001 to 456 million for fiscal year 2002. Approximately 14% of the increase was attributable to additional sales of our mail pharmacy services, resulting from a 95% increase in the number of mail prescriptions dispensed. Mail pharmacy prescriptions dispensed increased from 5.7 million in fiscal year 2001 to 11.0 million for fiscal year 2002. The remaining 4% of the increase in revenues resulted from an increase in clinical and other services revenues derived from formulary and disease management services as well as clinical trials.

     Gross profit. Our gross profit for fiscal year 2002 increased by $222 million, or 97%, compared to the same period in fiscal year 2001. This increase was attributable primarily to the additional revenue and gross profit associated with the PCS acquisition. As a percentage of revenues, gross profit was approximately 3.5% in fiscal year 2002 compared to 3.3% in the same period in fiscal year 2001. The increase was due to a decrease in data services revenues as a percentage of total revenues. Data services revenues generally have a lower percentage margin than other services.

     Selling, general and administrative expenses. Our selling, general and administrative expenses for fiscal year 2002 increased by $60.3 million, or 47%, compared to the same period in fiscal year 2001. This increase is due to the acquisition of PCS and the comparison of six months of financial data in fiscal year 2001 to one full year of PCS expenses in fiscal year 2002 offset by the decrease in goodwill amortization of approximately $23.8 million as a result of the adoption of FAS 142 . Selling, general and administrative expenses as a percentage of revenues was approximately 1.4% in fiscal year 2002

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compared to 1.8% in fiscal year 2001. This was due to greater economies of scale from the integration of PCS and due to the increase in revenue associated with our data services. Additional revenues generated by customers using our network pharmacy providers typically do not result in a proportional increase in selling, general and administrative expenses.

     Non-recurring and impairment expenses. Net income for the year ended March 31, 2001 reflected a non-recurring charge of $11.1 million ($6.8 million after taxes, or $0.09 per diluted share) representing an impairment related to the combination of our mail facilities. Our mail facility in Richardson, Texas has been closed and operations moved to the Fort Worth and Birmingham facilities. In addition, the charges include severance costs for certain management employees that were terminated or resigned following and as a result of the acquisition of PCS. All of these severance costs to management employees were paid prior to March 31, 2001.

     Net income for the year ended March 31, 2002 reflected a non-recurring charge of $1.8 million ($1.1 million after taxes, or $0.01 per diluted share) primarily representing a write-off of the human resources software previously utilized by Advance prior to the acquisition of PCS and severance costs for certain employees that were terminated or resigned following and as a result of the acquisition with PCS.

     Interest income and interest expense. Interest expense, net of interest income, for fiscal year 2002 increased $15.7 million compared to the same period in fiscal year 2001. The increase resulted from the acquisition of PCS, which was partially funded by over $800 million in additional debt.

     Loss from joint venture. In February 2001, we entered into an agreement with Express Scripps and Merck-Medco, to form RxHub, LLC (RxHub) to develop electronic prescribing technology. We own one third of the equity of RxHub. We have recorded our investment in RxHub under the equity method of accounting and record our percentage interest in RxHub’s results in our Consolidated Statement of Operations. Our prorata share of RxHub’s loss for fiscal year 2002 was $2.9 million.

     Income taxes. For fiscal year 2002 our effective tax rate was approximately 39.5%. For fiscal year 2001 our recorded income tax expense approximated an effective tax rate of 52.8%. The difference in rates is primarily due to the amortization of non-deductible goodwill in fiscal year 2001, which is approximately $21 million. Goodwill amortization was not recorded in fiscal year 2002 due to the implementation of FAS 142.

     Extraordinary loss on early retirement of debt. In connection with the bank debt repayments made in fiscal year 2002 and the securitization, we recorded an extraordinary loss, associated with the early retirement of debt. The loss was attributable to a non-cash charge to write-off a portion of the deferred financing fees related to the secured bank agreement in the amount of $5.3 million, net of tax.

     Diluted net income per share. We reported diluted net income per share of $1.18 per share for fiscal year 2002 compared to $0.30 per share for the same period in fiscal year 2001. The weighted average shares outstanding were 72.4 million and 98.3 million for fiscal years 2001 and 2002, respectively. We issued securities convertible into common stock in connection with the PCS acquisition, resulting in an increase in weighted average shares outstanding. On August 23, 2001 we completed the sale of nine million shares of Class A common stock. In addition, during fiscal year 2002 we completed a two-for-one stock split effected in the form of a stock dividend of our common stock. Financial information and stock prices contained throughout the Form 10-K have been adjusted to reflect the impact of the stock split.

Fiscal Year 2001 Compared to Fiscal Year 2000

     Revenues. Our revenues for fiscal year 2001 increased by $5.2 billion, or 283%, compared to revenues for fiscal year 2000. The increase in revenues was primarily the result of our acquisition of PCS on October 2, 2000. Approximately $4.5 billion, or 86% of the increase in revenues was attributable to data services and a 232% increase in the number of pharmacy claims processed during the period. Claims processed increased from 81 million in fiscal year 2000 to 269 million for fiscal year 2001. The addition of PCS added approximately 160 million claims for the period. Approximately 10% of the increase was attributable to additional sales of our mail pharmacy services, resulting from a 239% increase in the number of mail prescriptions dispensed. Mail pharmacy prescriptions dispensed increased from 1.7 million in fiscal year 2000 to 5.7 million for fiscal year 2001. The addition of PCS’s two mail pharmacies accounted for approximately 91% of the increase. The remaining 4% of the increase in revenues resulted from an increase in clinical and other services revenues derived from formulary and disease management services as well as clinical trials.

     Gross profit. Our gross profit for fiscal year 2001 increased by $154 million, or 204%, compared to the same period in fiscal year 2000. This increase was attributable primarily to the additional revenue and gross profit associated with the PCS acquisition. As a percentage of revenues, gross profit was approximately 3.3% in fiscal year 2001 compared to 4.1% in the

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same period in fiscal year 2000. The decrease was primarily due to a substantial increase in data services revenues from the PCS acquisition, which have lower margins than other services.

     Selling, general and administrative expenses. Our selling, general and administrative expenses for fiscal year 2001 increased by $89.9 million, or 230%, compared to the same period in fiscal year 2000. This increase is due to the acquisition of PCS. Approximately $26.8 million of the increase is due to additional goodwill and other intangibles amortization associated with the PCS acquisition. Selling, general and administrative expenses as a percentage of revenues was approximately 1.8% in fiscal year 2001 compared to 2.1% in the same period in fiscal year 2000.

     Non-recurring and impairment expenses. Net income for the year ended March 31, 2001 reflected a non-recurring charge of $11.1 million ($6.8 million after taxes, or $0.09 per diluted share) representing an impairment related to the combination of our mail facilities. Our mail facility in Richardson, Texas has been closed and operations moved to the Fort Worth and Birmingham facilities. In addition, the charges include severance costs for certain management employees that were terminated or resigned following and as a result of the acquisition of PCS. All of these severance costs to management employees were paid prior to March 31, 2001.

     Interest income and interest expense. Interest expense, net of interest income, for fiscal year 2001 increased $39.0 million compared to the same period in fiscal year 2000. The increase resulted from the acquisition of PCS, which was partially funded by over $800 million in additional debt.

     Merger costs. Net income for fiscal year 2001 reflected a pre-tax charge of $1.2 million ($926,000 after taxes, or $0.01 per share) relating to merger costs incurred in connection with the merger with FFI.

     Income taxes. For fiscal year 2001 our effective tax rate was approximately 52%. For fiscal year 2000 our income tax expense approximated an effective tax rate of 38%. The effective rate for fiscal year 2001 was higher due to the non-deductible nature of the goodwill and other intangible assets acquired in the PCS acquisition.

     Diluted net income per share. We reported diluted net income per share of $0.30 per share for fiscal year 2001 compared to $0.37 per share for the same period in fiscal year 2000. The weighted average shares outstanding were 55.5 million and 72.4 million for fiscal years 2000 and 2001, respectively. The decrease in diluted net income per share resulted from additional interest expense and goodwill and other intangibles amortization in connection with the PCS acquisition. In addition, securities convertible into common stock were issued in connection with the PCS acquisition resulting in an increase in weighted average shares outstanding.

Unaudited Pro Forma Results of Operations for PCS Acquisition

     The following table sets forth certain unaudited pro forma financial data assuming the PCS acquisition occurred on April 1 of the periods presented. Historical revenues for AdvancePCS and PCS have been revised to reflect adoption of consistent revenue recognition policies as described in “- Changes in Revenue Recognition.”

Pro Forma AdvancePCS:

Fiscal Year 2002 Compared to Pro Forma Fiscal Year 2001

     Revenues. Our revenues for fiscal year 2002 increased by $1.8 billion, or 16% compared to the pro forma revenues for fiscal year 2001. Approximately $1.3 billion, or 71% of the increase in revenues was attributable to data services and a 4.5%

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increase in the number of pharmacy claims processed during the period. Claims processed increased from 437 million on a pro forma basis in fiscal year 2001 to 456 million for fiscal year 2002. Approximately 23% of the increase was attributable to additional sales of our mail pharmacy services, resulting from an 19% increase in the number of mail prescriptions dispensed. The remaining 6% of the increase in revenues resulted from an increase in clinical and other services revenues derived from formulary and disease management services.

     Gross profit. Our gross profit for fiscal year 2002 increased by $111.7 million, or 33%, compared to the same period in fiscal year 2001 on a pro forma basis. This increase was attributable primarily to the additional revenue and gross profit generated by the improvement in operations at our mail facilities. The improvement resulted from the closing of the Richardson, Texas mail facility along with the acquisition of PCS and the cost savings from the integration and streamlining of operations. As a percentage of revenues, gross profit was approximately 3.5% in fiscal year 2002, compared to 3.0% in the same period in fiscal year 2001 on a pro forma basis.

     Selling, general and administrative expenses. Our selling, general and administrative expenses for fiscal year 2002 decreased by $33.5 million, or 15%, compared to the same period in fiscal year 2001 on a pro forma basis. This decrease was due to losses of approximately $7 million that were incurred in connection with performance-based contracts in fiscal year 2001. Savings also came from the integration and synergies created by the PCS acquisition. Also, savings came from the implementation of FAS 142 and the related reduction in amortization of goodwill. As a percentage of revenue, selling general and administrative costs for 2002 were 1.4%, compared to 2.0% in the same period in fiscal year 2001 on a pro forma basis. If SFAS 142 had been adopted for the twelve months ended March 31, 2001, selling, general and administrative expenses would have been $199 million, or 1.8% of revenues on a pro forma basis.

     Non-recurring and impairment expenses. Net income for the year ended March 31, 2001 reflected a non-recurring charge of $11.1 million ($6.8 million after taxes, or $0.09 per diluted share) representing an impairment related to the combination of our mail facilities. Our mail facility in Richardson, Texas has been closed and operations moved to the Fort Worth and Birmingham facilities. In addition, the charges include severance costs for certain management employees that were terminated or resigned following and as a result of the acquisition of PCS. All of these severance costs to management employees were paid prior to March 31, 2001.

     Net income for the year ended March 31, 2002 reflected a non-recurring charge of $1.8 million ($1.1 million after taxes, or $0.01 per diluted share) primarily representing a write-off of the human resources software previously utilized by Advance prior to the acquisition of PCS and severance costs for certain employees that were terminated or resigned following and as a result of the acquisition with PCS.

     Operating income. Our operating income increased by $154.5 million, or 146%, for fiscal year 2002 compared to the same period in fiscal year 2001 on a pro forma basis. The increase resulted from the factors mentioned above as revenues improved and due to the integration and related synergies.

Liquidity and Capital Resources

     As of March 31, 2002, we had a working capital deficit of $236.4 million. The majority of our current obligations are not due until cash is collected from our customers. We use our excess cash balances to reduce debt under our revolving credit facility, which results in a net deficit in working capital. Our net cash provided by operating activities was $143.3 million for fiscal year 2002 resulting primarily from net income and also due to the timing of receivables and payables resulting from our continued growth. During fiscal year 2002, we used cash of $51.1 million for purchases of property and equipment associated with the growth and expansion of our systems and facilities.

     Historically, we have been able to fund our operations and continued growth through cash flow from operations. In fiscal years 2000, 2001 and 2002 our operating cash flow funded our capital expenditures and our short-term excess cash was used to reduce our debt or invested in money market funds. We anticipate that cash flow from operations, combined with our current cash balances and amounts available under our credit facility, will be sufficient to meet our internal operating requirements and expansion programs, including capital expenditures, for at least the next 18 months. However, if we continue our expansion, acquisition and alliance plans, we may be required to seek additional debt or equity financing in order to achieve these plans.

     In conjunction with our acquisition of PCS in fiscal year 2001, we obtained an $825 million senior secured credit facility that included a $175 million revolving credit facility, a $100 million interim revolving credit facility and two term notes totaling $550 million. Our $150 million Term A note accrued interest at LIBOR plus 2.75%, with escalating quarterly principal payments and was fully repaid in fiscal year 2002. Our $400 million Term B note accrues interest at LIBOR plus 3.25%, with quarterly principal payments of $381,000 until December 31, 2006 and payments of $36 million thereafter on each of December 31, 2006, March 31, 2007, June 30, 2007 and September 30, 2007. Our revolving credit facilities accrue

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interest at LIBOR plus 2%. The Term B note has been fully repaid as of June 5, 2002. The revolving credit facility expires on October 2, 2005. As of March 31, 2002, we had no amount outstanding under this revolving credit facility. The senior secured credit facility contains covenants that are typical for this type of loan. The Company is in compliance with all covenants. The senior secured credit facility has been unconditionally guaranteed, jointly and severally, by all of our subsidiaries. In addition, the senior secured credit facility is secured by a first priority lien on the stock of our subsidiaries and substantially all of our assets and the assets of our subsidiaries. Each subsidiary is 100% owned. There are no restrictions on the ability of the subsidiary guarantors to pay dividends or make loans or advances to the parent. We also issued to Rite Aid $125 million in convertible preferred stock substantially all of which was subsequently converted into Class A common stock and sold by Rite Aid. In addition, we issued $150 million in 8.4 million shares of common stock and 65,854 shares of convertible preferred stock to JLL. Also, we issued to Rite Aid $200 million in senior subordinated notes. In March 2001, the Company issued $200 million in 8 1/2 % Senior Notes Due 2008 (Senior Notes). The proceeds from this offering were used to retire the $200 million senior subordinated notes due 2010 that were issued to Rite Aid in connection with the PCS acquisition. The Senior Notes contain covenants that are typical for this type of debt. The Senior Notes have been unconditionally guaranteed, jointly and severally, by all of our subsidiaries, which are all 100% owned. There are no restrictions on the ability of the guarantors to pay dividends, make loans or advances to the parent.

     On August 23, 2001 we completed the sale of nine million shares of Class A common stock. The proceeds, net of offering costs, of approximately $291 million were used to reduce debt. The Term A debt of approximately $147 million was fully repaid and the remaining $144 million was used to repay a portion of the outstanding Term B debt. In addition, during the three-month period ended September 30, 2001, our preferred stockholders converted their preferred shares totaling 65,854 shares into 6.6 million shares of Class B-1 common stock.

     In December 2001, we securitized certain of our accounts receivable pursuant to a $150 million facility (the Asset Securitization Facility). The $150 million commitment under the facility is due December 10, 2006. The Asset Securitization Facility incurs interest at the funding agent’s A-1+/P-1 commercial paper rate plus .65%. As of March 31, 2002, we had drawn $150 million under this facility. The Asset Securitization Facility is included in our debt balance as of March 31, 2002 and will continue to be reflected “on-balance sheet”. The proceeds were used to repay $150 million of our Term B debt. In addition, our $100 million interim revolving credit facility was eliminated. As of March 31, 2002 our debt consists of the following in thousands:

     In addition, we have a $175 million revolving credit facility that expires in 2005. As of March 31, 2002, no amounts were drawn on this revolving facility. In connection with the bank debt repayments made in the second and third quarters of fiscal year 2002 and the securitization, we recorded an extraordinary loss, associated with the early retirement of debt. The loss was attributable to a non-cash charge to write-off a portion of the deferred financing fees related to the secured bank agreement in the amount of $5.3 million, net of tax.

     On June 5, 2002 we completed an increase in our Asset Securitization Facility. The $150 million commitment under the facility was expanded to $300 million and is due December 10, 2006. The Asset Securitization Facility now incurs interest at the funding agent’s A-1+/P-1 commercial paper rate plus .85%. The Asset Securitization Facility is included in our debt balance as of March 31, 2002 and will continue to be reflected “on-balance sheet”. We used the proceeds to repay the remaining $150 million of our Term B note.

     Effective April 1, 2001 we adopted SFAS 133 “Accounting for Derivative Instruments and Hedging Activities”, as amended by SFAS 137 and SFAS 138. In order to hedge variable rate interest payments made in conjunction with our debt we entered into interest rate protection agreements that have fixed the LIBOR rate as of November 7, 2000 at 6.60% for $400 million. The notional amount dropped to $300 million in October 2001 and drops to $200 million in October 2002. We have declared these agreements fair value hedges in accordance with SFAS 133, as amended and have recognized the fair value of these financial instruments in the condensed consolidated balance sheet effective April 1, 2001 upon adoption of SFAS 133. As a portion of the debt interest rates and underlying index of the interest rate protection agreements do not coincide, we test for hedge effectiveness using the hypothetical derivative method. The results of this test at March 31, 2002 indicate that the hedge is highly effective and any ineffectiveness is not significant to the results of operations. These instruments have been marked to market at March 31, 2002 with the adjustment recognized as a component of other comprehensive income in stockholders’ equity. The fair value of our interest rate swaps, a liability of $14.5 million at March 31, 2002, was based upon quoted market prices. Under SFAS 133, we have recorded a charge to other comprehensive income of $8.8 million, net of taxes, for the fiscal year ended March 31, 2002.

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     The following table sets forth our schedule of current maturities of long-term debt, excluding the deferred interest rate swap gain or loss of $14.5 million at March 31, 2002, and future minimum lease payments due under noncancellable operating leases (in thousands):

     Additionally, we continue to evaluate the scope of modifications of our information systems needed to comply with applicable HIPAA rules. We expect that HIPAA requirements will result in additional capital expenditures over the level required for maintenance and growth of our operations though 2003, which is the scheduled deadline for HIPAA compliance. We do not expect costs associated with HIPAA to materially impact our financial condition, results of operations or cash flows.

Related Party Transactions

     In fiscal 2001 and 2002, the Company had an interest bearing note receivable of $500,000 and $400,000, respectively, due from an executive officer of the Company issued in conjunction with his relocation as a result of the acquisition of PCS.

Recent Accounting Pronouncements

     In June 2001, the FASB issued SFAS 143, “Accounting for Asset Retirement Obligations”. SFAS 143 addresses financial accounting and reporting for obligations associated with the retirement of tangible long-lived assets and the associated asset retirement costs. It applies to all entities and legal obligations associated with the retirement of long-lived assets that result from the acquisition, constructions, development and/or the normal operation of a long-lived asset. SFAS 143 requires that the fair value of a liability for an asset retirement obligation be recognized in the period in which it is incurred if a reasonable estimate of fair value can be made. The associated asset retirement costs are capitalized as part of the carrying amount of the long-lived asset and are subsequently allocated to expense over the asset’s useful life. This statement is effective for the financial statements issued for fiscal years beginning after June 15, 2002. We have not yet determined the impact that SFAS 143 will have on its financial position or results of operations.

     In August 2001 the FASB issued SFAS 144, “Accounting for the Impairment or Disposal of Long-Lived Assets”. SFAS 144 addresses financial accounting and reporting for the impairment of long-lived assets and for long-lived assets to be disposed of. This statement supersedes SFAS 121, “Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed Of”; however, this statement retains the fundamental provisions of SFAS 121 for (a) recognition and measurement of the impairment of long-lived assets to be held and used and (b) measurement of long-lived assets to be disposed of by sale. This statement also supersedes the accounting and reporting provisions of APB Opinion 30, “Reporting the Results of Operations Reporting the Effects of Disposal of a Segment of a Business and Extraordinary, Unusual and Infrequently Occurring Events and Transactions” for segments of a business to be disposed of. SFAS 144 is effective for fiscal years beginning after December 15, 2001. We do not believe that the adoption of SFAS 144 will have a material effect on our financial position or results of operations.

     In May 2002, the FASB issued SFAS No. 145 “Rescission of FAS Nos. 4, 44, and 64, Amendment of FAS 13, and Technical Corrections as of April 2002.” This Statement rescinds FASB Statement No. 4, Reporting Gains and Losses from Extinguishment of Debt, and an amendment of that Statement, FASB Statement No. 64, and Extinguishments of Debt Made to Satisfy Sinking-Fund Requirements. This Statement also rescinds FASB Statement No. 44, Accounting for Intangible Assets of Motor Carriers. This Statement amends FASB Statement No. 13, Accounting for Leases, to eliminate an inconsistency between the required accounting for sale-leaseback transactions and the required accounting for certain lease modifications that have economic effects that are similar to sale-leaseback transactions. This Statement also amends other existing authoritative pronouncements to make various technical corrections, clarify meanings, or describe their applicability under changed conditions. SFAS 145 is effective for fiscal years beginning after May 15, 2002. The Company has not yet determined the impact that SFAS No. 145 will have on its financial position or results of operations.

Impact Of Inflation

     Changes in prices charged by manufacturers and wholesalers for pharmaceuticals we dispense affect our cost of revenues. Historically, we have been able to pass the effect of such price changes to our customers under the terms of our agreements. As a result, changes in pharmaceutical prices due to inflation have not adversely affected us.

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ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

     The Company has not entered into derivatives or other financial instruments for trading purposes. We have entered into interest rate protection agreements (interest rate swaps — see Note 2 to the condensed consolidated financial statements) that have fixed the LIBOR rate as of November 7, 2000 at 6.60% for $400 million of our variable rate debt under our credit facility. The notional amount dropped to $300 million in October 2001 and drops to $200 million in October 2002. We use the interest rate swaps to manage our interest rate risk on future interest payments. In addition the Company has $200 million of 81/2% Senior Notes outstanding. As a result, virtually all of our debt is effectively fixed rate debt as of March 31, 2002. Due to these measures a change in interest rates would have no material effect on our statement of operations but could impact the fair value of debt outstanding relative to current market rates.

     A sensitivity analysis is used to determine the impact interest rate changes will have on the fair value of the interest rate swap, measuring the change in the net present value arising from the change in the interest rate. The fair value of the swap is then determined by calculating the present value of all cash flows expected to arise thereunder, with future interest rate levels implied from prevailing mid-market swap rates. Anticipated cash flows are then discounted on the assumption of a continuously compounded zero-coupon yield curve.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

     The information required by this item is found on pages F-1 through F-26 hereof.

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE

Previous Independent Accountants

     After a competitive bid process that began in September 2001, AdvancePCS dismissed Arthur Andersen LLP as its independent accountants effective February 12, 2002. AdvancePCS’s Audit Committee and Board of Directors participated in and approved the decision to change independent accountants. Arthur Andersen LLP’s audit reports on the AdvancePCS’s financial statements for the two most recent fiscal years did not contain an adverse opinion or disclaimer of opinion and no such report was qualified or modified as to uncertainty, audit scope or accounting principles. In connection with its audits for AdvancePCS’s two most recent fiscal years and through February 12, 2002, there were no disagreements between AdvancePCS and Arthur Andersen LLP on any matter of accounting principles or practices, financial statement disclosure or auditing scope or procedure, which disagreements if not resolved to the satisfaction of Arthur Andersen LLP would have caused them to make reference thereto in their report on the financial statements for such years. During the Company’s two most recent fiscal years and through February 12, 2002, there have been no reportable events as defined in Item 304(a)(1)(v) of Regulation S-K. AdvancePCS requested Arthur Andersen LLP to furnish it with a letter addressed to the Securities and Exchange Commission stating whether it agrees with the above statements made by the Company. A copy of such letter, dated February 15, 2002, was filed as Exhibit 16 to AdvancePCS’s Current Report on Form 8-K, dated as of February 12, 2002.

New Independent Accountants

     AdvancePCS engaged PricewaterhouseCoopers LLP as its new independent accountants as of February 12, 2002. During the two most recent fiscal years and through February 12, 2002, AdvancePCS did not consult with PricewaterhouseCoopers LLP regarding any of the matters or events set forth in Item 304(a)(2) of Regulation S-K.

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PART III

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

     The information required by this item will be incorporated by reference to our definitive proxy statement for our 2002 annual meeting of stockholders (the “Proxy Statement”) to be filed with the Securities and Exchange Commission not later than 120 days following our fiscal year pursuant to Regulation 14A.

ITEM 11. EXECUTIVE COMPENSATION

     The information required by this item will be incorporated by reference to the Proxy Statement.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

     The information required by this item will be incorporated by reference to the Proxy Statement.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

     The information required by this item will be incorporated by reference to the Proxy Statement.

PART IV

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K